Confusing Messages from the ESMA Chief on Rating Procyclicality

During the Sovereign Debt Crisis in Europe in 2010/12, the idea of monitoring the credit rating agencies’ timeliness of ratings came to the fore. Since then, the EU has been pushing for more impactful regulatory endeavours in the credit rating arena, with many missing the mark. Yesterday, the ESMA Chief Steven Maijoor turned his attention to the issue of procyclicality again as the CRAs being to downgrade a number of countries, with a number of others teetering between investment and non-investment grade status.

Maijoor started by stating that ‘the timing of ratings actions needs to be carefully calibrated’. This is because of the fear that procyclicality will be rearing its head once more, just like it did a decade ago. The concept of procyclicality is described as when credit ratings ‘are stricter during an economic downturn than in an expansion’. Scholars have discussed how, in good times, the ratings tend to be ‘inflated’ but that when the market turns, the ‘massive’ raft of downgrades contributes to massive flows out of particular areas of the marketplace, sometimes via the market responding to the downgrades or sometimes because areas of the market must respond to the downgrades, either because they are regulatory constrained, or constrained by internal investment policies. In the wake of the post-Crisis reforms, regulatory constraints should no longer be applicable, but the fear is that this will not stop the outflow of funds should a greater wave of rating downgrades occur. Another reason why procyclicaclity is so impactful is because of the oligopolistic structure of the industry; we saw recently how when one agency performs a downgrade on a particular entity, the others tend to follow.

Maijoor continued, however. He stated that ‘what’s important is the timing between taking into account the increased risks of poorer credit quality and not acting procyclically, and making sure the timing of these downgrades is done in an appropriate way’. He followed this up with ‘they need to do this independently. We cannot and should not interfere in the ratings processes themselves’. Now, regular followers of Financial Regulation Matters will know that I am often the first to criticise the rating agencies when they deserve it, but on this occasion the tone of the ESMA is not helpful in the slightest. In one breath Maijoor is increasing the pressure on the rating agencies to take action that will benefit the EU in dealing with a sovereign debt crisis, that it is tremendously susceptible too anyway because of its multi-State structure, but on the other hand declares that the ESMA and EU should not interfere. Whether one is a supporter of the agencies or not, it has to be remembered that they operate privately, and for the marketplace – not for the EU. If it were any other time it could be written off as Maijoor simply commenting (which he should be careful to do in his position as Chief of the European financial regulator), but the EU is bordering on crisis. The UK has left, France (before the pandemic) was witnessing civil unrest every week, and the EU’s handling of the pandemic where Italy has been concerned will likely result in a serious problem once the pandemic passes. The project as a concept is in danger, and applying pressure to the rating agencies to provide leniency is not appropriate, and that is before we get into the issue of procyclicality. It must be noted that procyclicality is an inherent issue within the rating industry (particularly at the top end, but in reality throughout), just as the conflicts of interest that come with the issuer-pays system are inherent too. However, what is the solution? Are the agencies supposed to trust the central banks who say the downturn will be temporary and will ‘snap back’ once the pandemic passes? Are they supposed to stagger the release of their downgrades? If so, who gets downgraded first? Whilst a crisis reveals the inefficiencies of the rating industry, a crisis also reveals the inefficiencies of others, and in this crisis the EU is being examined like it never has before. Yet, if the agencies do not downgrade quickly enough, then complaints regarding their timeliness will emerge once more – technically, the agencies provide a service for investors and nobody else, and they need the information as soon as they can receive it.

Maijoor raises a valid point, but perhaps he should not be the one to make it.

Keywords – credit rating, EU, procyclicality, sovereign, downgrades, @finregmatters