Credit Rating Agencies

Chuka Umunna Excerpts

Friday 13th May 2011 Commons Chamber

[Mr Chuka Umunna (Streatham) (Lab)]

I thank you, Mr Deputy Speaker, and the House for giving me the opportunity to debate this very important issue today, but before I do so, I should like to say to my constituents that I have been a Member for a year this week, and I have loved every week. It has been a great pleasure to serve the people of my constituency, and I will continue to work my socks off for them so long as I have the privilege of sitting in the House.

This debate comes at a crucial moment. The world is seeking to address the failings of the financial system in the wake of the 2008 crash. Much of that work is being driven by the G20 and the Basel Committee on Banking Supervision. Of course, credit ratings are hardwired into the new rules that are being implemented now. The sovereign debt crisis that is occurring in the eurozone reminds us of the sheer power of credit rating agencies. Of course, a number of recent studies have posed serious questions about the operation of the credit rating agency market in the wake of the 2008 crash, and I wish to explore some of those issues in the short time available this afternoon.

I should add that the European Commission will shortly publish its proposals to improve the regulation of the agencies. I hope that this debate will perhaps not only inform the national debate on the issue but give us more clarity on the Government’s position. Just three firms—Moody’s, Standard & Poor’s, and Fitch—control some 95% of the credit rating market. They rate a range of debt instruments, and their ratings are embedded in investment plans, price triggers and the new capital requirements that are being implemented.

A downgrade by one of the big three agencies can make or break an entire economy, as recent events in the eurozone have shown. Just last month, Greece’s Prime Minister accused them of

“seeking to shape our destiny and determine the future of our children.”

Some people might say that that is unsurprising, given Greece’s position at the moment and the difficulties that it has faced, but Greece is not the only country that has complained. The US Assistant Treasury Secretary, Mary Miller, also weighed in last month following the downgrade by Standard & Poor’s of its outlook for US sovereign debt.

The credit rating agencies thus exercise huge power, despite the deep failings exposed during and after the financial crash. Investigations into the financial and economic crisis that have been conducted since then have shown that the agencies played a large part in causing and then exacerbating the financial crisis. The US Senate sub-committee on investigations last month reported that

“perhaps more than any other single event, the sudden mass downgrades of residential mortgage-backed securities and collateralized debt obligations were the trigger for the financial crisis.”

The report of the US Government’s financial crisis inquiry committee stated that

“the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown.”

Here, the Financial Services Authority in Lord Turner’s review of 2009 said much the same when it concluded that

“the credit ratings-based system played an important part in the origins of the crisis”.

These are not isolated claims. Studies published by the Financial Stability Board, the Bank of England and the European Commission’s de Larosière group reach a similar conclusion. The key points are these. In the years preceding the financial crisis, the credit rating agencies fuelled a dangerous liquidity boom by underestimating the credit default risks of sub-prime mortgages and complex structured products. When the bubble burst, sudden downgrades to the ratings embedded in the investment plans, mandates and capital reserve requirements automatically triggered a liquidity crisis which, in effect, made a bad situation much worse.

Multiple major studies have concluded that the big credit rating agencies were key contributors to a financial crash that cost this country well over £1 trillion. It is therefore incumbent on us to ensure that the flaws in the credit ratings business are dealt with as a matter of urgency. One such flaw, which must be addressed, is the fundamental conflict of interest that arises through the so-called issuer-pays model. Under this model the issuer of a security can shop around for a rating, creating a race to the bottom in the integrity of ratings. Competition for this lucrative business puts pressure on rating agency staff to downplay risk and to collude with issuers, particularly when rating elaborate packages of structured debt. The result, seen in the sudden mass downgrades at the start of the financial crisis, is a dangerous ratings inflation.

This process was a common observation of all the investigations that I mentioned. The de Larosière report, for example, said

“the conflicts of interest in CRAs made matters worse. The issuer-pays model, as it has developed, has had particularly damaging effects in the area of structured finance.”

The US Senate report concurred, saying:

“The conflict of interest inherent in an issuer-pay setup is clear: rating agencies are incentivized to offer the highest ratings, as opposed to offering the most accurate ratings, in order to attract business.”

These findings are supported by evidence from within the rating agencies themselves. In internal correspondence published by US congressional investigations, staff joked that a deal

“could be structured by cows and we would rate it”,

and discussed “adjusting”, “spinning” and “massaging” ratings methodologies in order to preserve market share. I have read many of the documents and e-mails myself.

A 2008 survey of finance professionals by the CFA—chartered financial analyst—Institute found that 11% of respondents had witnessed agencies altering ratings under pressure or influence from outside parties, so any serious regulation of the system needs to target the inherent conflict of interest in the issuer-pays system.

This brings me to the recent moves by the European Commission. Recent EU legislation has taken some important steps in the right direction. It makes it mandatory for all credit rating agencies operating in the EU to register with the new European Securities and Markets Authority, which will monitor their methods and potential conflicts of interest. It also gives that authority powers to investigate agencies and, in the event of infractions, suspend agencies’ licences. For me, the question is: does this do enough? I am not sure that it does, because it does not fundamentally challenge the issuer-pays model that has been shown to incentivise ratings inflation.

I mentioned earlier that the European Commission is due to publish a series of new proposals, and the options that it floated in its consultation in November, which finished in January, included the creation of a European credit rating agency, support for investor-owned agencies, an independent clearing board to allocate ratings business, a network of small and medium agencies, and an obligation on institutional investors to obtain their own rating before purchasing a product. The Commission has said that it is about to table new legislation in this area. Does that accord with the Treasury’s understanding? I would be grateful if the Minister could tell me when that legislation is expected to be published.

The UK’s tripartite authorities produced a response to the Commission’s options in January 2011, which largely rejected the suggestions that had been placed on the table, placing great confidence in the pre-existing EU regime. Their response also called for a “more narrowly focused” approach to further reform. Most contentiously, their response said that there was

“no hard evidence that conflicts of interest in the ‘issuer-pays’ model lead to ratings inflation”.

It has to be said that that is very difficult to reconcile with the findings of the various investigations into the role of the issuer-pays model in the causes of the financial crisis, which I have just mentioned. I ask those interested in this to read the reports that I have mentioned and decide whether the tripartite response is appropriate.

It is clear to me that tackling the conflicts of interest is central to reforming the system. I know that Treasury Ministers, perhaps the Chief Secretary to the Treasury excepted, have not historically been the biggest fans of the EU, but I urge the Government to be bold and adopt an open-minded approach to the Commission’s proposals when they come out.

As the Financial Times has pointed out, a publicly owned but independent credit rating agency

“would go some way to mitigate”

the risks of the issuer-pays system. A variation on that idea, a European credit rating foundation funded by the financial industry, recently received the backing of the European Parliament’s Economic and Monetary Affairs Committee, which has called on the Commission to conduct a

“detailed impact and viability assessment”.

In the US, the Senate has already approved an amendment establishing a clearing body for credit ratings.

Finally, I draw the attention of the House to the Bank of England’s financial stability paper of March 2011, which explored the feasibility of moving from an issuer-pays to an investor-pays model. That concluded that, despite the obstacles, the challenges to such a radical change

“may…not be insurmountable”.

Ministers, particularly from the Treasury, with whom I tend to have much discussion on the Treasury Committee, of which I am a member, enjoy reminding me that much of what I have just mentioned happened on the watch of the last Labour Government, and I have admitted and said many times in the House that we did not get the regulation of banks completely right on our watch, although I do not remember there being a huge clamour for a massive clampdown from the Opposition at the time. What people out in the real world want to know from the Minister this afternoon is not how awful he thinks my lot were, but what the Government will do.

The 1997 Asian crash and the 2001 Enron collapse both exposed flaws in the way the agencies operate, yet their power remained unchecked and their failings went unaddressed then. We are all well aware of what followed in 2008, and we cannot afford a repeat of that mistake in 2011 and beyond. The status quo is not an option. Ultimately, the pensions, savings, jobs, homes and livelihoods of our constituents depend on a credit rating system built on integrity and accuracy. We owe it to them to ensure that that is precisely what the system is.

[The Exchequer Secretary to the Treasury (Mr David Gauke)]

May I first congratulate the hon. Member for Streatham (Mr Umunna) on securing the debate in this, the anniversary week of his election to Parliament? I am pleased to have the opportunity to explain and discuss the Government’s policy on credit rating agencies—an issue that has generated a fair amount of interest, including outside the United Kingdom. It might be helpful if I start by outlining the Government’s current position and set out the steps that have been taken here and in Europe to address the shortcomings in this area, but before doing so I would like to make two observations.

First, the financial crisis has clearly highlighted the fact that reform of CRAs is essential, as the hon. Gentleman has argued, both in the way they are supervised and regulated and in the way they conduct themselves and explain their decisions to the market. That has already led to significant regulatory changes. CRAs must now register to be recognised in the EU and comply with rigorous procedures and controls in using their ratings. The European Commission has identified further measures to address over-reliance on CRA ratings and to improve competition and CRA accountability.

However, although reform is necessary, CRAs play an essential role in international markets. They provide the market with a neutral assessment of credit worthiness, a service that is valued by investors and crucial to the functioning of the international financial system. Reform should therefore aim to improve ratings quality and the way ratings information is used by investors, but it should not unduly undermine what is an essential service to international capital markets.

Recent market events have highlighted concerns about the role of CRAs, which is why we fully support international efforts to improve their regulation, to introduce greater transparency and competition and to reduce reliance on credit ratings, while acknowledging the complexity of the issues and the important role played by CRAs. The UK authorities have been, and will continue to be, active in both the EU and the G20 processes, including discussions on possible further measures that the Commission is considering in this area.

With regard to what has been achieved to date, the hon. Gentleman is obviously aware that the first European credit rating agency regulation—CRA1—came into force in December 2009. It ensures that CRAs demonstrate that they manage potential conflicts of interest adequately and improve processes relating to the issuing and monitoring of ratings. It requires more robust internal control functions, greater transparency of methodologies and processes, due diligence procedures and the disclosure of performance. It provides a minimum standard of CRAs' systems and controls, ensuring that ratings in the EU are of a high quality.

As the hon. Gentleman will also be aware, that regulation has recently been amended to place rating agencies under European supervision. To be recognised for regulatory purposes, CRAs must go through a registration process, ensuring that they meet the standards of the new CRA regulation. From June, the newly established European Securities and Markets Authority will have the power to ensure that CRAs comply with the regulation. Other jurisdictions, including the US, are adopting similar regimes to ensure a consistent international standard. Those requirements of the European legislation apply to all asset classes and are aimed, in particular, at addressing the problems associated with structured products, an area where, as demonstrated during the crisis, CRAs have evidently failed to provide reliable ratings in some countries. CRAs are also banned from providing advisory services and are required to demonstrate that they have sufficiently analysed the underlying data in producing ratings for structured products. Overall, we consider that those measures will help to improve the quality and reliability of ratings.

[Mr Umunna]

Will the Minister give way?

[Mr Gauke]

I will give way, although I suspect that I am about to answer one of the hon. Gentleman’s questions.

[Mr Umunna]

I have a further point and a question about what the Minister has just said. I should have mentioned that I have met the senior management of the rating agencies, both here and in New York, and it is fair to say that they do not necessarily welcome such massive reliance being placed on them; they did not necessarily ask for responsibility on such a scale. What have the Government been doing at G20 level about these issues?

On a subsidiary point, the Financial Stability Board will obviously take an interest in this issue. Will the Minister tell me, or write to me to let me know, the members of the Financial Stability Board’s council? I understand that Lord Turner is a member, but it is a bit of a shadowy organisation and there have been some questions, not necessarily about its integrity, but about who is involved, because obviously it has a role to play in this area, too.

[Mr Gauke]

I will certainly write to the hon. Gentleman in response to that query.

The UK Government have been very much engaged at G20 level and at a European level on the issue. In the context of European engagement, the next stage, which the hon. Gentleman mentioned in his speech, is the further work that remains to be done. The European Commission released a consultation document in November 2010 on additional measures that might be adopted on credit ratings. The main proposals related to reducing over-reliance on ratings and the additional measures related to increasing regulation on sovereign ratings; enhancing competition, such as establishing a public CRA, as the hon. Gentleman suggested; potentially increasing CRAs’ exposure to civil liability; and addressing the conflicts embedded in the “issuer pays” business model.

The Government, together with the Bank of England and the FSA, have published a joint response to that consultation, setting out in detail our view of the Commission’s proposals, and I am very happy to provide the hon. Gentleman with a copy. In summary, we support measures to reduce reliance on CRA ratings—a point that he made in his intervention when he said that many of the problems relate to the level of reliance on such ratings. We also support measures to increase transparency and disclosure, and to stimulate competition by lowering barriers to entry. We believe, however, that measures to impose civil liability or to establish a public CRA to issue ratings, particularly sovereign ratings, would be counter-productive and lead to unintended consequences.

The hon. Gentleman raised the issue of a public CRA, but the potential conflicts of interests in any such arrangement—particularly in the context of sovereign debt—would undermine credibility. Alternatively, although I am not sure whether the two arguments are mutually exclusive, there is the danger that a public body would crowd out other credit rating agencies and reduce competition, and neither of us would be keen to welcome that. To answer the hon. Gentleman’s question, however, the Commission will publish its legislative proposals in September.

The recent sovereign debt crises have raised concerns about the role of CRAs in sovereign borrowing. The Government believe that, above all, it is crucial to ensure the impartiality of all ratings, including sovereign ratings, and that means improving transparency by CRAs to facilitate investor understanding, rather than regulating sovereign ratings in a way that compromises their credibility.

Internationally, there has also been a welcome initiative with the Financial Stability Board, considering measures to reduce the over-reliance on CRA ratings. That initiative is investigating what alternatives to CRA ratings can be used in regulatory requirements, in investor mandates and contracts and in central bank operations. Ways to encourage due diligence by market participants themselves are also being explored.

As I said earlier, the Government fully recognise the concern about CRAs. The coalition Government saw from the financial crisis that greater regulation was required to ensure high-quality ratings and a more judgment-based use of ratings by the market. The current sovereign debt crisis further highlights the need for CRAs to communicate consistently and effectively their analysis to the market, and for investors to understand what ratings represent.

That is why the coalition Government are supporting a reform package in Europe which focuses on the root cause of the problems associated with CRAs, while being cognisant of and safeguarding the essential role that CRAs play in the international financial system. We believe that, in addition to the substantial progress already made by CRA1 and CRA2, further reducing mechanistic reliance on CRAs, increasing transparency and reducing barriers to entrant CRAs would be effective ways of achieving that goal.

Question put and agreed to.