A draft law will be published in the middle of November by EU Internal Market Commissioner Michel Barnier that could dramatically alter the way ratings agencies work. In view of the reinsurance industry’s dependence on raters – either for demonstrating their own financial strength, or when they issue debt or for choosing their invested assets – there could be serious ramifications for the industry.
According to details of the proposals leaked to Reuters and to the Financial Times, policymakers want to increase competition between rating agencies and also to break up the ‘issuer pays’ model of doing business.
Barnier is also expected to mandate the “rotation” of agencies for corporate debt and structured finance whereby companies will have to switch every three years. Before working for the same company again, agencies would have to sit out a four year cooling off period, potentially disrupting the agencies’ stable revenues and business relationships.
The draft law also looks at the ownership of agencies, which market-watchers believe could prompt a restructuring of the big three US-based agencies: S&P, Moody’s and Fitch. That’s because if the agency is listed, as the trio are, its shareholders could be barred from investing in any company the agency rates. An agency also may not be allowed to rate a company that its shareholders have a stake in.
Another controversial change concerns sovereign ratings, currently in the industry spotlight after downgrades at Mapfre and Groupama. Policymakers think raters made it more expensive for governments to bail out Greece because downgrades were issued during negotiations. Their solution would be to allow ESMA, the European markets regulator, to temporarily ban ratings in exceptional circumstances, for example imminent changes to the creditworthiness of a state, immediate threat to financial stability and excessive volatility.
As the FT pointed out in its report, there is some confusion over how such a ban could be enforced, as ESMA would be unable to stop agencies outside the EU from issuing sovereign ratings on countries in bailout programmes. Credit ratings agencies are also likely to argue that a suspension would amount to a restriction of free speech as they consider their ratings to be opinions.
They will be concerned that other proposals further undermine their opinions: under the reforms, it is believed that ESMA will be asked to develop technical standards, to be endorsed by the Commission, to harmonise ratings scales and the presentation of reports. New rating methodologies, or adjustments to existing models, will have to be open to consultation and submitted to ESMA for “approval”.
But ultimately, the policymakers want to reduce the financial industry's reliance on ratings, saying, "Financial institutions... should therefore avoid relying solely or mechanistically on external credit ratings for assessing the creditworthiness of assets".
Yet the proposals are also believed to include a provision that allows investors to be able to sue agencies under civil law for having relied "on an incorrect rating”.
Whether this upheaval will encourage the formation of smaller rating agencies to compete with the ‘oligopoly’ of the existing US raters remains to be seen. One radical idea mooted earlier this year that the European Union itself establish its own rating agency seems to have been kicked into the long grass.
But big change is coming to the raters and it will be interesting to see how and if those changes filter through to established re/insurer rating relationships and methodologies.
It is hard to see reinsurance buyers and sellers reducing their dependence on raters anytime soon. Some industry figures have in the past bemoaned the fickle power of raters, usually after a well-timed downgrade. Others acknowledge that in the absence of any other form of grading or benchmarking, raters provide a necessary, though imperfect, service.
But the EU’s proposals could be the thin edge of a wedge that eventually leads to a change in that longstanding love-hate relationship – for better or for worse.