Embedding ratings in regulation is mistake-critic

By Jane Baird

LONDON, June 25 (Reuters) - The core problem of the current credit ratings system is that ratings are so embedded in financial regulation that they serve as regulatory licences, not just information, a well known former banker and academic said.

"The regulatory dependence on ratings is a cow that the ratings agencies have been milking for many years, and the cow has gotten fatter and fatter and fatter," said Frank Partnoy, a law professor at the University of San Diego and author of "Infectious Greed".

"If there were some way that we could get rid of it, we could move to the next stage and not have all this disfunctionality where people have to have a rating for capital reasons," he told the Euromoney Global Borrowers & Investors Forum on Wednesday.

The U.S. Securities and Exchange Commission said on Wednesday that it may propose eliminating the requirement that money market funds hold only securities with high ratings, among other measures to reduce reliance on ratings. [ID:nN25455722].

Europe, meanwhile, is moving to ensconce ratings in regulation with implementation of Basel II, which uses them to fix how much capital banks must set aside for different assets.

At the forum, executives of the three major agencies -- Standard & Poor's, Moody's Investors Service and Fitch Ratings -- said that they did not want ratings to play a regulatory role.

"What we produce is an opinion ... that's all it is intended to be," said Ian Bell, S&P's European head of structured finance ratings. "A number of governments, particularly the U.S. government, have decided to take that opinion and to attach certain rights to it.

WRONG THING TO DO

"We have vociferously said it is the wrong thing to do, but nevertheless governments have chosen to do that," he added.

Frederic Drevon, Moody's head for Europe, the Middle East and Africa, said, however, that investors in parts of the world without regulatory intervention had also become dependent on ratings.

"If you look at Basel II, trying to find a simple way of addressing credit risk is very difficult if not relying on some external independent source, and for better or worse you have the agencies doing that," he said.

"Alternative solutions do not always exist in the market," he added.

Partnoy acknowledged that the problem is deeper than regulation. "There is a follow-on behaviour effect that is associated with regulation. Once people start to use a certain kind of nomenclature, they lock in."

But he also proposed an alternative system.

"Regulation should depend on market prices ... on credit spreads," he said.

Some objections to this idea are that there are no spreads for a lot of securities that are not liquid and that market pricing could be manipulated over the short term, he said.

"But those are objections of the second order. If we could agree that we would like to harness the power of the market for regulatory purposes, then we could come up with some kind of a measure of a rolling average of the market's assessment of credit risk associated with particular investments."

Such a system would be simple and would react more quickly to an underlying change in creditworthiness, he added.

Philip McDuell, Fitch head of European and Asian structured credit, said, however, that if the agencies had performed better leading up to the credit crisis, "we wouldn't be having this debate". (Editing by David Cowell)