So, what does that mean for the U.S.?

In April, the European Union approved several new regulations

governing the activities of credit rating agencies there. Among other changes, the agencies can no longer provide advisory services, must disclose the models and methodologies they use, and must have at least two directors on their boards whose compensation isn’t tied to the agency’s business performance.

That prompts the question, Should the U.S. adopt similar rules?

The regulation prohibiting the agencies from also providing advisory services to their clients makes sense, given the clear conflict of interest it presents. “Agencies advising their clients and then providing ratings is one of the most egregious manifestations of the conflict of interest” in the business model of rating agencies like Standard & Poors and Moody’s, says James Gellert, president and chief executive officer with Rapid Ratings International, Inc. , a subscriber-paid rating firm. Gellert discussed the state of the U.S. rating system for a February blog post, “Assessing the Rating Agencies”.

Requiring agencies to disclose their models could backfire. For starters, simply disclosing the models does nothing to ensure that the assumptions and methodologies are sound. And, users of the ratings still need to conduct their own analysis of both the ratings and the assets they cover. Moreover, requiring firms to disclose their models is, in essence, forcing them to give up their intellectual property.

The most effective way to boost the quality of ratings is by fostering greater competition within the ratings business. Currently, three firms – Moody’s, S&P, and Fitch — produce about 98 percent of all ratings, Gellert says. Often, investors have no option but to use them. That’s the case even though the quality of their work is debatable, to say the least. Earlier this year, SEC commissioner Kathleen Casey called their ratings work “catastrophically misleading” and noted the “virtual absence of any accountability to investors, markets, and regulators.”

Boosting competition and prohibiting conflicts of interest would put the onus on all ratings agencies to take steps to ensure that their ratings are sound and robust, appropriately consider risk, and are as free of bias as possible. ###