Early On, Europe Is Out Front in Overhaul of Global Financial System

Treasury Secretary Timothy Geithner will wrap up meetings in Italy today in part aimed at coordinating regulation efforts among Group of Eight nations. (By Claudio Longo -- Associated Press)

While Europe is moving relatively fast, critics in industry argue that it is taking a piecemeal approach, going after rating agencies one day, hedge funds the next. When Washington's broad reform plan is finally announced, it may leapfrog the Europeans'. In some areas, such as executive compensation, Washington is already out front. And neither side, experts note, has yet proposed measures to address some of the biggest regulatory challenges, such as setting new leverage guidelines for major banks.

In recent weeks, the European Commission has passed measures on rating agencies and capital requirements, and proposed others. Although the hedge fund plan is months from possible ratification, it could, analysts say, end up setting standards for borrowing limits and leverage for funds based in the United States and elsewhere. U.S. funds could be exempted from such rules if European regulators determine that U.S. laws are roughly as good as their own.

This week, E.U. financial chiefs additional agreed in principle on the creation of the European Systemic Risk Board (ESRB), which would monitor larger risks to the European financial system, and the European Supervisory Authorities (ESAs), which would set standards for the regular supervision of banks, insurers and securities markets. The boards may be given the power to overrule national regulators in Europe, something that has caused consternation in Britain and some Eastern European countries.

Perhaps the most sweeping step taken by Europe so far, however, was the adoption in April of new measures on rating agencies. They would force agencies in the United States, for instance, to establish European offices if Washington does not beef up its own standards to a roughly equal level. Agencies would also be forced to rotate their analysts more frequently, provide 12-hour advance notice of any rating changes to the issuers, and use new coding to identify certain types of riskier investments.

The agencies would need to comply no matter where they are based if they want to do business with European clients. Thus, agencies say, not complying would put them at a competitive disadvantage.

The rule changes are meant to address concerns that these agencies allowed toxic assets, such as U.S. subprime mortgage-backed securities, to be bought and sold with top-notch ratings certifying them as safe. But critics call them heavy-handed and ill thought out. For instance, while the 12-hour advance notice on rating changes to issuers are suppose to cut down on factual errors, critics -- including some U.S. officials -- say it may provide a new window for insider trading. Also, while the rotation of analysts every four to seven years is supposed to dispel the impression that they are too chummy with the issuers of certain bonds and securities, agencies counter that mandatory rotations will limit their ability to keep analysts with expertise constantly on top of certain complex financial instruments.

Most importantly, critics say, is that Europe's new rating agency rules go against the idea that nations will take coordinated steps on regulation, getting rid of existing differences along the way. The European measures, for instance, go well beyond existing U.S. regulation on rating agencies, and include elements -- such as coding changes on certain investments -- that previously have been ruled out on this side of the Atlantic.