The European Commission (EC) disclosed its proposal for regulating credit rating agencies, following calls for regulatory oversight of these companies.

The regulations aim to impose rules that address four main areas: conflicts of interest, quality of the ratings and methodology, transparency, and consistent regulations among European Union (EU) countries.

Credit rating agencies have historically followed a voluntary code of conduct in the EU, and non-specific regulations. And now they have been heavily criticized for their part in the financial crisis.

The EU believes a regulated industry is necessary because it is likely the only option that could sufficiently protect investors and European financial markets against the risk of credit rating agency malpractice.

"Whenever it comes to regulation tightening and new rules, the first thing is that the reason why you change and propose something is that it may not have worked right beforehand. Hence the CRA regulation proposals do make sense, as market trust in rating agencies has been lost but ratings remain key for Basel II, as well as for less sophisticated and smaller investors [who are] unable to do all the analysis on their own," said Markus Ernst, senior ABS/securitization research analyst at UniCredit. He added that, with the new rules, regulators will keep better track of the procedure of assessing credit risk ratings from an agency point of view

Under the new legislation, rating agencies will no longer be able to provide advisory services to clients. They will have to disclose their models and methodologies, publish an annual transparency report, and create an internal control to review the quality of their ratings. The EC calls for changes to the agencies' organizational set up to include three independent directors at board level, limits on non-ratings related work, and analyst rotation.

Additionally, no rating will be issued if there is insufficient information available. Rating agencies are also required to publish an annual transparency report on conflicts, methodologies, assumptions, compensation policy and rating performance. They will also not be able to charge a fee for disclosing information about their methodologies and ratings, among other items.

As such, compliance with the wide range of requirements laid out in the EC proposal means that the agencies are likely to see an increase in operational costs.

"These potential cost increases and limits on revenues could have significant commercial repercussions for the agencies, and might affect their ability to attract and retrain the appropriately experienced and trained staff that the new EC rules also insist upon," Hans Vrensen, an analyst at Barclays Capital, said in a research note last week. "We believe this last issue might need to be further discussed to arrive at a commercially viable solution."

Vrensen added that many of these requirements seemed sensible and should assist in restoring trust in the ratings among investors and others, once implemented. He also said that the proposal offers a sensible alternative to solely mandating the use of a different rating category for structured finance instruments, which is an idea that has been put forth in the past. The proposed new requirements would also allow the rating agencies to provide a report with additional information on the rating methodology and risk characteristics of structured finance instruments, explaining how they differ from other instruments.

"We expect that this will be the rating agencies' preferred option, [as it] avoids potential confusion around separate structured finance ratings," Vrensen said.

However, in some cases, these proposed directives look difficult to implement and monitor after implementation. In other details, the proposed directives are already in place at the agencies. Standard & Poor's, for example, has responded that some of the proposed solutions that were created to fight "conflict of interest" cases have already been implemented through the rotation of analysts every four years, delinkage of analysts' salary and issuer payments, and formal or informal recommendations by analysts.

Additionally, the initiative to prohibit rating agencies from rating certain transactions when too much information is missing is creating widespread uncertainty. "Overall, the initiative focuses on the right aspects, but too few quantitative limits have been set," Ernst said. "However, also setting detailed rules may not automatically help."

Ironically, Ernst said that the best way to avoid conflict of interest and an eventual negative impact on investors would be to give more power to ratings firms, as well as more reasons to say 'no' to rating certain transactions. Investors, in the past, have relied on deals rated by at least two rating agencies. In a Darwinian way, currently no complex products are accepted by the market when three rating agencies are needed to place a transaction.

It is still unclear to what degree the European action will interfere or be coordinated with eventual U.S. government actions.

"All changes in regulation bear the problem of overregulation if the problem beforehand was immense - agencies are among the most blamed [for triggering] the crisis, hence overregulation or rules which are hardly feasible might be the outcome," Ernst said. "The changes can also have the problem of mis-coordination: there is always the risk of boltholes that may be left open if you do something on a European side, but do not regulate in the same manner on a U.S. side, for example."

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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