The European Union’s securities market regulator indicated it discovered some shortcomings in how the major rating agencies assess risk to sovereign debt.

rating agencies

The European Securities and Markets Authority (ESMA) said its investigations into Fitch, Moody’s and Standard & Poor’s revealed issues in the sovereign rating processes.

Big three could be fined

In its report, the ESMA pointed out its investigation revealed shortcomings in the sovereign ratings process which could pose risks to the quality, independence and integrity of the ratings and of the rating process. The work was carried out before new European Union regulations came into force last June.

The probe focused on conflicts of interests in the ratings process, safeguards to ensure ratings actions remain confidential until their release and the adequacy of the ratings staff.

According to Huw Jones of Reuters, sovereign ratings became politically charged at the height of the Euro zone crisis when S&P infuriated Greece in 2011 by cutting the rating of its debt while the country’s EU bailout was being renegotiated. This led to the third of three EU laws to regulate rating agencies in as many years. To enhance transparency, starting next month, the rating agencies can only release changes to sovereign ratings according to a pre-set calendar.

The “Big Three” credit rating agencies that score European Union government debt could be fined after failing to fix poor practices from the past.

Senior management driven ratings decisions

Standard & Poor’s, Moody’s and Fitch control 90% of the ratings market and the review of their practices raised concerns about the independence of ratings action. The ESMA found at least one instance of a member of a ratings agency’s board of directors holding discussions with senior members of ratings teams on the appropriate actions to be followed or having a vote in ratings decisions.

The ESMA also believes in certain cases senior management had driven ratings decisions, with limited or late-stage involvement by the lead analysts.

Interestingly, in at least one ratings agency, the ESMA observed several instances of disclosure of upcoming rating actions to an unauthorized third party, before publication and in some cases, before the rating committee had taken place.

Paris-based ESMA also expressed concerns about how the appeals process is carried out for sovereign rating changes and whether specific protocols are in place at the agencies to ensure that ratings changes are kept confidential until they are released publicly, as well as the timing of how those changes are released.