The European Commission has announced plans to create an EU body that will supervise credit rating agencies. The move comes amid European anger toward U.S.-based credit rating agencies as the Continent still reels from economic crisis. The European bid will struggle to overcome the powers of geopolitics, however, that have made the United States more amenable than Europe to the pooling of capital.
The European Commission announced plans June 2 to enhance the monitoring and regulation of credit rating agencies by giving a new EU body — the European Securities and Markets Authority (ESMA), planned to be in place by 2011 — the power to supervise the agencies. The decision comes as criticism of credit rating agencies has mounted in Europe, with EU economic policy chief Olli Rehn on May 10 going so far as to suggest that the European Commission was thinking of setting up a European-based credit rating agency. The announcement comes just a day after rating agency Standard & Poor's revised its credit outlook for the municipality of Brussels — home of the EU — from stable to negative. The impetus behind enhanced supervision of U.S. credit agencies — Moody's, S&P and Fitch — comes from the role they have played in the European economic crisis. European policymakers have argued that it is folly to leave the fate of EU member states in the hands of U.S.-based financial institutions. Whether by regulating the American ones or simply creating a European credit agency to take their place, the creation of the ESMA represents a bid to resolve the problem of not having any major indigenous credit rating agencies Particularly troubling for the European Union, the European Central Bank (ECB) uses the agencies' ratings to determine whether a government bond is eligible as collateral for ECB liquidity. These ECB liquidity injections have been a lifeline (as the interactive graphic below shows) for both European banks and governments dependent upon deficit spending (in particular, Greece) in the ongoing debt crisis. A succession of Greek sovereign credit downgrades nearly made Greek bonds ineligible as collateral — perhaps the only reason banks still held on to them in the first place. This would have extinguished demand for Greek debt and increased the costs of issuing new debt for Athens, quite probably precipitating a crisis in the whole eurozone. The ECB avoided the crisis by lowering the credit rating threshold at which it accepts Greek government bonds as collateral, but the episode clearly illustrated Europe's dependence on the ratings determinations of non-European financial institutions. (click here to view interactive graphic) It might seem logical that European government debt and banks should be rated by a European credit rating agency. But geopolitical constraints have dictated that the three main institutions that rate European government debt and banks are American. Unless Europeans can overcome these geopolitical constraints to a European credit rating agency, European efforts to regulate or create an alternative, European agency will represent purely political — rather than economic — moves designed to let EU member states off the hook in terms of debt rating. It is likely that instead Europe will not be able to overcome these constraints, and that any attempt to do so will produce less-than-optimal institutions.
The Geopolitics of Credit Rating
Credit rating is about providing investors an assessment of credit risk of a corporate, municipal or sovereign bond. Many investors rely on, or incorporate, agencies' ratings when making investment decisions. Higher-yield debt is normally riskier than lower-yield debt, which is all the more reason for investors to seek information from credit rating agencies when investing in higher-yield debt. At base, credit rating agencies are not much different from movie critics. A movie review provides consumers — in this case, viewers — an assessment of whether they should spend their money (and time) on a particular movie. But just as movies are made in different languages and cultures, so, too, does debt come in different flavors. Different governments (developed versus emerging) and corporations (companies versus banks) all issue debt. A globally accepted credit rating agency must be well versed in capital formation and movement on a continental scale; it cannot be too specialized in any one region, business or market. Similarly, a movie critic specializing in Italian postmodern cinema would probably not be deemed competent to review a Hollywood blockbuster in the eyes of most moviegoers. Because of a series of geopolitical variables, the U.S. credit agencies are thus able to provide research on a global scope. (click here to enlarge image)
Keeping this in mind, we can begin to discern why the major credit rating agencies are American. American geography is advantageous to capital formation. The Intracoastal Waterway interlinks the entire Eastern Seaboard and Gulf Coast of the United States, while the Mississippi and Ohio river valleys link the Atlantic and Gulf of Mexico with the core agricultural regions of the Midwest. The St. Lawrence Seaway completes the circle in the north. When transportation costs are low, more trade is possible, profit margins are greater and capital is accumulated more quickly. These benefits are then grafted onto the American political landscape. The United States has been a single political entity since the late 18th century, and so can spend all its resources on becoming even richer rather than fighting among its own regions (although that did happen in the Civil War, but that was a one-off affair). Europe, on the other hand, has a divided political geography created by the islands, peninsulas and mountains that crisscross the Continent. As European history shows, it is nearly impossible to gain political control of the entire Continent. While navigable rivers and valleys are plentiful and the cost of transportation is cheap, the Continent's geography splits different capital pools from one another, a process reinforced by Europe's disparate political authorities. Separate capital pools and governments reinforce each other's independence. Political centers of power jealously guard their banks for financing while the banks promote the expansionist forays of their governments on the Continent and globally to add market share. The end result is that there is no New York of Europe. Instead, the Continent has a number of capital centers focused on river valleys and seaborne trade such as the Rhine, Po, Danube, Thames, Seine, Rhone and the Baltic Sea.
The Geography of Development and Types of Capitalism
Ironically, the obstacles the United States did face actually gave rise to its credit rating agencies. Despite cheap transportation costs, developing the United States called for overcoming certain geographic challenges, mainly scaling the Appalachian and Rocky Mountains. Railroad construction was an extremely capital-intensive project that forced investors in New York, Boston and Philadelphia to seek information on where to invest their capital, often in places half a continent away. It was with the railroad boom of the late 19th century that both S&P's and Moody's developed, providing information and financial research about distant investment opportunities to the capital holders on the Atlantic Coast. Europe never had the same environment, because, as discussed, its capital pools were relatively enclosed and focused on specific river valleys. Information was still at a premium, but investment opportunities were far less about the unknown Wild West, where credit rating agency reports became essential for would-be investors. Third, the isolation of the United States, which lies an ocean away from the nearest power center, has given America the luxury of not having to compete for capital with other governments directly. It has also made the continental United States secure enough to not have to worry about any significant external threats since the War of 1812. This has meant that the United States has had the luxury of allowing capital to move freely and engender growth without direct government involvement. In this environment of free-market capitalism, credit agencies make sense since the government does not care as much who wins and loses. It is therefore possible to rely purely on a credit rating agency relaying information for one's investment decisions. This is not to say that the government does not intervene in or regulate the market, but that interventions are far less obvious than they are in continental Europe. In Europe, such luxury does not exist. Europe is a cauldron of political entities that have considerable security concerns. When industrialization arrived on the Continent in the early 19th century, Europe's states realized they did not have the time to let capital flow freely and go through trial-and-error evolutionary processes of figuring what works. Only the United Kingdom had this luxury due to the (relative) isolation provided by the English Channel. Industrialization became part of the national security complex — especially in terms of coal and steel production — with capital the necessary fuel for the state-building project. Germany is the best example of this, as Berlin encouraged close links between the biggest banks and industrialists whose leaders often sat on each other's boards. This form of collusion between politicians, industrialists and financial institutions was necessary to develop Europe's states, and influences the Continent to this day. Europe's corporations are still far more reliant on banks — in Germany close to 80 percent — for financing than on the stock or bond markets like in the United States, and hybrid private-state owned banks dominate the Continent (such as Cajas in Spain or Landesbanken in Germany). In an environment where policy influences capital access, the value of information provided by credit rating agencies is diminished. It is far more useful to read a tip on an upcoming regulation change in the business weekly than to read a report on the bank's balance sheet when the investment environment is heavily politicized. Credit rating agencies have very little comparative advantage in the latter.
Implications for the Future
A tradition of free-market capitalism coupled with the benefits of free capital movement and low security outlays have given the United States the know-how and tradition to develop global credit rating agencies. And as the global hegemon, the United States is often seen as the most impartial adjudicator as well. This is not to say that U.S. credit rating agencies are infallible; their role in the subprime mortgage crisis is well established. But it does mean that investors in France will always be more comfortable relying on a U.S. agency to rate an Italian bank than, say, a credit rating agency from Spain — or, of course, Italy. This lack of a unified capital/financial structure is Europe's ultimate problem. Despite the free movement of capital being one of the central tenets of the European Union, independent capital pools still very much exist. Capital centers to this day largely track the river valleys that defined medieval capital flows, with Milan, Frankfurt, Amsterdam, Rotterdam, London, Paris, Stockholm and Vienna all representing different capital systems. There is no definite capital of European banking. Furthermore, banks centered in these cities largely focus their investments on the 19th century routes of capital flows, with the Austrian banks dominant in former Austro-Hungarian territories, Swedish banks dominant in former Swedish imperial possessions around the Baltic Sea and Spanish banks active in Latin America and Mexico. It is notable that in the 20 years since EU integration went into high gear, European stock markets are still more integrated on a bilateral basis with the United States — particularly the French Euronext, the largest European stock exchange, and the Nordic Exchange — than with each other. Any attempt to force U.S. credit agencies to conform to European regulation or to create a European credit agency from scratch will therefore run into two inherent problems. The first is how to develop a credit agency or set of regulations that work for the disparate capital centers, each with different investment traditions and needs. The second is how to adjudicate conflicts of interest between the different capital centers. These issues will rub against sensitive concerns about EU member state sovereignty, particularly as the links between governments and financial institutions are so deep in Europe. And this raises the question of which capital center will seek to dominate the new regulations and institutions. Even a simple issue of where to headquarter the new regulatory agencies becomes tense in this situation. Considering the current disposition of power in Europe, this probably would be Frankfurt or Paris — the German and French capital centers — something unpalatable to London, Milan, Vienna or Stockholm. This is why, ironically, Europeans may actually trust American agencies more than they trust each other. With Europeans in a mood to blame U.S.-based credit agencies for many of their problems, establishing a new, European credit rating authority represents a politically expedient solution. But the problem with this strategy is that beyond agreeing to blame the United States, there is very little Europe's capital centers can agree on.
EU, U.S.: The European Credit Rating Agency Challenge