Forcing bond issuers to switch credit rating agencies risks giving the raters an incentive to offer more flattering opinions to get business, the European Central Bank said on Wednesday.
The ECB said a draft European Union law aimed at boosting competition may need to be further assessed.
As proposed, it could have a "negative impact on the quality of ratings, in particular since there may be a risk that new entrants might compete by offering inflated ratings or by lowering prices," the central banks says in an opinion on the draft reform.
The bloc's financial services chief, Michel Barnier, who authored that draft, wants more competition in a sector dominated by the Big Three: Standard & Poor's (>> The McGraw-Hill Companies, Inc.), Moody's (>> Moody's Corporation) and Fitch (>> FIMALAC). At its core would be a rule forcing corporate bond issuers like banks to switch to another agency after a certain number of years.
"Determining the exact number of years after which rotation should take place may warrant further analysis," the ECB says.
Banks are typically rated by at least two of the big three players and have warned they could face problems attracting investors if they switch to lesser known agencies.
The ECB's concerns echo those of the sector's regulator, the European Securities and Markets Authority. EU states and the European Parliament have the final say on the reform and a watering down of rotation appears inevitable.
Last weekend at a meeting of the bloc's finance ministers in Copenhagen, Barnier signaled a retreat, saying he would support the call for a rethink on how rotation could work.
The ECB backed some of the less contentious elements of the EU reform, such as weaning the financial system off its heavy use of ratings, especially at banks who use them to calculate the size of their regulatory capital buffers.
"The ECB supports the Financial Stability Board's (FSB) and the European Commission's common objective of reducing overreliance on external credit ratings," the ECB said in a legal opinion published on its website.
"The ECB supports the gradual approach advocated by the FSB and notes that references to credit rating agencies' ratings should be removed or replaced only once credible alternatives have been identified and can safely be implemented."
Still some elements to dilute the influence of ratings "could prove difficult to apply."
It also gave its strong backing to plans to have rating firms update their sovereign ratings more frequently and provide more information more often when rating changes are particularly sensitive.
Many policymakers are still seething over what they say have been ill-timed rating agency downgrades of countries such as Greece, Portugal, Ireland and Italy, arguing they have added to the debt crisis turmoil.
"The ECB recommends exploring ways of reducing the volatility induced by the timing of the rating changes, notably when an issuer is on ratings watch and is close to losing its investment grade status as well as when a potential downgrade of several notches is being contemplated," the ECB said.
"In these situations, proposals to communicate more frequently to the market in ways that would smooth cliff effects could be further explored."
It also recommended dropping plans to harmonize the various ratings scales the main firms use for now and instead suggested Europe's main sector regulators revisit the idea at the end of 2015.
For full legal opinion click http://www.ecb.int/ecb/legal/pdf/en_con_2012_24_f_sign.pdf)
(Reporting by Marc Jones in Frankfurt and Huw Jones in London)
By Marc Jones