EU has credit rating agencies in its sights

While Europe's attention has this week focused on Greece and the possibility that it might need to borrow more funds to avoid defaulting on its debts, another struggling eurozone economy has indicated its unwillingness to accept austerity-flavoured medicine without a fight – writes Daniel Mason.

Reports have surfaced that Portuguese authorities are conducting an investigation to determine whether there is any evidence that could lead to criminal charges being brought against the credit rating agencies Moody's, Fitch and Standard & Poor's. The attorney general's office is acting on a complaint made by four academics who contend that the big three CRAs have caused Portugal severe financial damage and are too dominant in the credit ratings market.

Perhaps this is merely an expression of bitterness and frustration from within a country that has just negotiated a €78bn bailout from the European Union and International Monetary Fund – and has suffered downgrade after downgrade while the cost of government borrowing has soared.

The Greek government has also reacted angrily to recent downgrades. When S&P cut Greece's rating to BB- in March, Prime Minister George Papandreou said the agencies were "seeking to shape our destiny and determine the future of our children". But it is not only in periphery EU countries that questions are being raised about the role CRAs have played in the financial crisis.

The American firms Moody's and S&P together account for 80 per cent of the CRA market. Fitch, with headquarters in both London and New York, has a market share of 12 per cent. They provide opinions on a company or country's ability to meet its debt obligations – opinions on which investors rely. If a country is downgraded it means it is considered a greater risk, so the government will be charged higher interest rates on the money it borrows.

Their influence has been causing concern for EU decision makers throughout the eurozone crisis. Marking an earlier downgrade suffered by Greece an EU spokesman said: "We, of course, expect the credit rating agencies, like all other financial players, and in particular during this very difficult and sensitive period, to act in a responsible and rigorous way." The criticism was thinly veiled.

Members of the European Parliament have been still more outspoken. Leader of the Socialists and Democrats group Martin Schulz said the CRAs "have no morals". He added: "Those who placed bets on the failure of the euro on international markets want to win those bets. We have to make sure these people lose their bets on the markets. We have to make sure we win this battle."

Nikos Chountis, a Greek member of the GUE/NGL group described CRAs as a "mafia of speculators," adding: "With the outbreak of the crisis the EU recognised the negative role played by rating agencies so one would expect the commission to restrict the role of CRAs in some way."

And Chountis' colleague Jürgen Klute said that lessons had not been learnt. "They failed in the crises of the 1990s, they failed again in the Enron case, they provided incorrect assessments of financial products based on US mortgages in 2007 and they kept on giving Lehman Brothers high ratings, although the investment bank was already teetering." He said CRAs should have warned about the danger of financial crisis well before it happened.

It is an opinion shared by many Americans, where commentators and academics – and a congressional report – have pointed the finger of blame at CRAs for their role in the subprime mortgage crisis which triggered the recession, as well as for giving Enron a clean bill of health right up until its collapse in 2001.

In the New York Times last month Robert M Fishman, a professor of sociology at the University of Notre Dame, wrote that rating downgrades have become a "self-fulfilling prophecy: by raising Portugal's borrowing costs to unsustainable levels, the rating agencies forced it to seek a bailout". He has called for tighter regulation of the sector on both sides of the Atlantic.

And tighter regulation seems to be the direction in which the EU is moving. A regulation adopted in 2009 has now come into force which mandates that every CRA be registered and subjected to supervision and rules on governance. A new body created in January, the European Securities and Markets Authority, will regulate the market. It will have powers to fine CRAs up to 20 per cent of their previous year's turnover and make dawn raids, as well as ensuring that previous predictions are evaluated. The agencies have not yet been registered, though, and there have been delays implementing the regulations.

But the EU already wants to go much further. In March, Commissioner for Internal Market and Services Michel Barnier and Commissioner for Economic and Monetary Affairs Olli Rehn, issued a joint statement. They said: "Last year, we improved the framework by requiring that credit rating agencies be supervised directly by ESMA, the new European authorities for markets. The full implementation of the 2009 regulation including effective supervision by ESMA of ratings methodology and ratings quality is a big improvement already. But as we have often said, that is not enough. And a further overhaul of rules applicable to credit rating agencies is necessary."

New proposals are being devised that will be brought forward later this year and concentrate on creating more competition, reducing the reliance on CRAs, improving ratings methodologies and dealing with conflicts of interests.

One possibility is the creation of an independent EU rating agency. It is an option favoured by the Socialists and Democrats. Gianni Pittella MEP said: "The impact on financial markets of credit agencies continues to raise many concerns, especially when it comes to their assessments of sovereign debt risks. These are the agencies that failed to foresee the financial crisis of 2008 but that exercise worrying influence over the markets as we attempt to exit the crisis.

"For example, the decision of Moody's to downgrade Spanish debt, right before the government announced plans to recapitalise Spanish saving banks, is troubling. Moody's also downgraded Greece on the eve of a crucial European summit, while the government was negotiating new measures for its austerity programme."

His colleague Udo Bullmann MEP added: "These events confirm that the EU needs new rules. We can't leave these agencies to do what they want without control. The S&D group will fight to strengthen the independence of the rating system including through a public European rating agency."

The commission's proposals will be informed partly by a report adopted by the parliament's Economic and Monetary Affairs Committee in March. It also calls, among other things, for the establishment of an independent European Credit Rating Foundation.

The report's author, German MEP Wolf Klinz, said: "A European credit rating agency is only advisable if it is fully independent and free from influence from public or other bodies. The idea behind an independent European Credit Rating Foundation is to foster competition in the quasi-oligopolistic industry structure where three globally active firms dominate the market." The commission has hinted that it supports the idea, although the European Central Bank has been less enthusiastic.

Presenting his report, Klinz said: "The key problem however was that credit rating agencies both rated these assets and at the same time were rendering advice services to the clients who were paying for the rating. This conflict of interest is at the core of the problem.

"Credit rating agencies cannot simply state that their ratings are mere expressions of opinions, but they have to assume responsibility for their judgments. Furthermore, the blind over-reliance by market players on ratings has led to dependency on credit ratings in financial markets and little to no own risk assessment from financial actors. We need to restore investors' ability and willingness to conduct their own due diligence and risk assessment."

Greece, €327bn in debt, had its rating cut again this week by S&P from BB- to B, putting it on a par with Belarus and below some developiong countries. Moody's has said it might follow suit, and the value of the euro took a hit.

The Greek government immediately issued a statement saying the move "comes at a time when there have been no new negative developments or decisions since the last rating action by the agency just over a month ago and therefore is not justified". Rightly or wrongly, as governments and the EU as a whole naturally look for someone to blame for the eurozone crisis, they have the credit rating agencies in their sights.