Is it possible to create an international and impartial credit rating agency?
In recent years, no business has lost its reputation as devastatingly as credit rating agencies have. Leading up to the worst financial crisis in decades, the top rating agencies: Moody's, Standard & Poor's, and Fitch, rated questionable financial products with excellent marks. They exacerbated the ensuing credit crises by downgrading many European countries’ debt—wrongly, as many politicians later found. In order to prevent this from happening again, an international rating agency is sorely needed. This is true especially for the EU, which has learned its lesson from the crisis of the past years. The call for an international or European rating agency has arisen. The endeavor to make this possible has already faced setbacks and seen various new proposals.
The Bertelsmann Model
In the quarrel concerning the reform of the rating agencies, the Germany-based Bertelsmann Foundation pushes for the establishment of a European credit rating agency with a new model. A study published on the 17th of April by the Foundation demands a global solution, as the assessment of the credit risk of countries is an international concern.
Their model proposes the setting up of a global institution that is financed by governments, international organisations, companies, and civil society. This agency should work independently and carry out assessments free of external influence. “Questionable assessments of the credit standing of states have considerably contributed to the latest financial crisis”, stressed the Chairperson of the Bertelsmann Executive Board, Gunter Thielen. He added, “we urgently need an additional, independent institution for the assessment of land risks, and we must improve the quality of the land ratings.” The Bertelsmann Foundation plans to begin with 37 employees and offices in the US, Europe, Asia, and Latin America.
Firstly, the Foundation wants to convince the governments and companies of the G20 countries of their proposal. The planned, non-profit-oriented rating agency INCRA (International Non-Profit Credit Rating Agency) should be financed by a fund in the volume of $400mn. This money should be invested in a way that the distributions cover the annual operational expenses of the rating agency ($15-24mn) during the first five years.
In comparison, the dominating three companies—Standard & Poor’s, Moody’s and Fitch—earn their money through ratings. The companies being rated by these agencies are at the same time their clients. Because of this, AAA-grade ratings can be bought, which is absurd and defeats the purpose of an independent agency. The biggest problem that resulted from this system of misaligned interests, was the rating of synthetic securities that were created by big customers of the credit rating agencies. Rating these synthetic securities offered big returns to the raters if the latter judged them favorably.
The Bertelsmann model intends for countries to be financiers of the INCRA. An independent committee should oversee its activities to make sure that there are no conflicts of interest. Berlin responded to these plans by stating that setting up a rating agency must be initiated by the private sector. The German government regrets that up to now the financial industry has not found the strength to initiate an independent rating agency.
Secondly, to make ratings clearer and more transparent, the INCRA would connect the evaluation of macroeconomic data with political and socioeconomic indicators. A basis for the latter would be the two indexes calculated by the Bertelsmann Foundation: The Transformation Index, which measures state stability, elections, political participation rights, division of powers and corruption; and the Sustainable Governance Index, which values the demand for reforms and the state’s ability to implement reform. This information from the indexes should enable country assessments that are more long-term, realistic, and transparent than those made by the current three dominant agencies.
Thirdly, INCRA wants to create transparency in assessments by publishing all the data that influences their ratings. The biggest deficit of the three dominant rating agencies is the lack of transparency behind their analysis. This is one of the reasons behind the need for an international rating agency, which additionally is not geared towards creating profit. The reason for pursuing an international solution is that the oligopoly of the big three US agencies cannot be broken simply by setting up an institution that is regionally restricted. The failed attempts of India and China to set up their own rating agencies, are proof of this.
After five years of its existence, the model proposed by the Bertelsmann Foundation should be accepted by the market and by governments. There is no concrete schedule for its implementation: According to a recent statement, it is expected to contract its first ratings by next year. During the next few months, discussions on political levels are planned, after which potential private investors might be approached. In contrast to the model proposed by the German consulting firm Roland Berger, the model proposed by the Bertelsmann Foundation wants to appeal to not only potential investors in Europe, but also to organizations worldwide.
The Berger Model
However, up to now, European politics seem to favor the model proposed by Roland Berger. Last autumn the EU introduced a bill to reform the rating industry and sections of the bill read like a supposed "Lex Berger". Inter alia the bill intends a rotation model—companies have the duty to change their rating agency regularly. This should also make it easier for new rating agencies to enter the market.
The Berger model would turn the credit rating industry upside down. It would be the investors in debt, rather than the issuers of debt or equity, who would pay for the ratings. Thus the agency would no longer have the conflict of interest that current profit-oriented rating agencies do.
The Berger group proposed the following foundation model. A total of 30 investors from the financial industry should contribute €10mn euros each to the rating agency. After five to seven years the new agency should be profitable enough that the financiers can be paid out from the cash flow. Berger wanted to renounce tax money to avoid the suspicion that the agency could bee under too much state influence. How and how much the investors would pay for the ratings remains unclear. Many potential financiers questioned the functionality of this investor-based model.
After many months of negotiations, Berger’s management admitted that they had still not received concrete commitments for the financing of a European rating agency to compete with those from the US. After failing to accumulate income through private capital, Berger now suggests financing the model through income from a possible financial transaction tax (FTT). Representatives of the German government again categorically refused any state financing. It is safe to assume that without the German government’s support, there is no chance for a European rating agency. The German government continues to strive for a European agency financed by the private economy, rather than by governments. In their opinion this is the only way the credibility of the agency can be guaranteed in the market. They say that the failure of the Roland Berger project would be unfortunate, because more competition is necessary in the rating market.
Despite this, Berger is unwilling to bury the project completely. For now a small team of Frankfurt investors is supposed to provide enough money so that the project can at least continue working on the basic idea.
What if Europe fails?
With the likely failure in creating a European or international rating agency, the oligopoly of the American agencies S&P, Moody's, and Fitch is cemented for years. Their market share lies at 95%. The three caused the financial crisis by providing dubious US mortgage loans with best credit standing rates. This strengthened the speculative bubble with the so-called subprime loans, the bursting of which ended in global financial disaster. Moreover, European politicians accuse the US agencies of having contributed to the euro-crisis by downgrading Greece and other debt countries.
Credit ratings must be an international public good. During times in which debt crises can tear down whole national economies, the broader public must have access to independent information. The current rating methods of the big three lack transparency and are therefore problematic. In contrast to the fact that an agreement on an international rating agency does not seem to be possible, it is hard to believe that the global financial markets are regulated by international rules. Why does it seem impossible to agree on an international credit rating agency when its establishment would clearly be advantageous for all participating countries and industries? The assumption that state financing would lead to dependence cannot be valid. If it was, all other international institutions (such as the UN, or IMF) would be prejudiced. While we cannot categorize these institutions as entirely independent, at least they allow countries besides the US to have a voice.
Right now the monopoly of the three American rating agencies is not at risk and all other countries will remain dependent on them. The trials of the financial crises have already shown us that they will not be held responsible for their actions.
The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.
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