Credit rating agencies came away from the global financial crisis with damaged reputations but they have since taken a step forward in redeeming themselves by showing their independence against their government regulators. To wit, Standard & Poor’s recently placed a negative outlook on the U.S. government and Moody’s warned that the U.S. will need to reverse the expansion of its debt if it hopes to keep its current rating. With sovereign debt being a large part of the investment portfolios of institutional investors, such as pension funds, the creditability of external ratings is important even though ratings agencies have shown themselves to be a lagging indicator of problems behind markets.

Prior to the global financial crisis, credit rating agencies were already under scrutiny because of corporate scandals such as Enron where the agencies failed to detect financial irregularities in companies that later collapsed. These scandals resulted in regulatory initiatives such as the establishment of a code of conduct by the International Organization of Securities Commissions (IOSCO), an international umbrella group of securities regulators. The code of conduct includes four principles, one of which is “rating decisions should be independent and free from political or economic pressures and from conflicts of interest arising due to the agency‘s ownership structure, business or financial activities, or the financial interests of the agency employees.”

The global financial crisis prompted regulators to apply the accelerator to their regulatory agenda for credit ratings agencies. With a G20 commitment to extend regulatory oversight to credit rating agencies to ensure they meet the IOSCO code (with emphasis on conflicts of interest), G20 members have introduced new regulation often going well beyond what the G20 called for.

Ironically, aggressive regulatory intervention may have done more to create a new conflict of interest than resolve existing ones as the governments that make regulation rely on their ratings to borrow cheaply. Rating sovereigns is a core business of the agencies; therefore, they need to be free of the threat of regulatory retaliation for their ratings actions.  However, Europe demonstrated last June that it is not shy about coercing ratings agencies. Following a downgrade of Greece to junk status by Moody’s, an EU Commissioner said the decision raises questions about the role of rating agencies in the financial system. His was followed EU Commission proposals for a publicly funded sovereign rating agency to rival the big three rating agencies.

Despite a new regulatory regime coming into force last December to implement the IOSCO code, the EU nevertheless chose to consult on further regulatory actions on the basis that the euro debt crisis has renewed concerns that financial institutions and institutional investors may be relying too much on external credit ratings. These institutions and investors are likely patting themselves on the back now for their reliance on ratings now that the risk of a Greek sovereign default is higher than ever despite European officials insisting last June that financial markets would see they were wrong about Greece.

The behaviour of the EU towards credit ratings agency must have left management at Standard and Poor’s and Moody’s nervous prior to the announcements they just made, particularly with the new powers that regulators have under the Dodd-Frank Wall Street Reform and Protection Act.

But the recent announcement by the manager of the world’s largest bond fund that it was shorting U.S. treasuries, as well as other recent criticisms of the U.S. fiscal situation, probably took some pressure off Standard and Poor’s and Moody’s in the sense that their own announcements simply affirmed what everyone has already realized. Nevertheless, the rating agencies deserve credit in showing the capacity to act independently on sovereign ratings despite the potential for regulatory retaliation as demonstrated by Europe. To ensure the integrity of sovereign ratings in the future, G20 members need to develop standards to regulate their own behaviour.