News reports on the Eurozone in the last few weeks have been characterized by a dichotomy between those touting credit downgrades by rating agencies on the one hand, and attempts by Europe to reassure the markets on the other. Now that the major credit rating agencies are continuing their ‘mass downgrade’ despite the additional guarantees made by the EU leaders, the European Central Bank (ECB) is striking back by questioning the role of rating agencies in the marketplace.
The European debt crisis originated when many Eurozone countries found themselves facing increasingly high public debt after the late-2000s financial crisis. Over the past few years, countries such as Greece, Ireland and Portugal have experienced difficulties refinancing their debt, forcing the EU and the ECB to take a prominent role in tackling the debt crisis. A series of emergency measures and interventions followed, including the creation of the European Financial Stability Facility (EFSF) – a bailout fund at the EU level.
More recently, on January 9th, French President Nicolas Sarkozy and German Chancellor Angela Merkel met in Berlin where they agreed to speed up the enforcement of stronger budgetary discipline, and on February 21, 2012, the Member States signed a new agreement to lend Greece 170 billion euros conditioned on Greece’s enacting a number of austerity measures.
Three days later, on January 12th, cautious optimism was the keyword when the ECB announced that that it would leave its basic interest rate unaltered at 1%. In both November and December, the ECB had lowered the rate by 25 basis points, but there would not be a third decrease. Mario Draghi, president of the ECB, stated in a press conference that although some important risks remain present, there are signals that the economy in the Eurozone is stabilizing.
So far so good, it seemed, but on Friday, January 13th, the credit rating agency Standard & Poor’s lowered the credit ratings of nine European countries, including France and Italy. The subsequent Monday, the EFSF saw its rating downgraded from AAA to AA+. Although these ratings do not have any legal value, they are influential in the market as banks and insurers generally rely on them to value their investments. A downgrade is therefore likely to increase borrowing costs.
But the Eurozone leaders are not throwing in the towel. During his visit to the European Parliament on January 16th, Draghi urged investors not to blindly follow credit rating agencies. Rather than attacking specific downgrades, Draghi questioned the role of credit agencies and stated that the legislation should lead to less reliance on them and more on competition. Meanwhile in Germany, politicians from Chancellor Merkel’s party are advocating a bill that would reduce dependence on rating agencies by forcing banks and insurance companies to rate their own investments.
The big three credit rating agencies, Standard & Poor’s, Fitch Ratings and Moody’s, continue to defend their role in financial markets. Even though they may constitute only one of many sources for investment decisions, the agencies tout the importance of an independent opinion of creditworthiness. Stavros Gadinis, Assistant Professor of Law at UC Berkeley, explains the position of the credit rating agencies: “What the rating agencies are arguing is that they are only analyzing information that is already in the market, and that the prices already take [that information] into account. So if you believe that markets are efficient, rating agencies don’t matter very much, because they are just working with the information already out there.”
He adds, however, “in reality there are various provisions in the law that tie obligations of financial institutions to ratings provided by rating agencies. So the counter-argument is that regulation has created these categories that cause abrupt movements in the market depending on whether a rating changes.” Professor Gadinis points out that an additional concern with credit rating agencies is the inherent conflict of interest. “Usually the bank that organizes a transaction also hires the rating agency. Of course there are rules for that, but there is still this concern that there might be a conflict of interest.”