Das empire strikes back: German banks have had enough of Standard and Poor's and other agencies, and they're not going to take it any more.

• Author: Engelen, Klaus C.

For more than a decade, bankers, industry executives and politicians on the Continent have complained about Europe's humiliating dependence on the almighty U.S.-regulated rating oligopoly. Now, the revolt against America's unchecked rating power is pressuring politicians to push the European Union towards regulating the global rating trio. There is a groundswell of support for establishing a European rating agency. But all this is easier said than done.

As European companies move from borrowing money from their banks to tapping the world's capital markets directly--by issuing bonds, medium-term notes, or commercial paper--their securities need to be rated. But there is a problem: Europe doesn't have a major rating agency that would take into account the special characteristics of European accounting or the prevailing differences in financial ratios as they evolved in a bank-based financial system.

Finally, this problem is becoming political. Proposals by the European Parliament's Committee on Economic and Monetary Affairs to establish a European Registration Authority for rating agencies under the auspices of the Committee of European Securities Regulators (CESR) may be far ahead of the curve. They point to "a European nightmare--that unchecked American rating agencies become the Continent's boss men." EU parliamentarians are looking for ways to contain American rating power by putting global rating giants like Standard & Poor's, Moody's, and Fitch under some kind of new EU regulation. So far the Brussels Commission--with the British government keeping a watchful eye on the stakes for London as a global financial center--is playing for time. But the German government, faced with a domestic revolt against damaging rating decisions by Standard & Poor's, is under mounting pressure to control what is perceived as an excessive level of American rating power.

Because the completion of the EU single market in financial services requires an appropriate framework of financial market regulation, a question fraught political and financial dynamite arises: Can Europe accept that the debt instruments issued in its expanding European capital markets are only regulated by a U.S. securities supervisor, the Securities and Exchange Commission?

This is today's reality. More than a decade ago the Europeans missed their chance to establish a major rating agency more attuned to the bank-based financial systems prevailing in Europe rather than the capital market-based financial system and the highly developed equity culture of the United States.

How financial intermediation differs in the financial systems of Germany and the United States has important implications for the role and the focus of ratings. As the International Monetary Fund stated in its recent "Financial System Stability Assessment for Germany," the banking sector still accounts for approximately 78 percent of the German financial system's gross total assets. Most companies still rely on bank loans even though the share of securitizations in intermediation flows is expanding rapidly. This compares with a U.S. financial system where banks only represent around 20 percent of gross total assets.

This explains why historically it was the U.S. financial system where the need for rating agencies first arose. Based on 2001 numbers--presented in Congressional hearings on the role of the major rating agencies following the Enron debacle--the three globally dominant rating concerns reach a market share of 95 percent. Only Standard & Poor's, owned by the McGraw-Hill Companies (42 percent); Moody's (38 percent); and Fitch, owned by European investors (14 percent); together with the first newcomer in ten years, Dominion Bond Rating Service, are registered by their supervisor, the Securities and Exchange Commission, as "Nationally Recognized Statistical Rating Organizations" to do business in the globally dominant U.S. capital markets.

Recent German anger about how Standard & Poor's jolted the embattled state bank sector by trying to put forward fictitious ratings is putting pressure on politicians, financial supervisors, and the Berlin government. The way the world's largest rating agency has been downgrading major German companies such as ThyssenKrupp to junk status because it changed the treatment of pension obligations in the rating process was another jolt. Due to S&P's recent rating actions, the decade-long tensions between embattled "Germany, Inc." and its global raters are reaching a breaking point.

By announcing, on November 13, 2003, that it would come up, by November 24, with down-grades on unguaranteed Landesbank obligations, Standard & Poor's was set to deal a fatal blow to an important sector of Germany's banking system, the Landesbanks. This is why. Under an agreement with the EU Commission in Brussels, eleven Landesbanks must phase out state guarantees by July 18, 2005. This is considered an important step toward securing a level playing field in European financial markets. The Landesbank guarantees have supported top-notch credit ratings, which in turn meant cheap funding. Critics charged that by publishing Landesbank ratings on the basis of unguaranteed obligations immediately, i.e., long before the phase-out of state guarantees in 2005, Standard & Poor's was unsettling the difficult phase-out process. Indications from the "unguaranteed debt" ratings that were leaked following the announcement on November 13 suggested that all but three Landesbanks would be allocated ratings in the BBB--range, compared with the AA and AAA ratings they currently receive. What a blow.

To large segments of Germany's political and financial establishment, Standard & Poor's rating action amounted to a declaration of war. It was noted in German official and business circles that Moody's, the other major U.S. rating agency, distanced itself from Standard & Poor's bombshell. Juergen Berblinger, managing director of German operations for Moody's (who left at the end of 2003), indirectly criticized his competitor's rating action by stating: "In our view it is inappropriate and premature to publish unguaranteed ratings." He was supported by Moody's veteran European bank analyst Samuel Theodore, who sharply criticized...