Monday, June 16, 2008

Time to end the rating agency "rot"

(FT Alphaville) I've had less cause of late to criticize the Wall Street Journal as the paper has made strides in its coverage of the credit markets. However, today's paper has a story in which ideology appears to have compromised its reporting.

Today Charlie McCreevy, EU internal markets commissioner, is to outline proposals for closer, tougher oversight of rating agencies (see full speech below). His speech contains some withering attacks on the US regime, not merely its structure, but also the failure of regulators to exercise the powers they had. From the Financial Times:
Mr McCreevy is to make clear that nothing short of supervision will do. "I am now convinced that limited but mandatory, well-targeted and robust internal governance reforms are going to be imperative to complement stronger external oversight of rating agencies," he will say. "I have concluded that a regulatory solution at European level is now necessary to deal with some of the core issues."

The announcement comes just weeks after the International Organisation of Securities Commissions proposed changes to the industry code of conduct, a code Mr McCreevy will make clear falls far short of what is needed.

In withering language, Mr McCreevy will describe the code as "a toothless wonder" and point out that "no supervisor appears to have got as much as a sniff of the rot at the heart of the structured finance rating process before it all blew up".

He will say that he is "deeply sceptical" about its usefulness. "Many of the recent IOSCO task force recommendations do not appear enforceable in a meaningful way," he will suggest.

He will also call for "robust firewalls" to protect those responsible for the integrity of the process from executives whose priority is "to drive forward" earnings.

So McCreevy thinks both the current regime and the IOSC proposals are grossly inadequate. And how does the Journal present his views?
Europe's top markets official is set to unveil a plan to regulate bond-rating companies, a move that adds heft to similar efforts by U.S. officials to address causes of the yearlong global credit crunch.

Charlie McCreevy, the European Union commissioner for internal markets and services, plans to say in a speech Monday that he will propose legislation designed to address what he sees as conflicts of interest at credit-ratings companies. In a draft of his speech, he called current voluntary codes of conduct a "toothless wonder."...

Among other measures, Mr. McCreevy wants to enforce so-called fire walls between operations of the ratings companies that raise fees from clients issuing bonds and operations that rate the bonds. He wants ratings companies to register in a way similar to that in the U.S.

Policy makers have criticized ratings companies because their ratings of structured products failed to reflect their true risks, particularly under stress. Critics say there is an inherent conflict of interest in the business: an issuer of debt pays the agencies to rate its product and sometimes, in the case of structured credit, to help design the product, too.

The U.S. Securities and Exchange Commission recently recommended that credit-rating firms make more information about ratings publicly available.

Mr. McCreevy's plans would ban some practices and require firms to distinguish between corporate or government debt and complex structured products.

So the Journal intimates that McCreevy is pretty much on the same page as US regulators, and makes no mention of his unusually harsh criticism or specifically, that supervision was woefully inadequate and is badly needed.

Misconstruing where McCreevy stands relative to his US counterparts seems a deliberate attempt to play down calls for more stringent regulation.

Inaugural Global Financial Services Centre Conference, Dublin, 16 June 2008

The financial services sector in Europe is both a significant sector in its own right, and vital in providing capital and investment across a single EU market. In recent years the growth in the sector was nearly twice that of EU GDP- and double the levels of the late 90s. This is a significant change and illustrates the recent expansion of this sector in Europe.

In today’s global markets, regulation can no longer be considered ‘domestic’. International standards and financial globalisation have dramatically changed the landscape, both for the financial services sector and for its regulators.

Today I would like to focus on the European Commission’s approach to regulation and how we have gone about opening our markets and ensuring, as far as possible, the global competitiveness and attractiveness of Europe as a leading global financial centre.

Integrated, global financial markets

The recent financial turmoil has clearly shown just how integrated financial services markets have become. A collapse in the US sub-prime mortgage market sparked a global breakdown in both investor and financial sector confidence.

Here in Europe it did not take long before we saw first hand these effects - with the near failure of a bank in Germany, and the first run on a UK bank in over a century.

We are still to see a full evaluation of the impact that this turmoil has had, both on Europe and the world, but expect it to be significant.

EU policy approach - getting the legislative framework ‘right’
Our job as regulators is to make sure that the legislative framework is right and to own up when it is not. The quality of regulation is tested in bad not in good times. Our regulatory system needs to be designed to cope with difficult situations.

The difficulty lies in creating the right balance between creating a framework which is flexible enough to allow entrepreneurs and innovation to flourish, but which also creates an environment where both investors and consumers have confidence in the market. The recent turmoil has vividly illustrated the significant impact that a loss of investor confidence can have on the financial services market.
I believe that good regulation, and by definition, a globally competitive regulatory environment, is based on three key factors.

Firstly, that there are fewer, and where they do exist, better targeted rules.

Second, that we have clear but not inflexible procedures that are followed before rules are adopted. These include open consultation, economic impact analysis, early participation of market professionals and national regulators. But let me make one thing clear: Regulators must not be captured by market participants and economic impact analysis is no substitute for commercial common sense or a proper understanding of the structures and cultures that drive bad behaviour whether in mortgage brokers, banks, or credit rating agencies.

And third, that there is effective enforcement.

The foundation for the EU’s common financial services market was laid in 1999 with the adoption of the Financial Services Action Plan. The objective was to create an integrated, Europe-wide, single market in financial services through a framework of legislation, co-operation and practice. We foresaw significant benefits that could come from this approach - from stimulating pan-European competition and innovation, reducing the cost of capital for industry, strengthening financial stability and providing a regulatory environment that would attract further investment.

Nine years on we have seen a transformation of the financial services landscape across Europe.
The Lamfalussy process has served us reasonably well in the policy making process and has provided a basis for greater supervisory convergence and cooperation but the processes must also continue to be refined to ensure that the Lamfalussy process and the level 3 committees are best placed to add value in the policy making process.

The response to the credit crisis
Last October, Europe’s Finance Ministers agreed on a ‘roadmap’ as a first response to the many weaknesses that the turmoil had identified in the financial system. The roadmap had four key objectives, to improve transparency in the market, to improve valuation standards - especially for illiquid assets, to strengthen the EU’s prudential framework for the banking sector, to investigate structural issues, and to examine the role of credit ratings agencies.

On some of these issues work is well advanced. Endless procrastination is not my style and where good progress- involving supervisors, regulators and market experts - has been made in deliberating on potential solutions I intend to move forward purposefully rather than allow clever lobbyists manipulate or slow things down in the interests of their clients.

I said before that I would not wait indefinitely for the credit rating agencies to come forward with meaningful proposals to put their houses in order. And I mean what I say. The IOSCO Code of Conduct to which the rating agencies signed up has been shown to be a toothless wonder. The fact is that despite the checks on compliance with the IOSCO Code , no supervisor appears to have got as much as a sniff of the rot at the heart of the structured finance rating process before it all blew up. I am deeply sceptical that the appropriate response lies in building on and strengthening the IOSCO code: While external oversight of rating agencies is important it is not sufficient to adequately address the issues. Many of the recent IOSCO task force recommendations do not appear enforceable in a meaningful way and I am now convinced that limited but mandatory, well targeted and robust internal governance reforms are going to be imperative to complement stronger external oversight of rating agencies.

While some of the additional steps that the main rating agencies have announced are welcome, they are insufficient. I know some would be willing to do more but I can quite understand why they are reluctant to move forward with more ambitious proposals if there isn’t going to be a level playing field. This is one of many reasons why I have concluded that a regulatory solution at European level is now necessary to deal with some of the core issues.

I want to thank both CESR and ESME for their valuable work even if I do not agree with ALL of their conclusions…

I welcome the focus on analytics and policy and also on the importance of corporate culture, and on corporate governance of the rating agencies as stressed by ESME. It is absolutely essential to ensure that there are sufficiently strong and robust firewalls between those who, on the one hand, are charged with the primary responsibility to shareholders of driving forward earnings and those who on the other hand must have the primary responsibility for managing the quality and integrity of the rating process. Remuneration and incentive packages for analysts must also be geared to underpinning long term confidence in the ratings they disseminate. ESME correctly identify the management challenge of promulgating the appropriate organizational culture to effectively manage the conflicts of interest arising from the trade off between quality standards and profitability, especially in structured finance because of the exceptional and disproportionate impact on earnings of the flow of new structured finance ratings issued . Their recommendations on corporate culture are ones I fully endorse.

However ESME’s argument that regulation of the rating agencies could be seen as some sort of official endorsement of the ratings they disseminate is not a view I share because the rating agencies have already been given recognition, legitimacy, and implicit trust in key pieces of European financial services regulation that is designed to underpin financial stability and investor protection -including UCITS and the CRD.

Indeed it is appropriate that we ask ourselves if in circumstances where so many of the rating agencies have standards of governance that fall so far short of best practice : Is it right that their ratings should be so embedded and implicitly “endorsed” in these pieces of legislation without best practice in corporate governance? That is an issue that merits focus in the final stages of the CRD review, as well as in Solvency 2 and in the UCITS “eligible assets” regime.

I recognise that the views of our Member State governments on various aspects of corporate governance diverge. For that reason I will not be proposing a template for rating agency governance that would create or could be seen as a precedent for other businesses that do not play such a central role in our financial market regulatory system or have such embedded conflicts of interest in their business models.

Having considered the reports from CESR, from ESME, and indeed the work of the IOSCO task force, and having consulted with the rating agencies themselves I am convinced that meaningful but targeted regulatory measures are now necessary for rating agencies operating in the structured credit markets in Europe, including registration, external oversight and much better internal governance. Let me be clear: External oversight is absolutely necessary in respect of, for example, the policies and procedures of CRAs.

But on the substance of ratings and design of models it would be inappropriate. Regulators should not be in the business of opining on individual rating content. However robust, ring-fenced internal governance of rating content , including statistical modelling and of the quality and remuneration structures of analysts and the promulgation of appropriate corporate culture, is absolutely essential. We have now started work on the issues involved and I want to propose appropriate measures to the College in coming months. I hope we can also craft these measures in a way that will encourage entry to the market by new players, working perhaps on a different business model.

We will continue to listen to stakeholders but we will not be diverted by delaying tactics. Europe must and will take a lead in addressing the challenges and risks presented.

Integration and globalisation in financial markets means that much regulation can no longer be evaluated at a purely ‘local’ level. Regulators must consider global as well as local risks, international developments in financial innovation, as well as the increasing complexity of multinationals and cross-border service providers.

It is with this in mind that the EU has set up regulatory dialogues on financial services. Primarily with the US, but also with Japan, China, Russia and India. Naturally, our dialogue with the US is the most developed and I am sure that Paul (Atkins) will confirm that it works well and that it works at every level. In our discussions with the U.S. we have agreed on a number of current and critical issues including accounting, banking, securities and many other issues.

One of our key objectives has been to promote international standards. Carefully crafted, they are a powerful tool to extract the best from globalisation. Late last year, SEC Chairman Christopher Cox announced the ending of reconciliation from IFRS to US GAAP. This decision will not only greatly benefit EU companies with a US listing but is a major step forward for global convergence of accounting standards. Just as importantly, this decision has taken less than two years to come into being after the SEC and the European Commission affirmed their commitment to a roadmap to do away with costly reconciliations between US and EU accounting standards.

Importantly, during the recent turmoil we have been in close contact with the US and you will note that there is broad consensus between the EU and the US on many of the policy responses to the turmoil. Of course while there will often be consensus on ends there will not always be consensus on means. That however does not mean, in the case of rating agencies for example, that we shouldn’t -over the longer term - see whether there could be some further convergence of approach. In the meantime however Europe cannot fail to address the issues in the way we consider necessary to protect the interests of our investors and as part of the enhanced architecture for underpinning the stability of our financial institutions.

In all of our dialogues, we are pragmatic. We want to solve problems and not get bogged down in establishing more bureaucracy or complex procedures but to address regulatory issues which are creating real business problems. This approach is consistent with the ‘light touch’, principles based regulatory approach I outlined earlier. But when I say ‘light touch’ I in no way mean ’soft touch’. I firmly believe in international competition and open markets. To this end I have always been very firm with Member States and national regulators when protectionist tendencies spring up. It is the same for third countries.

I believe that we have come a long way towards creating an environment in Europe that fosters growth and innovation in financial services. But there is still more to be done and we, and by that I mean, all regulators, must make sure that the regulatory environment remains flexible and current to the needs of the global financial sector. If we can achieve this aim we will ensure the success of all financial centres, not only in Europe, but throughout the world.

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