Hidden away in the European Commission’s proposals to reform Europe’s trillion euro money-market fund industry is a bold and perhaps revolutionary idea that might have implications for the entire financial system.
Apart from the main thrust of the EC’s plans – altering the way these funds are valued and stepping up their capital buffers – an equally important part relates to credit rating agencies, and breaking money-market funds’ mechanistic reliance on them.
These funds, together with the rest of the world’s institutional investment industry, have long relied on credit ratings as a gauge of sovereign and corporate creditworthiness. This is not out of choice; rather it has been thrust upon them by the world’s financial regulators.
For decades, credit ratings have been enshrined in regulation, institutionalizing the opinions of the biggest agencies – Fitch Ratings, Moody’s Investors Service and Standard & Poor’s.
It is this, combined with the agencies being so deeply embedded into a vast array of financial contracts and market practices – everything from bond indices and performance benchmarks to secured funding, repo and over-the-counter derivatives markets – that has given the credit raters so much power.
Under the EC’s reform proposals however, this might change.
In an unprecedented move, the EC is proposing banning money-market fund managers from using credit ratings: "In line with the general policy to curtail ‘overreliance’ on third-party credit ratings, any MMF manager is obliged to conduct its own credit assessment according to a set of harmonized rules."
This is a bold move by the EC. Should these proposals become law and be replicated elsewhere, it might mean the de-institutionalization of credit ratings. By extension, this might help cut the power the big rating agencies have held for so long.
Unsurprisingly they are angered by this.
In a statement, S&P said: "Banning independent ratings would be unprecedented internationally, wholly unjustified, and do nothing to improve market confidence globally in the stability of European money-market funds."
It added: "We don’t support mechanistic reliance on ratings, but money-market fund managers and their investors should be free to use the investment tools they deem appropriate. The future of European money-market funds requires more, not less transparency, and more rather than fewer independent views of risk."
However, whether ratings are de-institutionalized or not, the reality is that they will continue to be widely used by market participants, and blindly relied on by some. It is a problem that possibly cannot be solved.