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Overrated: Why Relying Solely on Credit Rating Agencies Is No Longer Worth the Risk

The crisis of the last few years showed that although credit rating agencies can be useful, they are far from infallible.

If you depend on someone for their assessments, it helps if they are reliable.

On 15 October 1987 weatherman Michael Fish famously told people not to worry, just hours before the worst storm to strike south east England since 1703.

Twenty years later experts failed to predict another devastating disaster. Dubbed by some the Great Recession, the economic crisis of the last few years is considered the worst financial crisis since the Great Depression dragged the global economy through the mud in the 1930s. It was not just that economists generally who had not seen it coming, neither had the credit rating agencies, whose job it is to assess the credit worthiness of companies, governments and other organisations that issue bonds and debt-like securities. Worse, the agencies are accused of helping to cause the crisis by issuing positive assessments of risky financial products that in hindsight proved to be far too optimistic and assisted in fuelling the housing bubble in the United States.

Of course, credit rating agencies play a highly valuable role in today's economy. Their ratings help investors to assess credit risk. This boosts market efficiency and helps to lower costs. But for the agencies to do their job efficiently, their assessments need to be as reliable as possible. The crisis of the last few years showed that although credit rating agencies can be useful, they are far from infallible.

Despite their recognised shortfalls, credit rating agencies continue to be highly influential. Especially in Europe, where countries are toiling to shrink the size of national debt, the agencies' ratings can spark off a vicious circle. A negative rating can drive up the cost of borrowing, making it more difficult to reduce debt, leading to another downgrade.

The European Parliament is this week looking at twoproposals to make the work of credit rating agencies more transparent and reliable, including a limit on unsolicited sovereign debt ratings and a moratorium on specific policy recommendations. In addition, to ensure the independence of ratings and prevent conflicts of interest, their shareholdings in rated entities would be capped

The two MEPs charged with steering these plans through parliament have broadly welcomed the draft legislation drawn up by the European Commission, but have come up with suggestions to improve it further by prohibiting unsolicited sovereign debt ratings and imposing restrictions on mergers and acquisitions by rating agencies.

MEPs had already adopted a resolution on 8 June 2011 calling for a stronger regulatory framework for credit rating agencies and stressing the need to reduce over-reliance on them. They also suggested the setting up of a European rating agency, but this has not been incorporated into the current proposals.

Infographic © European Union 2013 - European Parliament