Sovereign Credit Ratings: EUC Report

Lord Vallance of Tummel Excerpts

Tuesday 15th November 2011 Lords Chamber

[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.