(Adds S&P comment, SIFMA)
By Huw Jones
BRUSSELS, July 31 (Reuters) - Credit rating agencies which breach strict new European Union rules aimed at making them more accountable could be banned or prosecuted under a draft law published by the EU's executive on Thursday.
Standard & Poor's MHP.N, Fitch (LBCP.PA) and Moody's (MCO.N) are under the regulatory gun on both sides of the Atlantic and already face lawsuits in the United States.
They are widely blamed for being slow to warn investors about risks in securitised products they rated.
Despite high ratings, the products became untradable when U.S. home loans underpinning them went upaid, forcing banks holding them on their books to suffer massive writedowns.
The draft law would replace a voluntary code of conduct.
"The crisis has shown that self-regulation has not worked," EU Internal Market Commissioner Charlie McCreevy said.
The draft law is open to public consultation until early September before a final version is adopted for approval by EU states and the European Parliament.
Agencies are paid by the companies whose debt or products they rate, a situation that makes regulators uneasy.
"Credit rating agencies will have to comply with exacting regulatory requirements to make sure ratings are not tainted by the conflicts of interest inherent to the ratings business," McCreevy said.
TOUGHER THAN U.S. SYSTEM
The draft goes much further than a registration system introduced in the United States last October.
Under the U.S. system, an agency that runs foul of the rules would be deregistered but could still operate.
McCreevy is proposing far stronger sanctions that could force an agency to shut up shop in the EU altogether.
Agencies would have to identify and disclose conflicts of interest, and staff compiling ratings cannot take part in discussions on fees. Methodologies used to arrive at a rating must be published, the draft law says.
Moody's said it hoped that any approach adopted by authorities will promote global consistency. Fitch said a single-EU approach was better than each country going it alone.
"It is important that such an approach focus on compliance with the... code of conduct, avoid a bevy of additional rules and have an oversight body comprised of independent capital market regulators," Fitch Ratings Managing Director David Weinfurter said.
S&P said it would look at whether the draft provided consistency for investors and issuers operating internationally and preserved the independence of ratings opinions and methodologies used to draw up a rating.
The Securities Industry and Financial Markets Association, an industry lobby, said agencies failed to check "suspect" data used to compile ratings and called for a global, independent ratings advisory board.
For the EU, McCreevy proposes a "one stop shop" for authorising agencies and puts forward two options for achieving this.
One would give a key role to the Committee of European Securities Regulators (CESR), made up of national market watchdogs from the 27 EU states. National supervisors would oversee agencies on their turf, with strong coordination by CESR.
The other approach would be to create a new EU agency, either a new body or a reform of CESR.
Sanctions could include an EU-wide ban, a temporary suspension of activity, a public warning for breaches of the law and even criminal prosecution.
Banks rely on ratings to work out how much capital they must set aside to cover liabilities such as securitised products on their books.
McCreevy wants to end this "excessive reliance" at banks.
The Commission is thrashing out separate measures to force banks to look "beyond ratings" in calculating capital. "If banks fail to do so, they would not be allowed to use external ratings for regulatory capital calculations and would have to deduct the full securitisation exposure from regulatory capital," the Commission said.
Ratings could also carry "health warnings" to warn of specific risks in the securitised products found at the heart of the credit crunch.
(Reporting by Huw Jones; Editing by Jason Neely and David Cowell)