Sovereign Credit Ratings: EUC Report
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Lord Harrison
To ask Her Majesty’s Government what is their response to the Report of the European Union Committee on Sovereign Credit Ratings: Shooting the Messenger? (21st Report, HL Paper 189).
Lord Harrison
My Lords, I bring to the House’s attention Sovereign Credit Ratings: Shooting the Messenger?, a report of the European Union’s Sub-Committee on Economic and Financial Affairs, and International Trade, which I have the honour to chair.
As noble Lords will be aware, credit rating agencies have had a very high profile since the banking crisis erupted in 2008, in relation to which there has been widespread and, in the committee’s view, deserved criticism of their role. When the banking crisis hit, the rating agencies were revealed to have woefully underestimated the risk that complex financial products, such as mortgage-backed securities, posed. Thus we were told in the evidence that some securities that carried an AAA rating one day were downgraded to a CCC the next. Indeed, many commentators accused the rating agencies of contributing to the severity of the crisis.
In the crisis aftermath, many sovereigns, as well as the European Union, sought to sharpen regulation of the credit rating industry. In the European Union this led to the creation of the European Securities and Markets Authority, or ESMA. With the reputation of the credit rating agencies yet to recover, many people were quick to blame them for exacerbating the European Union sovereign debt crisis after it intensified in 2009. They were accused of failing to predict the crisis, and then of precipitating it by downgrading the ratings of euro area sovereigns too far and too fast. In the midst of this, the Commission in November 2010 launched a public consultation to discuss the need for further regulation in the credit rating industry and invited views on proposals to foster a European credit rating foundation which might challenge the oligopoly of the major rating agencies.
In April 2011, and in the light of these developments, our committee launched this inquiry, seeking to analyse the interaction between the credit rating agencies and sovereign debt, with a particular focus on the role of the CRAs in the euro area crisis. We took evidence during May and June from representatives of the “big three” rating agencies—Fitch Ratings, Moody’s and Standard & Poor’s; from representatives of the OECD and the International Centre for Financial Regulation; from Dr Wolf Klinz, the European Parliament rapporteur; and from the Financial Secretary to the Treasury, Mark Hoban. We also received a welter of additional useful written evidence, for which we are grateful. Our report was published in July and we are pleased that the Government’s response now brings this debate to the Chamber tonight.
The committee concluded that the rating agencies could not be accused of precipitating the euro area crisis. Their downgrades, in reality, reflect the seriousness of the problems that some member states currently face. Indeed, in most cases the CRAs followed, rather than led, market sentiment. We acknowledged that downgrades can, in certain circumstances, exercise a disproportionate influence on markets, exacerbating existing fragile situations. However, whether this happened in relation to the euro area crisis is more difficult to determine. Yet the committee did conclude that the credit rating agencies conspicuously failed to challenge the assumptions on which their assessment of the sustainability of sovereign debt was based in the years running up to the crisis. They palpably failed to identify risks in some member states which began building up long before the crisis hit. However, they were not alone in that misjudgment.
The committee has two central concerns apart from the ones that I have expressed. The first relates to the extent, or otherwise, of competition in the industry. We concluded that the credit rating agency industry is, at present, an oligopoly. The stranglehold of the largely United States-based big three has proved impossible to break. This is not for want of trying on the part of some. As I have already mentioned, the Commission has floated the possibility of the establishment of a European credit rating agency, whose start-up costs could be,
“wholly or partially covered by the public sector”,
although over time,
“public investment could … be phased out”.
The European Parliament Committee on Economic and Monetary Affairs raised the possibility of an independent, non-publicly funded European credit rating foundation. We concluded that there was a compelling argument for a thorough competition inquiry into the structure and regulation of the credit rating industry, but we also felt that the European Union should not fund, either initially or in the long term, a credit rating agency. An EU-sponsored credit rating agency would simply lack credibility with the markets.
Our second concern relates to the use of credit ratings. Sovereign ratings can play a useful role that contributes to the smooth, efficient working of the worldwide sovereign debt market. However, there is a compelling need to reduce the mechanistic role that credit ratings play in regulations, investment mandates and private contracts. This hardwiring of ratings leads to knee-jerk rating changes which can cause deleterious cliff-edge effects, herd behaviour among investors and systemic disruption. Indeed, there is an overwhelming imperative for investors to see sovereign ratings for what they ultimately are: subjective provisions that rely heavily on the personal judgments of rating agency staff. Investors should not follow ratings blindly but should view them as opinions that need to be balanced and confirmed by other market indicators. Responsibility for investment decisions ultimately lies with investors, and they should bear in mind the principle of “caveat emptor”—buyer beware—when deciding how much reliance to place on the judgment of rating agencies.
Where, then, do we stand today? We have received the Government’s response to our report and I am heartened that they agree with so many of the committee’s recommendations. I am sure that the Minister will want to elaborate on the Government’s position.
The question now turns to the Commission. Given that ESMA has only recently taken over the direct regulation of credit rating agencies, we argued in the committee that the new system should be given time to bed down and its effectiveness should be assessed before further changes are made. Yet Commissioner Barnier has pressed the case for further regulation of rating agencies for some time now and today—as if to prove the timeliness of this evening’s debate and the fact that he has obviously read our report—he launched the Commission’s latest proposals. Significant among them is the decision to postpone the proposal to suspend the credit ratings of sovereigns receiving funds. I would like the Minister to respond to that in particular. I underline the fact that, as I understand it, the suggestion is only to postpone the proposal. The Commission also has ambitions to reduce the overreliance on credit ratings, to improve the quality of the rating process and to promote the general obligation on investors to do their own assessment. I hope that the Minister will respond to those three ambitions.
There is also the question that ESMA might be communicated with by the credit rating agencies. That flies in the face of what we said on the committee—that 12 hours is a sufficient break and we do not require the three-day break that might confuse the markets even more because something might be said out of turn. We need more diversity and stricter independence of the credit rating agencies and, again, I ask the Minister to respond to the question of competition.
This is an important issue. Recently the credit rating of France was reduced from AAA, with deleterious effects on the markets. We need to be serious about this. I hope that we can have a good debate and that the Minister will be able to respond to the Commission’s proposals.
Baroness Noakes
My Lords, I had not originally intended to take part in today’s debate. I had seen the report of the EU sub-committee chaired by the noble Lord, Lord Harrison, and agreed with its balanced view and recommendations. I also agreed with the Government’s response to that report. Then I noticed, as the noble Lord, Lord Harrison, has already pointed out, that the noble Lord has cleverly timed this debate to coincide with the expected announcement of the EU Commission’s latest regulatory onslaught on credit rating agencies. So here I am.
I start from the position that we have to push back at the relentless tide of regulation from Europe and that any more regulation has to have the highest level of justification. I also believe we should make a start on returning powers to the UK, but stopping further regulation from Europe is not a bad place to start.
Looked at dispassionately, it is not clear that the rating agencies deserve the degree of punishment that has been meted out to them in the wake of the global financial crisis. Both Europe and the G20 needed scapegoats to cover up the fact that neither Governments nor their regulatory and prudential agencies had the faintest idea of the financial mayhem that was stalking the world in 2007. So the credit rating agencies, which certainly did not cover themselves in glory in relation to structured financial products in that period, ended up subject to a range of regulatory interventions and technical standards.
As is well known, the European Commission has never intended to let the financial crisis go to waste. The noble Lord, Lord Harrison, and I attended a breakfast briefing last week where a senior member of the Commission’s staff positively bragged that the crisis had led to 29 pieces of legislation affecting the financial services sector. His justification for this onslaught was, to say the least, minimal, but he evidently relished the opportunity to increase the regulatory reach of Brussels, and credit rating agencies have been caught up in this Commission land grab.
As the noble Lord, Lord Harrison, has noted, the Commission now wants to ratchet up the regulatory pressure on the rating agencies even further. This appears to be retaliation for their alleged failings in relation to the stressed eurozone economies. There is no doubt that Ireland, Portugal, Greece, Spain and Italy have not enjoyed having their credit ratings reduced—the reductions were late and sudden—but those countries had to face up to the fact that their credit ratings had been overstated for too long.
I completely agree with the report of the sub-committee chaired by the noble Lord, Lord Harrison, that the credit rating agencies did not precipitate or exacerbate the euro area crisis. I also agree that they did a rather bad job of not identifying the real risks in those economies. However, this is not a sufficient excuse for additional regulation.
It took me rather a long time today to confirm whether Commissioner Barnier did in fact launch his latest round of regulatory assault on the credit rating agencies. In fact, one blog this afternoon reported that Commissioner Barnier himself had been downgraded from “punctual” to “tardy” because he was late for the relevant press conference. However, a couple of hours ago I managed to track down a one-page summary of the proposals.
As the noble Lord, Lord Harrison, has noted, one of the things being mooted as part of the proposals is one which would allow credit rating agencies to be silenced if a country was in some kind of crisis intervention. That idea should have been killed at birth and never taken into the heart of EU policy-making. Constraining the credit rating agencies from placing their sovereign debt evaluations in the market is contrary to free speech. It is also impractical because the rating agencies would presumably have to declare that they were unable to issue a rating, which could well trigger a panicked response in the sovereign debt markets. The creation of an information void—or, at least, one with only government-controlled information—is likely to have the worst possible effect on credit markets. Fortunately, the Commission has stepped back from the brink on this and the matter is now marked, in the summary that I saw, as “for further consideration”. I hope that that means that the proposal is gone for good, but we have yet to see.
A dodgy proposal that has survived is that of compulsory rotation of rating agencies every three years or every 10 issues. I share the view of the committee and the Government that greater competition in the rating agency market would be a good thing, but there are problems with the rotation proposals. First, as most issuers already use more than one agency, the impact of the rotation proposal is huge turbulence in what is a very small market. It might well give the smaller agencies an opportunity to improve their position, but does that end actually justify the means? Creating further competition through turbulence has no respectable precedent.
Secondly, there are likely to be real impacts. Certainly, issuers will be faced with varying increased internal costs in dealing with additional rating agencies, possibly annually if they do a lot of issues. More importantly, it is far from clear that the markets which look to credit agencies will accept any new players at face value. Disruption in corporate credit markets, and through that disruption in the real economy, may be the only certain result of these proposals. It is not surprising that the Association of Corporate Treasurers is deeply concerned about these proposals and it wrote to the Commission in clear terms recently. It was disappointing and unsurprising in equal measure that Commissioner Barnier’s spokesman dismissed the association’s views as “a typical lobbying move” that “smacks of desperation”.
A further bad idea is the proposal to create a European framework for civil liability. The sub-committee chaired by the noble Lord, Lord Harrison, had it right when it said that civil liability is best left to member states. It is clear that S&P’s foolish error last week on the rating of France has touched a raw nerve, and has strengthened the resolve of those at the heart of the European project to control and punish credit rating agencies. But anybody who has looked at France’s economic position might marvel that it has hitherto escaped the analytical stringency applied to others in the eurozone. Credit spreads are now telling their own story on France. The mistake was unfortunate, but do we want a credit rating sector terrified of making a mistake, or one which is not prepared to boldly challenge received wisdom? What the markets want and what, for example, France might want, may not coincide. I have not had time to look in detail at the Commission’s proposals in this area, but I hope that they do not live up to the rhetoric of punishing mistakes that was being bandied about last week.
The only good aspect of the latest proposals is that the Commission has dropped the barmy idea of establishing the European credit rating foundation, which the noble Lord, Lord Harrison, has referred to. I understand from the press that there is now a suggestion in Brussels that another non-credit rating agency approach might be adopted, possibly using, for example, the European Court of Auditors. Will the Minister say whether the Government will give any support to an EU move to take credit rating agencies out of sovereign debt ratings? More generally, will my noble friend say whether these new proposals from the Commission will be subject to the UK’s veto, or can they be bulldozed through by qualified majority voting?
The Government’s official response to the committee’s report agreed with the committee that further changes should take effect only once the existing raft of changes had had time to bed in. Will my noble friend confirm that the Government will stick to that position?
Lord Myners
My Lords, I congratulate my noble friend Lord Harrison and his committee on the excellent work that they have done on this issue. They have produced a flawlessly argued case which, on the whole, the Government have very sensibly accepted in their written response. I share with the noble Baroness, Lady Noakes, a great interest in how the Minister will respond to what the Government have said.
I am delighted to see the Minister here as I was a little worried that the noble Lord may himself have been downgraded. The appointment of the noble Lord, Lord Green of Hurstpierpoint, as a member of the Treasury team was relayed to us in a press release issued very quietly by the Treasury and was not given a lot of publicity. He is to give advice to the Chancellor on issues relating to banking, which seems to me to be the job that the noble Lord, Lord Sassoon, was doing. I am delighted to see that the noble Lord, Lord Sassoon, is here and that he has not been downgraded, which would have been a great disappointment to me and to other Members of the House. It would be interesting to know why his advice on banking is not sufficient for the Chancellor, and why the Chancellor now needs the noble Lord, Lord Green, to be a member of the Treasury team.
As the noble Baroness, Lady Noakes, said, credit rating agencies have, to some extent, been used as scapegoats by those who should have taken responsibility for policy errors but instead sought to deflect the blame on to others. The credit rating agencies clearly played a lamentable role in the rating of SIVs, CDOs and other packaged products. They engaged in misdirected behaviour, employed flawed processes and had a business model based on suspect economics: the issuer pays protocol. Some would say, in respect of sovereign debt, that the case is not proven as to whether the rating agencies also had a role in triggering some element of the sovereign crisis. I am more inclined to give the rating agencies the benefit of the doubt and to say that they did not play any significant part in causing the sovereign crisis.
Here I disagree with paragraph 22 of the committee’s report, which says that credit rating agencies play a role in determining the cost to governments of borrowing. They simply do not. The realistic situation of the borrowing nation’s capacity to pay determines the price it pays for credit. The thermometer does not trigger the fever. The credit rating agencies measure the likelihood of repayment. They certainly do not have any impact on the cost of credit. Again, at the risk of giving even more credit to the noble Baroness, Lady Noakes, she was absolutely right in pointing to the case of France, where the credit rating agencies may say one thing about the rating of that country but the pricing of its debt in the markets says something rather different in terms of differentiation between France and Germany, the quality of covenant and the capacity to honour debt obligations.
The reality is that credit rating agencies are a lagging indicator rather than a leading one. They tend to verify the market’s judgment rather than to lead it. We should not be terribly surprised by that. My experience is that, on the whole, credit rating agencies employ rather average people. They are given extraordinary status by Mr Peston and others on television when they talk about changes in rating, but quite frankly, if you are good at the job, you work in an investment bank, a bank or a hedge fund; you do not work for Fitch, Standard & Poor’s or Moody’s. On the whole, these are at best average folk. They express opinions. Their opinions are worth little more than many other opinions—certainly a lot less than those of people who make decisions with real money or authoritative commentators such as Mr Martin Wolf in the Financial Times and others. In many ways, these credit rating agencies are of little consequence at all. We should probably not spend too much time on them, except that they tend to be taken rather seriously by the media and—more importantly—regulators.
We need to understand the way in which the credit rating agencies are hardwired at the moment into regulatory architecture and find a way to eliminate the central role that they play. In that respect, we should strongly support international efforts to reduce the role of credit rating agencies in helping to determine risk-weighted assets and other important calculations that feed into Basel and other capital requirements. Unfortunately, the role of the credit rating agencies is rather helped in this respect by their standing in America, under the SEC regulations, as nationally recognised agencies or quasi-regulatory authorities. This is a deep lacuna. I urge the Financial Policy Committee of the Bank of England to look at the role of credit rating agencies and see whether we can find a way of taking them out of the central role that they currently play.
The implementation of the credit rating agency directive will be in the hands of the European Securities and Markets Authority—ESMA. This has only recently been established but is an important agency because it will exercise direct regulatory authority. I hope the Minister will correct me if I am wrong here, but I believe that ESMA has the power to overrule national regulatory agencies. In other words, the FSA is subordinate to ESMA and could not, if it wished to, introduce higher standards. ESMA has been clear that it intends to ensure that its rules are enforced uniformly across the EU and in so doing will limit the ability of individual countries to require additional measures. Mr Steven Maijoor, the chair of ESMA, was quoted in the Financial Times recently as saying that,
“we are moving toward common supervisory standards”.
The regulations will not be based on the UK’s “comply or explain”. They will be enforced on all national regulatory agencies by ESMA. I would welcome an assurance from the Minister that he will stand up for self-determination of regulation in the UK and not allow us to be steamrollered by ESMA or any other part of the European regulatory architecture.
We saw some very flawed thinking from the European Commission on credit rating agencies—that there should be a government-sponsored CRA, the banning of the publication of ratings, and the pre-approval of methodology, which implies again some process by which these become nationally recognised outcomes rather than the opinions of rather average people. I worry very much about Mr Barnier. I met Mr Barnier when he was a Minister. He came to see us at the Treasury. He came down the corridor and I was watching him. I am a great fan of art and I was rather impressed that he stopped to look at every painting. I thought this is a man with whom I share a common interest—until I realised he was actually looking at his reflection in the glass on every painting, and adjusting his hair or his toupee. This to me is a man whom we should treat with a very long spoon. I hope the Minister will take due care in working with Mr Barnier because we have been forewarned that this man intends to seek even more powers than those he announced today. He said he wants to return to the issue of censoring rating agencies. I sincerely hope that the Government and the Opposition would have no part in endorsing such an activity.
The Financial Secretary to the Treasury—it is not the noble Lord, Lord Sassoon, but Mr Hoban—said in his letter to the noble Lord, Lord Roper, on 28 September that he would be reporting back to us on the work of the Financial Stability Board on rating agencies,
“which was due to report in mid September”.
He actually wrote the letter on 28 September, but I am accustomed to how timing and seasons change when Ministers come to author letters. I would be interested to know whether this reply has been produced and whether the Minister can tell us what the FSB has decided on credit rating agencies.
Finally, as my time expires, I regard the CRAs as just another of those innocent fools and victims who played a part in the financial crisis. Your Lordships have already had an excellent committee report on the auditors. We have now had a report on the credit rating agencies. I think attention should now be turned to the benefit consultants and, finally, to those rascals who decide whether a credit event has been caused in the credit default swaps. Plenty for the Minister to do even though he is now job-sharing with the noble Lord, Lord Green of Hurstpierpoint.
Lord Vallance of Tummel
My Lords, I first congratulate the noble Lord, Lord Harrison, on his admirable chairmanship of our committee during the production of the report. My first brush with the credit rating agencies was when the Select Committee on Economic Affairs produced its report, Banking Supervision and Regulation, in June 2009. We were highly critical of the part the agencies played in the run-up to the preceding year's financial crisis, of their failure to detect the toxicity of many of the financial instruments they rated, of their potential conflicts of interest and—this was not to be laid at their door—of the systemic risk of hard-wiring ratings into financial regulations and the mandates of institutional investors, which the noble Lord, Lord Myners, referred to. Therefore, it comes as something of a surprise to find myself defending the agencies, at least in part, as they sit in the firing line from the Commissioner for the Internal Market.
It also comes as something of a surprise, although a pleasant one, to agree with almost all of the Government's response to the report on sovereign debt ratings. I will not rehearse again the arguments about the distinction between the rating of corporate and sovereign debt that is set out in our report. Suffice it to say that sovereign debt ratings are almost always unsolicited, so the issues of conflict of interest that surround the issuer-pays model and of ratings shopping simply do not apply.
What matters in the context of sovereign debt boils down to three main things. The first is the oligopolistic nature of the credit rating agency market, which is dominated by the three main players. Such a concentration of power is uncomfortable to say the least. The second is the hard-wiring of credit ratings into the regulatory system and the systemic risk that goes with it. The third is the issue of what regulatory constraints are warranted in respect of the methodology, content and timing of credit ratings. This will inevitably include a degree of political judgment overlaying the economic analysis.
As to the nature of the market, I think it is something of a natural oligopoly. An open market for credit ratings will lead inevitably to concentration on a small core of players with the skills, experience and global reach to do the job. In this respect, the market is similar to that of financial auditors. This is one area where I question the Government's view that one should be,
“lowering barriers to entry rather than intervening in the market directly”,
to quote their response to our report. Lowering barriers is a necessary but insufficient approach when there is a natural and entrenched monopoly of this kind. So if Commissioner Barnier wants to rotate the use of agencies by limiting the frequency with which an issuer can use the same agency, he is broadly on the right track. The promotion of competition in this market will mean not just removing potential barriers to entry but the direct handicapping of the large incumbents, although the calibration might need some work. Incidentally, rotation would not bear directly upon unsolicited sovereign debt issues, where potential conflicts of interest do not apply.
As to the phasing out of the hard-wiring of credit ratings in regulatory structures or in the mandates of institutional investors, everyone seems agreed on the objective, whether they are regulators or rating agencies. However, it is one of the things that is easier said than done, as there is a real risk of throwing out the baby with the bath-water, or at least of unintended consequences. One thought that occurs to me is to take a leaf out of the book of UK corporate governance here and apply the principle of “comply or explain”. If minimum levels of credit rating were not mandatory requirements but subject to the comply or explain rule, there would be at least some leeway for financial institutions to use their own judgment, subject to their explanations satisfying the relevant regulators. That limited exercise of judgment might just put a brake on the automatic mass selling of a security that can follow a downgrading which breaches a mandatory requirement. It is a passing thought that the Government might like to bear in mind.
Finally, and specifically with regard to sovereign debt, what regulatory constraints are genuinely warranted as to the method, content and timing of credit ratings? The sensitivity in certain parts of the eurozone to a credit rating agency having the temerity to pass judgment not just on the credit-worthiness of a nation's sovereign debt but, by extension, on the competence and effectiveness of those who are trying to prop it up is very clear. But that is no excuse for what one might call retaliatory regulation—and there is a sense of retaliation in some of the possible measures being aired by the Commission and others.
In terms of principle, there is no question that the agencies need to be properly registered and subject to some degree of regulation, and it is clearly appropriate for ESMA to insist on transparency of methodology. However, to my mind the recent suggestions that ESMA should effectively determine in advance which methodologies are, or are not, to be deployed is right over the top and an undue interference in the market.
As to the Commission’s thankfully postponed suggestion that ESMA should have the power to ban or suspend credit rating when a country is in negotiations or is covered by an international solidarity programme with the EU or IMF, as we said in our report, and has been said this evening, that smacks of censorship. Perhaps the Commission would like to suspend the “Lex” column in the Financial Times on the same grounds. It also smacks of naivety; as the noble Baroness, Lady Noakes pointed out, a ban could easily put the financial markets into a spin. Other commentators would inevitably fill the gap, and the whole exercise could end up being self-defeating. No doubt the Government will do their best to keep that one at bay, should the postponement prove only temporary.
Credit ratings of sovereign debt matter—hence all the sensitivity surrounding them. If you will pardon my lapse into Franco-German, some may have experienced a brief “frisson de Schadenfreude” when Standard & Poor's inadvertently downgraded French sovereign debt earlier in the month. But it was really no laughing matter. The credit rating agencies may not have precipitated, or even significantly exacerbated, the eurozone crisis, but the oligopoly’s sins of omission or commission can do real damage. It follows that the power and dominance of the three large agencies need to be addressed, but to my mind that is best done through promoting structural change in the market and not by more regulation of a retaliatory kind.
Lord Foulkes of Cumnock
My Lords, I join in the warm congratulations to my noble friend Lord Harrison on securing the debate. I am a member of the European Union Select Committee, which is very ably chaired by my noble friend Lord Roper.
I joined the committee just as this report was being concluded, and although I welcome the report, I feel it does not go far enough. I disagree with much of the essence or strength of what has been said up to now. Some of the action of the credit rating agencies has, frankly, been scandalous and it needs more urgent action. As the Minister knows, I have raised it two or three times at Question Time, and although the Minister has been reasonably helpful and wrote to me recently about it, I am not sure that he or the Government are really seized of the concern that is widely held about the action of credit rating agencies and the urgency of action that is necessary.
It is quite ridiculous that three US-based agencies have 95 per cent of the global credit rating agency work. They are private companies, with their own shareholders, their own owners, who often benefit from the decisions made by those agencies. Whether my noble friend Lord Myners—who has disappeared suddenly—thinks they should get any credence or not, they are given great credence, not just by the media, but by a whole range of other people. Yet look at their record. Joseph Stiglitz, the Nobel prize winner, said that the subprime crisis would simply not have happened without the CRAs’ contribution. He says:
“They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies”.
It was that subprime crisis which started the global financial crisis that we are currently in. Look at the accuracy of their forecasts. They gave positive ratings to AIG and to Lehman Brothers right up until the very moment of their collapse. What an astonishingly poor record that was.
I disagree with the report when it says, “Do not shoot the messenger—they did not exacerbate this situation”. The inherently pro-cyclical way of functioning aggravated the European sovereign debt crisis and pushed several European countries to the brink of bankruptcy. For example, explaining the reasons for Italy’s downgrade on 17 September this year, Standard & Poor’s put forward that,
“market interest rates are anticipated to rise”.
Of course, interest rates would only rise even further as a result of the downgrade by S&P, so it exacerbates the problem and you get this vicious cycle downwards. Of course the creditors are happy, and some of the people behind Standard & Poor’s might be making quite a bit of money out of it.
In the current European context, it is questionable where the true responsibility lies for the austerity and the dire economic consequences we see in nearly all of the European countries in the eurozone, and the social consequences resulting from that. Are democratically elected Governments really able to decide their fiscal and economic policies in full sovereignty and independence, or do Moody’s, S&P’s, and Fitch effectively assume true economic power in the European Union? I think that is a question that needs answering, and I hope we will get a response from the Government in relation to that.
Let us then go to the conflict of interest of credit rating agencies. As I said earlier, they are private companies, and as such their primary purpose is to seek profit and to enhance their market position. The experience of the recent crisis, as well as testimony of former employees of the CRAs, has shown that managerial pressure on analytical units is used in order to modify outcomes and to decide on ratings models which are more likely to enlarge the CRA’s market share in this respect. Accuracy would not seem to be the prime objective of the credit rating agencies.
I think the answer—I disagree with the noble Baroness, Lady Noakes, on this—is that we need to look to the European Union. If this Government were prepared to consider regulation and to deal with this as far as the United Kingdom was concerned, I would welcome that and look at it, but they have ruled that out. The noble Baroness said that she wants less regulation; that is why we need to look to Europe to see some ways of protecting ourselves. I favour the establishment of a European independent credit rating agency. First, such an agency would ensure that we become less dependent on the CRAs’ opinions and would use alternatives to risk assessment in legislation and regulation. Secondly, I would argue that competition between CRAs should be promoted, as some have said already, by lowering the barriers to entry to the market and by increasing transparency. Thirdly, the inherent conflict of interest which I have described in the predominant current business model would be bypassed through sound measures to combine different business models. Rating states and companies needs different criteria; using the same criteria for them does not work.
I would argue that the European Union has the power. I get concerned at this growing Euroscepticism that seems to be infecting both Houses of this Parliament. We saw it with the noble Baroness, Lady Noakes, and, I am afraid, with my noble friend Lord Myners. I am glad that my very good and noble friend Lord Roper is here. He is a long-standing supporter of the European Union and we should be enthusiastic still about what can be achieved collectively. Just a few days after Remembrance Day, we ought to remember why the European Union was set up in the first place. The European Union has an unequivocal mandate in anti-trust matters, determined by the treaty and by directive 2003/6/EC on insider dealing and market manipulation and its amendments, so it has the power to take action in relation to this. I would argue that it should take action.
In summary, the subprime crisis would simply not have happened without credit rating agencies. In the 10 years up to 2007, the revenues of credit rating agencies rose by 900 per cent. That is what they are in it for—to make money. The ratings delivered by credit rating agencies constrain decisions taken by Governments, by pension funds, by banks and by the ECB, because of the credibility given to them. As I said earlier, the three US-based credit rating agencies share 95 per cent of the market. Their business model is riddled with conflicts of interest, and I would argue that fixing credit rating requires tighter regulation of existing private agencies, as well as the establishment of a European independent credit rating agency.
I am not anticipating that the Minister will agree with what I have suggested, but I certainly hope that it will get a positive response from my colleague and noble friend Lord Eatwell, the shadow Minister.
Lord Kerr of Kinlochard
I will not follow the noble Lord, Lord Foulkes, into his trenchant criticism because most of it seems to apply to the role of the credit rating agencies in respect to private issuers; I will stick to the sovereign risk role which is discussed in the admirable report from the committee chaired by the noble Lord, Lord Harrison. I was a member of his committee and he has presented our report clearly. I have virtually nothing to add on the substance.
I do not believe that the credit rating agencies performed very well in the nine or 10 years leading up to the financial crisis. It is very odd that Ireland stayed on an AAA rating from 1999 to 2009—an extraordinary rating—and it is pretty odd that Greece was left by Moody’s unchanged from 2003 to 2009 and then shot down nine notches in under a year and a half.
One of the minor elements in the Commission package of proposals announced today may be quite useful: the idea that there should be more frequent reviews. It suggests six months, which might be worth considering. Most of the other bits in today’s package that seem to be good are the omissions from the rumours of what would be in the package. I do not at all agree with the noble Lord, Lord Foulkes, that it would have been a good idea that the Commission should, as it floated in the summer, put forward the idea of an EU-sponsored, public-sector-paid-for, CRA. That would be a very bad idea for the reasons that the noble Lord, Lord Harrison, has explained. As our report points out, it would be assumed in the markets that,
“EU governments … would have undue influence over its decisions”.
I am puzzled about the present situation of the other very bad idea—it was not floated before we wrote this report, and therefore is not in this report—of the ban on credit ratings, and the power of ESMA to impose temporary exceptional bans. That seems to me to be a rotten idea for a lot of reasons, particularly the one given by the noble Lady, Baroness Noakes, and the noble Lord, Lord Vallance. The moment a credit rating agency signalled that it was under a ban—and it would have to do so, so that the market was not misled into thinking that the previous rating was its considered judgment as of that day and in future—the market would at once react severely, with a panic sell-off of the relevant sovereign debt.
I am very glad to know how the Minister rates these strange events in Brussels today. It looks as if there was a debate in the Commission, and Commissioner Barnier did not win. The text that it has put out today, which explains the draft directive and the draft regulation, says that ESMA will be granted the power to ban sovereign ratings, although such bans would be temporary, exceptional, and subject to strict conditions. In the press release, Monsieur Barnier says,
“The possible suspension of sovereign ratings is a complex issue which … merits further consideration”.
I disagree. It is straightforward, it is black and white, and it is a rotten idea. I hope that the postponement is sine die, and that the Minister may be able to throw some light on that.
There is, in a way, a philosophical problem here. It has been inherent in a lot of things in the European Union since the beginning. Monsieur Barnier says today in his press release that, ratings,
“are not just simple opinions”.
Oh yes they are. That is exactly what they are. We say in our report that investors should not rely on them,
“as an authoritative indicator of creditworthiness, but view them as opinions … to be balanced and confirmed by other market indicators”.
We say caveat emptor should rule. That is because we believe in markets. You could caricature the Barnier philosophy as Colbertian. Ours you could perhaps overwrite as Adam Smith. On one side we have a dirigiste philosophy, and on the other we have the invisible hand. That debate has existed on a lot of much more important matters than this one, and on the whole it is going the right way. The arrival of the Scandinavians and the eastern Europeans has meant that the Colbertians are definitely a minority in the European Union now. I hope the postponement of the idea of suspension means that this issue is also going the right way. The press reports that in the debate in the Commission the British and Swedish commissioners were arguing against the proposal, and that seems plausible. Possibly the debate in the Commission is going the right way because of the admirable report produced by the noble Lord, Lord Harrison. Let us say it could certainly be a factor.
I have a little time left and I want to use the rest of it to raise a slightly wider issue. In the financial crisis and the subsequent lessons-learnt exercises such as the G20, there was general agreement on the need for changes in financial regulation. For EU members, that means changes in EU regulation. I say to the noble Baroness, Lady Noakes, that the Commission is doing its job when it produces drafts. The one produced today is minor, peripheral and not very important. Some of them are very important indeed. Some of them are very silly. In my view, the Tobin tax proposal is very silly and likely to fail for that reason. Some of them are a bit Colbertian and need to be exposed to a good Adam Smith critique, but they are not cooked up on a whim.
This country was part of the international consensus on the need for changes and the Government in whom the noble Lord, Lord Myners, played such a key role was part of that consensus. I say to the noble Lord, Lord Myners, that Michel Barnier is a serious politician who had a long career as an elected politician in France and has had previous successful terms as a commissioner. We should not regard Barnier as a figure of fun. He is not a figure of fun. Nor should we regard some of these regulations as daggers aimed at the heart of London. They are not an anti-British conspiracy. Of course, since they are about financial regulation and the London market is the biggest and most important European market, they are particularly relevant to London.
It is very important that this country plays a central part in the legislative process, making sure that the voice of Adam Smith is properly heard. That might not happen if we were to come to be seen as unconstructive and to describe ourselves as sceptics; if we were seen to be hectoring and unsympathetic in the current debate about the eurozone; if we were showing that we were unaware of what the German constitutional court says, or even what the treaties say; if we were seen to be criticising our partners for prevarication and pusillanimity and delay. They are dealing with a very serious problem. Remember the parable of the bacon and eggs. The 17 eurozone members are the pigs; the 10 non-eurozone members are the hens. Our contribution might be quite useful; theirs is a matter of life and death. This is their currency we are talking about. If, unlike some of the other 10 non-members, we are absolutely determined not to provide any eggs, perhaps we would do well not to cluck quite so much. Perhaps a period of silence, as a great Prime Minister once said, might be called for.
Diplomacy often consists of getting someone else to put forward our ideas as his. He cannot do that if we have already shouted about them aggressively in public, and he will not want to do it if we have previously lambasted him for not acting on them already. I do not expect the Minister to respond to these thoughts but I hope he will take them back with him as he wends his weary way back to Great George Street, where I used to work, and make my successors think about them.
Lord Monks
My Lords, it is a puzzle to me, as it is to some of you, that the three major credit rating agencies, which have made such great errors of judgment in recent years, managed to survive and to prosper. Yet that is the story of the big three, and despite their level of failure investors certainly take notice of their assessments. I can sympathise with what my noble friend Lord Myners said about perhaps not taking them so seriously, but the reality is that many people do and they are a significant influence. I am afraid that we cannot belittle them and pretend that they are a marginal influence. At the very least they are an alibi for investors, with their boards, to say, “Well, it got AAA ratings”, or whatever it was on a particular investment that has gone wrong.
Let us look at their record briefly. Enron was rated AAA. In addition, there were the sub-prime mortgages mentioned by my noble friend Lord Foulkes. The display of a near-fatal lack of curiosity about the people to whom sub-prime mortgages were being sold—mainly people who were low paid and in precarious work—in the United States, was curious, to say the least. Somehow, it was forgotten that there was a risk to those people on the margins of home ownership if interest rates rose a bit and real estate prices fell. The credit rating agencies missed that point. A lot of people missed a lot of points in the economic crisis, as we know, but the credit rating agencies were somewhere at the heart of what went on. They were not on the margins in the C-stream, making comments that people took little note of.
Now the agencies are passing judgments on the troubled eurozone countries. I do not think that they are doing so with much sensitivity to the consequences of their judgments. Several noble Lords referred to the mistake about the downgrade of France last week. The mistake was corrected promptly, but that correction has proved insufficient to quell nervous markets, which had already been betting that France would soon lose its coveted AAA rating. The announcement of the downgrade, therefore, should have been very carefully checked before the judgment was given in the first place, given France’s linchpin position in the eurozone crisis. It clearly was not checked.
Before 2008, credit rating agencies gave dodgy products the benefit of nearly any doubt, provided they were being paid by the issuers of the debt. Now they seem to be compensating for their earlier misjudgments with strict assessments of the sovereign debt of individual countries. I do not believe that there is a conspiracy to do down Europe or the euro. But I do believe that incompetent businesses in a key area like this should pay a price and not fly free.
I congratulate the European Union Committee on the way that this was presented by my noble friend Lord Harrison, and on the analysis, which hits the right note about these agencies. I am more sceptical about the central recommendation, that a more competitive environment will be enough to raise standards. It is obvious that a more competitive environment—as the noble Lord, Lord Vallance, said—could lead to a bidding war between agencies to curry favour with their potential customers.
I do not share the scepticism that several noble Lords expressed about the European Commission proposals. I am not quite sure exactly what the status is of the proposals that were issued this afternoon, but I would not rule out the idea that agencies’ conflicts of interests could be better regulated. Nor would I rule out the idea that agencies might refrain from action during the rescue of a particular country with sovereign debt problems. It is fairly clear that a country in such a position is already in big trouble, without Standard & Poor’s coming along and possibly giving an inaccurate judgment on the situation that the country finds itself in.
I would like to see a register of past performance of credit rating agencies—where they have been right or wrong. That would aid transparency in what is a difficult and risky area.
The other proposal the European Commission was set on—whether it is in the final proposals remains to be seen—was the idea of a civil action in the event of bad advice or a bad rating. People in professions have to pay a price if they are negligent in some way. I do not think that there should be a rush to judgment, or a rush to say that this is another example of Europe trying to barge into the sacred fields of the City of London. The City of London’s future cannot be as a greater Monaco—slightly offshore—if it is to thrive and meet the top standards in the country. It should be welcoming good standards, not appearing, as it often does, to be pushing them away. I do not agree with my noble friend Lord Myners in his judgment of Commissioner Barnier.
I ask the committee, in its future work, to look carefully at the proposals of the Commission to add to its own. We can perhaps find some degree of unity. The Government’s position was reasonably positive: to place a tighter rein on the agencies and develop a more reliable system than the current dangerous oligopoly.
Lord Eatwell
My Lords, a great strength of this report, on which my noble friend Lord Harrison is to be congratulated, is that it distinguishes clearly between the role that rating agencies play in the markets for private securities and the role that they play in the sovereign debt markets. In private markets, rating agencies provide a relatively simple rating for what are often mathematically very complicated financial instruments. Without this sort of interpretation, the markets in complex products could not operate. The role of the rating agencies is to provide confidence to the buyers. Unfortunately, in the recent past that confidence was seriously misplaced, as my noble friends Lord Foulkes and Lord Monks both commented.
However, as the report makes clear, and as the noble Lord, Lord Kerr, pointed out, the task of rating agencies in respect of sovereign debt is quite different. Sovereign debt instruments are typically fairly simple; they are standard bonds of fixed duration. In this instance, the necessary rating skills are quite different from those needed in unpicking a complex statistical model. First, they consist of a devotion to whatever is the conventional economic wisdom of the time. It is convention, not good economics, that matters and often drives markets. Secondly, the sovereign appraisal should include an assessment of the political and economic controversy within and between sovereign states. Here, political fashion inevitably plays a role in determining whether any given package of economic policies is deemed sound or not. As we in this country know to our cost, the current fashion is for austerity—today’s cure for all economic ills.
It is not at all obvious, as the report acknowledges, that the rating agencies have any particular superiority in evaluating sovereign risks over any intelligent investor, as my noble friend Lord Myners emphasised. If the role of rating agencies is so straightforward, why are they of any importance at all in the discussion of sovereign debt? Neither the report nor, disappointingly, the Government’s response addresses this core question. If, as the report’s title suggests, rating agencies are but the messenger, what is the origin of the message that they bear? To put it another way, if they are but the symptom—distressing and perhaps worth treating in itself, but not fundamental—what is the nature of the disease? It is in the light of that more basic issue that we should judge the Government’s response.
The basic issue has two dimensions: the development of the international bond market over the past three or four decades and the particular design of the sovereign bond market in the eurozone. The current structure and scale of international bond markets are a relatively recent phenomenon. For example, today the annual value of cross-border transactions in UK sovereign bonds comfortably exceeds 1,000 per cent of UK GDP. In 1971, the comparable value was nil. A similar explosion of cross-border activity is to be found in the sovereign bond markets of all G7 countries other than Japan. Into this environment of huge cross-border flows is thrust the eurozone, an economic entity larger than the United States of America. The sheer scale of the eurozone economy ensures that any significant bond fund manager anywhere in the world who is seeking to diversify exposure must have major holdings of US dollar bonds and sovereign bonds denominated in euros. However, whereas exposure to the dollar may be obtained by investing in US treasuries, exposure to the euro may be obtained by investing in any of the various eurozone sovereign bonds. Investors have a choice as to which euro sovereign to hold—a choice that is likely to be informed by their estimate of risk and return, and influenced to a greater or lesser degree by the rating agencies. This is a perfect structure for costless speculation and costless hedging, leading to huge flows between euro sovereigns and exposing any given sovereign to almost unlimited speculative pressure via naked trades. This is the disease.
Let me put the matter another way. The state of California, comprising 13 per cent of the US economy, is bankrupt. This has no impact on the US bond market. Greece, comprising 2 per cent of the eurozone economy, is similarly compromised, with disastrous destabilising consequences for the eurozone as a whole. It is against this background of a huge international bond market and a serious design flaw in the eurozone that the Government’s response to the report should be judged.
Do the Government’s proposals, such as they are, help to suppress the symptoms, or do they provide a guide to tackling the disease? The Government rather downplay the report’s criticism of the rating agencies’ performance prior to the sovereign crisis in the eurozone. The report is forthright:
“The valid charge against the rating agencies … is ... that they failed … to identify risks in some Member States”.
The Government’s response ignores this conclusion altogether and focuses instead on the need to share “factually correct information”. Can the Minister explain why the Government do not share the committee’s views on the failings of the rating agencies prior to the crisis?
On the symptoms, the Government are surely right to support measures to reduce hard-wiring of ratings into legislation rules and guidance. Yet the Government’s statement that they believe that,
“the more sophisticated use of ratings by investors should be encouraged”,
is surely one of the more vacuous platitudes of recent times. The Government’s support for greater transparency in the methodologies of the rating agencies, mentioned by the noble Lord, Lord Vallance, is likely to make matters worse rather than better, by increasing volatility as traders, knowing the methodologies, anticipate ratings changes.
In contrast to the noble Baroness, Lady Noakes, the Government express enthusiasm for greater regulation of the ratings agencies. As was pointed out, the Government signed up to this at the G20. Will the Minister tell us what regulatory steps the Government propose and explain how these steps will enhance the smooth operation of sovereign bond markets? What is most striking about the Government’s response is that it makes no attempt whatever to locate the role of the rating agencies in the context of the overall operation of the eurozone sovereign debt market. That, after all, was the topic of the report. Mr Cameron and Mr Osborne have repeatedly urged the eurozone Governments towards action, without spelling out exactly what action they propose. Perhaps the Minister will help fill the void in government thinking this evening by telling us what steps the Government propose should be taken to stabilise the eurozone bond market and where the rating agencies fit in to the Government’s plans.
The Commercial Secretary to the Treasury (Lord Sassoon)
My Lords, I start by thanking your Lordships for a thorough and insightful debate on the role of the sovereign credit rating agencies. I particularly thank the noble Lord, Lord Harrison, and the members of EU Sub-Committee A, on Economic and Financial Affairs and International Trade, for their report. It is a report of considerable importance as we continue to live with the consequences of a financial crisis in which credit rating agencies played a significant role, and as we cope with a sovereign debt crisis in which they continue to have a key role.
The Government believe that the report contains a number of valuable insights, with which they largely agree. We have had a surprising alliance of dissenting voices, starting with the noble Lord, Lord Foulkes of Cumnock, who spoke in his characteristically vigorous style. I am sorry that the noble Lord, Lord Myners, did not hear that analysis of the credit rating agency scene, which differed completely from the one that he gave. The noble Lord, Lord Monks, was also a dissenting voice. In a rather different way, the thoughtful analysis of the noble Lord, Lord Eatwell, came to some different conclusions. However, the Government believe that your Lordships’ report is very valuable and will continue to inform the European-led decisions.
We are firmly of the view that credit rating agency reform is needed. However, as the committee rightly highlights, it is also important to remember that credit rating agencies play a critical role in efficient financial markets by providing independent assessments of creditworthiness. Since the financial crisis, Europe has already agreed new regulation on CRAs, which has come into effect. Therefore, today’s new proposals constitute a third round of proposals coming out of Europe since the crisis. I should say at this point that the subject of the debate is for the Government to respond to your Lordships’ committee. I understand that many of the questions concern the European proposals that have emerged just this afternoon. I will address them as far as I can but your Lordships will appreciate the shortness of time in this debate and the fact that my first duty tonight is to respond to the committee’s report. However, we have had a third round of proposals from Europe today.
As has been noted, CRAs are now supervised under the European Securities and Markets Authority and must comply with raised standards on methodology, conflicts of interest and disclosure. That is business that is already agreed. While this represents substantial progress, the Government believe that further CRA reform should focus on three aspects which closely reflect the committee’s overall conclusions. First, it is vital to reduce overreliance on CRA ratings. That point has been made by a number of speakers this evening. We strongly agree with the report that investors must ultimately take responsibility for their own investment decisions—caveat emptor, indeed. The hard-wiring of ratings in legislation, or in the internal risk assessments of financial institutions, leads, among other things, to cliff-edge effects and instability.
Secondly—this was also recommended by the committee—we support increased disclosure of ratings assumptions and process, and of underlying assets embedded in complex products. This will encourage investors to use CRA ratings in a more sophisticated manner. It will also make CRAs more accountable for their ratings.
Finally, we support fostering competition in the credit rating agencies, but without compromising ratings quality. We agree with the committee’s recommendation against the public provision of ratings. Instead, we favour reducing reputational barriers to entry such as through initiatives to establish a central platform of CRA performance statistics. The Government also strongly agree that international consistency on CRA regulation is important. We shall continue to use the Financial Stability Board to stress this because it is not only Europe but IOSCO and others that are coming forward with proposals, so the FSB will be important.
I want to take this opportunity to respond to some of the key conclusions of the report. We agree with the committee’s assessment that CRAs cannot be held responsible for precipitating or exacerbating the euro area crisis. Sovereign downgrades in Europe have reflected fundamental internal and external imbalances and CRA reform should not distract us from the key task of addressing those imbalances. The noble Lord, Lord Eatwell, challenges me with the rather bigger question of what action needs to be taken to stabilise the eurozone. I wish that we had time for that subject tonight, but there will be other opportunities. A lot of critical action is needed. CRA reform is important but it should not distract us from the other actions that he talks about which are for another debate.
We also agree that the proposal to suspend ratings for countries receiving international aid would only reduce information in the financial markets, possibly leading to further contagion. The key to reducing the destabilising effects of rating changes is timely and effective communication by the CRAs, not suspension. The Government agree that CRAs should always seek to learn from their past performance and endeavour to provide markets with timely and accurate ratings. However, the build-up of imbalances in the euro area was not reflected in the data in the run-up to the sovereign crisis, so it is crucial that the quality of national statistics in Europe is improved to underpin the assessment by CRAs and all others.
The committee also suggests that there should be a competition inquiry into the industry—a point that was touched on by the noble Lord, Lord Harrison, and others this evening. The competent authority to survey competition in the industry is the European Commission. It should keep the industry under review. The concentrated nature of the industry has been referred to a number of times, but it is for the Commission to decide whether there is evidence of the abuse of a dominant market position on which to base a competition inquiry. Such an inquiry should have regard to the impact of recent and forthcoming reforms in the CRA industry.
As we know, the debate has been particularly timely because the European Commission today released its proposals for this further package on CRA reform, which I believe will be voted on under qualified majority voting. I have to say at this point that I very much agree with the noble Lord, Lord Kerr of Kinlochard, that it is not necessary or appropriate for the noble Lord, Lord Myners, to lampoon Commissioner Barnier. I hope that this debate is read in Brussels for a lot of the serious comment that is highly relevant to the Commission’s ongoing deliberations; but frankly the comments of the noble Lord, Lord Myners, do the UK absolutely no favours by lowering the tone of the debate in a rather demeaning manner. He sits there and laughs, but it exemplifies why the previous Government made so little progress in many European negotiations. He takes a flippant and dismissive attitude to the Commission, and it really is not necessary.
Our initial response to the Commission’s proposals is very much in line with the committee’s conclusions. We welcome the proposals to reduce the overreliance on CRA ratings and to improve the transparency of ratings, the methodology and the structured finance products. Such transparency will help foster competition. It is worth noting that already 31 CRAs have applied for registration in Europe, so there is evidence of developing competition—a point raised by my noble friend Lord Vallance of Tummel, as well as my noble friend Lady Noakes.
We oppose measures to interfere directly with industry structure or with ratings methodology. We strongly oppose efforts to harmonise and increase the scope of CRA liability, for which we already have an appropriate regime in the United Kingdom.
Clearly, many parties raised concerns about some of the proposals that were suggested earlier—particularly the ban on sovereign ratings and the thought of a publicly funded EU rating agency. We share those concerns and are glad that the Commission has agreed that they merit further reflection. I am not able to say whether it is a sine die, kick-into-the-long-grass situation; we will have to look at the detail and see what happens. However, it is a good first step to see the proposals taken off the table for the moment. Of course, we do not want to see a special regime for regulating sovereign markets, which would reduce their impartiality and comparability and hence their value in international markets.
The Government are committed to reforms that will ensure that credit ratings are credible and transparent, and will continue to serve as a useful indicator to international financial markets. The Government will continue their close engagement with European and international partners to achieve these objectives. We look forward to examining today’s Commission proposals in detail and to keeping the House fully abreast of the Government’s developing response.