EU: Screw Credit Rating Agencies; We'll Do Rating

Credit rating agencies have long been bogeymen for those facing down financial crises. During the Asian financial crisis, Ferri, Liu, and Stiglitz (1999) found these agencies complicit in procyclical ratings that worsened matters. Here is the abstract of their paper:

We demonstrate that credit rating agencies aggravated the East Asian crisis. In fact, having failed to predict the emergence of the crisis, rating agencies became excessively conservative. They downgraded East Asian crisis countries more than the worsening in these countries' economic fundamentals would justify. This unduly exacerbated, for these countries, the cost of borrowing abroad and caused the supply of international capital to them to evaporate. In turn, lower than deserved ratings contributed – at least for some time – to amplify the East Asian crisis. Although this goes beyond the scope of our paper, we also propose an endogenous rationale for rating agencies to become excessively conservative after having made blatant errors in predicting the East Asian crisis. Specifically, rating agencies would have an incentive to become more conservative, so as to recover from the damage these errors caused to them and to rebuild their own reputation.

Well it's 2010 and it seems these same credit rating agencies haven't learned their lesson at all. In this game of perception, have a gander at the view of market participants at what EU actions mean. To them, the ECB allowing Greek bonds to be used as collateral regardless of their credit rating is the latest in a long line of concessions to erring EMU countries:

Still, crucially, this isn't the first key rule behind the euro to be scrapped. Greece, and a number of the other 15 euro members, have already disregarded the rule that borrowing levels should be kept low. Another perceived rule, that no euro member should bail out another, has also been ignored. Now, market watchers warn that this fresh rule-bending exercise creates a further dent to the solidity of the single-currency project. "Junk debt is junk debt. You can't have different rules for different members of the euro. Otherwise, what's the point of having a single currency?" said Simon Derrick, a senior currencies analyst at The Bank of New York Mellon in London

Ah, well. Markets will markets, eh? Far more interesting has been the response from EU bigwigs, In particular, Michel Barnier, Commissioner for the Internal Market and Services, has been keen on policing the dreaded Anglo-Saxon abuses of the credit rating agencies:

"I think we need to go further to look at the impact of the ratings on the financial system or economic system as a whole...," European Internal Markets Commissioner Michel Barnier told members of the European Parliament. "That's why I asked for responsibility to be assumed in the work they are doing." Barnier added: "If you look at Greece, for example, I was quite surprised by the quite rapid deterioration in rating." His comments follow a reminder from the executive European Commission to rating agencies to be careful in their work.

The kicker, though, is that he's now proposing that the EU itself do the job of rating (or at least sponsor an organization doing so on the EU's behalf):

The European Union is examining plans to set up a European credit-ratings authority for sovereign debt ratings in the wake of the Greek crisis, the bloc’s top financial regulator said today. Financial Services Commissioner Michel Barnier is also examining whether ratings companies have too much power, he told the European Parliament’s economic and monetary affairs committee in Brussels today.

“We are undertaking work on creating a European agency,” Barnier said. “We need a very fast, but not off-the-cuff reflection,” he said. “The power of these agencies is quite considerable, not just for products but also for states.” Scrutiny of credit-ratings companies intensified after Greece’s rating was last week cut to junk status.

Is it just me or are there similar conflicts of interest inherent here as when financial service concerns approached credit rating agencies soliciting business? While credit rating agencies' reputations are deservedly junk, you have to wonder if the alternative here can be made to be worth rather more. Yes, EMU countries are probably suffering from credit rating agencies' overreaction now as during the Asian crisis. However, the 'cure' may be worse than the disease.