The EU Regulation on Credit Rating Agencies

At the political level, developments in the EU fast outpaced the recommendations of CESR and ESME. The end of July 2008 saw the European Commission launch consultations on regulating CRAs and this was followed in November 2008 by the publication of a proposal for an EU regulation. After controversial discussions in the European Parliament and the European Council, the Regulation on Credit Rating Agencies was adopted by the Parliament on 23 April 2009, approved by the Council of Ministers on 5 May and now applies directly in all member states (European Parliament 2009).

The Regulation contains some provisions that are also to be found in the IOSCO Code but that are now legally binding. On the other hand, some important points of the Code have not been incorporated into the EU Regulation. This is unfortunate because it is unclear what role the IOSCO Code should now play in the EU. It is not intended that the Regulation should replace the established process of recognizing ECAIs. The ECAIs already recognized in the EU should apply for registration in accordance with the Regulation (European Parliament 2009: Article 2a).

A registration procedure has thus been introduced that will enable European supervisors to monitor the activities of CRAs. The primary objective of the Regulation is to avoid the existing and potential conflicts of interests between CRAs and the organizations they rate.

The key points of the Regulation are:

1. Scope
   Credit institutions (i.e., banks) may only use “for regulatory purposes” ratings that have been issued by a CRA that is registered within the EU, or satisfies the equivalence criteria in the Regulation.
2. Registration and supervision of CRAs
   The Regulation establishes a mechanism for CRAs to be registered with their home member states' competent authorities, and for their EU affiliates to be supervised through a “college of supervisors” coordinated and moderated through the CESR.
3. Equivalence and endorsement For recognizing the ratings of instruments and entities given by CRAs outside of the European Community:
   1. Registered CRAs can endorse the ratings of entities or instruments given by their affiliates outside of the European Community provided that (among other things)
      1. the registered CRA can verify on an ongoing basis that the conduct of the third-country CRA operates under a no-less-stringent supervisory regime;
      2. there is an objective reason for the rating to be performed in the third country rather than within the European Community; and
      3. there is an “appropriate” cooperation agreement in place between the national regulator of the registered CRA and the third-country CRA's regulator. This way multinational CRAs may be able to endorse within the EU the ratings given by their foreign affiliates, although it is critical that the Commission publishes a list of third countries with which such cooperation arrangements have been made.
   2. Ratings of third-country CRAs relating to third-country instruments or entities may be used by credit institutions for regulatory purposes provided that (among other things)
      1. there is a cooperation agreement between the Commission and the third-country regulator in effect;
      2. the European Commission has adopted an “equivalence decision” confirming that the standards of regulation in the third country are equivalent to EU standards; and
      3. the third-country CRA has been “certified” by CESR.
4. Withdrawal of registrations and transition periods
   If a CRA's home regulator withdraws that CRA's registration, there will be a transition period during which the CRA's ratings of any investments or entity may still be used by credit institutions for regulatory purposes. This period is:
   1. ten working days where the rated investment or entity is also rated by a different registered CRA; or
   2. three months otherwise—a period that may be extended by the Commission in circumstances where there is “potential for market disruption or financial instability.”
5. Structured finance
   Structured finance instruments will have some sort of an “additional symbol” to distinguish them from other rating categories. CRAs will also be required to disclose information about the due diligence processes they have performed, loss information and cash-flow analysis, their assumptions, and the stress scenario simulations they have undertaken.
   
   There is a further restriction on the issuance of ratings for complex products: “where the lack of reliable data or the complexity of the structure of a new type of financial instrument or the quality of information available is not satisfactory or raises serious questions as to whether a credit rating agency can provide a credible credit rating, the credit rating agency shall refrain from issuing a credit rating or withdraw an existing rating.”
6. CRA internal governance and transparency
   The Regulation imposes standards of internal governance to ensure (among other things) that CRAs manage any conflicts of interests, have independent compliance departments, and review their rating methodologies periodically.
   
   Additionally, the analysts or persons who approve ratings must not “make proposals or recommendations, whether formally or informally, regarding the design of structured finance instruments on which the credit rating agency is expected to issue a credit rating.”
   
   CRAs are now subject to extensive disclosure requirements. They have to disclose their models, methodologies, and the basic assumptions on which their ratings are based. They must demonstrate that they have carried out their assessments on the basis of all the information available from reliable sources. An annual transparency report must also be published detailing not only their financial figures but also their systems of rotation.
   
   Their supervisory or administrative board must include at least two independent members whose remuneration is not linked to the CRA's performance. At least one member must be an expert on securitization and structured finance instruments.
   
   The Regulation also sets periods during which former analysts may not take up certain positions within entities that they have rated.

The fact that banks are required to use the ratings of registered CRAs only for regulatory—and not for wider—purposes is a favorable outcome for the banking industry. Earlier drafts of the Regulation envisaged that a potentially much broader scope of banking activities would require the use of ratings issued by registered CRAs. By linking the use of ratings issued in accordance with the Regulation to regulatory purposes (meaning compliance with European Community law), the scope is more clearly defined.

Registration standards are maximum harmonization measures, meaning that no member state can impose threshold requirements in addition to, or higher than, those set out in the Regulation. Given the purpose and scope of the Regulation, this is appropriate.

The endorsement approach is aimed at larger CRAs, and the equivalence approach at smaller CRAs without a group presence in the EU. While it is helpful in principle to set out a regime for recognizing third-country ratings equivalence, it is not yet clear how endorsement criteria will be satisfied or what the exact procedure will be for concluding cooperation agreements and making equivalence decisions. Nor is it completely clear what constitutes “equivalence.” In particular, the substantive requirements of the Regulation—against which equivalence will be judged—are more detailed and extensive than the international IOSCO Code of Conduct. This may restrict the ability of CRAs to obtain equivalence rulings.

The idea of an additional symbol proposal has been floated for some time; the IOSCO Final Report of May 2008 included a similar proposal. Politically desirable as it may be, this requirement may confuse investors and suggest that there is some qualitative difference between structured finance and other ratings. For regulatory capital purposes—i.e., determining the applicable credit quality step assigned to a rating—the additional symbol is unlikely to make a difference.

This raises the question as to what the additional symbol will achieve. If the credit quality of a structured product is inferior, why should this not be reflected in a lower rating? And if it is not inferior, why do we need the additional symbol? Certainly, one of the overall challenges for regulators is to ensure that published ratings capture qualitative differences between various types of rated entities or instruments. Given that structured instruments are fundamentally different from corporate bonds and behave in very different way, the additional symbol may be seen as part of the response to this challenge.

While it is possible that the additional disclosure requirements for structured finance instruments may help some investors in their investment decisions, they may also serve to diminish investor appetite for such instruments. The concern is that, having been provided with this additional information, some investors may balk at the idea of spending the extra time and effort needed to review it. Furthermore, although it may seem common sense and sound business practice for CRAs not to issue ratings if the complexity of the instrument or amount of available information does not permit satisfactory analysis, enshrining this point in the Regulation may have the effect of stifling financial innovation.

From the banks' point of view, the final version of the Regulation contains a number of improvements on the initial proposals and drafts. These include the restriction of the Regulation's scope to ratings used for regulatory purposes, the twelve-month window before regulatory capital will be affected, and the transitional arrangements so that ratings can continue to be used temporarily if registration is revoked. For CRAs, the Regulation imposes an additional administrative, disclosure, and supervisory burden; for agencies that already comply with the IOSCO Code, however, the adjustments required to be Regulation-compliant may be less onerous than those they have already carried out. For third-country CRAs looking to do business in the EU, and for EU banks wishing to buy securities rated only by third-country CRAs, the Regulation's impact may be considerably harsher.

Download this Paper [ PDF 169.2KB| 26 pages ].

Comment(s)

There are [0] comment(s) for this entry. Post a comment.