This post was also written by Sebastian Barling.

The aftermath of the credit crunch and U.S. house price collapse between 2005 and 2007 saw considerable criticism levelled against credit rating agencies (CRAs) for their rating of various structured finance instruments.

Following on from this criticism, the International Organization of Securities Commission (IOSCO), in conjunction with CRAs, domestic regulators and other interested industry participants, revised its voluntary “comply and explain” code of conduct for CRAs. However, this was insufficient to stem the criticism of the industry (with the IOSCO code previously having been described by the then-European Commissioner for Internal Market and Services, Charlie McCreevy, as a “toothless wonder” due to its non-binding nature).

As a result, the European Commission has introduced pan-European regulation and supervision of CRAs. Regulation 1060/2009 on credit rating agencies (CRA Regulation) came into force on 7 December 2009, with a twelve-month implementation period for the bulk of the regime.

Whilst the registration of CRAs and the requirements in the CRA Regulation will help ensure that competition, conflicts, transparency and quality issues are dealt with, it is not all that is required. Investors have been effectively outsourcing their due diligence to CRAs, without monitoring them and carrying out their own reviews. This issue needs to be addressed.

Too much emphasis is placed upon CRAs and their ratings by policy makers and investors. They are effectively intended to be the opinions of the CRA and the quality of them is essentially based upon information available to them.

Investors need to be educated that they must not overrely on credit ratings. They will be provided with more information as a result of the CRA Regulation and should be encouraged to use it to form their own opinions and to carry out their own due diligence. It would be helpful if, under the Basel Accord, even those on the foundation prudential approach were able to use alternative methods of assigning risk weights, than the formulaic requirements linked to CRA ratings. It is particularly important that the CRA requirements do not in themselves lead to even more reliance being placed upon CRA ratings than is currently the case.