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Updated: Sept. 25, 2012 (Initial publication: April 1, 2010)

Sectorial Analysis

II-6.8 : Credit Rating Agencies: Post-Crisis regulatory measures adopted by the European Union Regulation of 16 September 2009

http://www.thejournalofregulation.com/spip.php?article150

 

Main information

 

The European Regulation of 16 September 2009 implements a new regulatory framework for credit rating agencies, in order to restore investor and consumer confidence, enable the supervision and transparency of credit ratings, and avoid conflicts of interest.

Themes

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0001:0031:EN:PDF

 

Context and Summary

 

 

Reasons for the European Regulation :

The main reason for regulating credit rating agencies lies in the assumption that they play an important role in global securities and banking markets, as their ratings are used by investors, borrowers, issuers and governments in the process of making informed investment and financing decisions. Credit institutions, investment firms,insurance undertakings, and occupational retirement funds may use credit ratings as the reference for the calculation of their capital requirements for solvency purposes or for calculating risks in their investment activity. Consequently, credit ratings have a significant impact on the operation of the markets and on the trust and confidence of investors and consumers. The European Regulation is bound to ensure that credit rating activities are conducted in accordance with the principles of “integrity, transparency, responsibility and good governance”, i.e. that credit ratings used in the Community are independent, objective and of adequate quality. The European Regulation also deals with the issue that currently most credit rating agencies have their headquarters outside the European Community and that most Member States do not regulate the activities of credit rating agencies or the conditions for the issuing of credit ratings, despite their significant importance for the functioning of the financial markets.

Purpose of the regulation :

 Credit rating agencies are considered to have failed, first, “to reflect early enough in their credit ratings the worsening market conditions, and second, in adjusting their credit ratings in time following the deepening market crisis” (§10). The European Regulation aims at dealing with those failures by taking measures relating to conflicts of interest, the quality of the credit ratings, the transparency, the internal governance and the surveillance of the credit rating agencies.
The European Regulation therefore lays down important rules ensuring that all credit ratings issued by the credit rating agencies registered in the Community are of “adequate quality” and issued by credit rating agencies subject to “stringent requirements”. The Regulation suggests laying down a common framework of rules regarding the enhancement of credit ratings’ quality, in particular those used by financial institutions and entities themselves regulated by harmonised rules in the Community. Indeed, should this common framework not be implemented, the risk is that credit agencies will continue not to be regulated by Member States despite their impact on financial markets, or that, conversely, Member States start regulating autonomously, taking divergent measures at the national level which could create obstacles to the good functioning of the common market (not to mention that diverging national quality requirements could lead to different levels of investor and consumer protection). Finally, as underscored in §11, the new framework should make it easier on users to compare credit ratings issued in the Community with credit ratings issued internationally
 
New registration constraints:
 
“In order to ensure a high level of investor and consumer confidence in the internal market, credit rating agencies that issue credit ratings in the Community should be subject to registration”, especially when credit ratings are intended to be used for regulatory purposes in the Community. The Regulation therefore suggests harmonised conditions and procedure for the granting, suspension and withdrawal of such registration.
 
An important provision demands that when endorsing a credit rating issued in a third country, agencies in the community should determine whether these third country credit ratings comply with the regulation’s requirements for the issuing of credit ratings, and achieve the “same objective and effects in practice” (§13). Indeed, as recalled by the regulation’s drafters (§13), such lack of establishment in the community could be an obstacle to the stringent supervision the European Regulation tries to implement[#_ftnref1">[1]
Moreover, the European Regulation also provides that credit rating agencies with headquarters located outside the Community must set up a subsidiary in the Community so as to attain an effective supervision of their activities in the Community and ensure they comply with the above mentioned endorsement regime.
 
The main idea of the Regulation’s registration provisions is to make sure that any credit rating agency, once registered by the competent authority of the relevant Member State, may issue credit ratings throughout the Community. The regulation suggests establishing a “single registration procedure for each credit rating agency which is effective throughout the Community” (§45).
The framework is organized so as to establish a single point of entry for the submission of applications for registration. It is for the Committee of European Securities Regulators (CESR) to receive applications for registration and inform the competent authorities in all Member States. After CESR informs and advices the national competent authority on the registration process, the examination of applications for registration and the taking of individual decision is to be carried out by the latter. The regulation also provides that competent authorities should set up “operational networks (colleges) supported by an efficient information technology infrastructure” (although only the competent authorities of home member state, and not the college, have the power to issue legally binding individual decisions in regard to credit rating agencies’ registration). It is also expected from the CESR to establish a subcommittee specialised in the field of credit ratings of each of the asset classes rated by the agency, as financial instruments and assets evolve rapidly and are subject to constant innovation by financial institutions.
 
Supervisory measures:
 
The above mentioned “college” is intended to work as an effective platform between competent authorities for the exchange of supervisory information, coordination of their activities and supervisory measures. The college is also in charge of determining whether third countries credit ratings used in the community fulfill the certification conditions and exemptions provided for in the European Regulation (ideally, cooperation arrangements between competent authorities in Member States and the relevant competent authorities of third-country credit rating agencies should prevail). It is therefore expected from the CESR to contribute to the uniforms application of the Regulation’s rules and to the “convergence of supervisory practices”[2]. The College may also designate a facilitator, to chair the meetings of the college, coordinate its actions and modulate, in liaison with the CESR, the registration process.
 
As for the supervision of a credit rating agency, it is intended to be carried out by the competent authority of each Member State in cooperation with those of other Member States’ , using the above mentioned College and keeping the CESR involved. The latter will createa central database of information on the past performances of credit rating agencies and information about credit ratings issued in the past.
 
 Regulatory Measures to ensure transparency and avoid conflicts of interest:
 
In order to avoid potential conflicts of interest, credit rating agencies must focus their professional activity on the issuance of credit ratings and not carry out consultancy or advisory services. In particular, a credit rating agency should not make proposals or recommendations regarding the design of a structured finance instrument. The regulation also provides specific rules on the rating agencies’ methodologies and ratings models, as they are expected (i) to be disclosed to the public[3] and (ii) to be “rigorous, systematic, continuous and subject to validation including by appropriate historical experience and back-testing” (§23). These methodologies and models used for determining credit ratings must be maintained, up-to-date, subject and published to a comprehensive review. Should the data used by agencies for credit rating, or should the financial instruments appear as not reliable, the agency should not issue, or should withdraw the produced credit rating.
 
Moreover, in order to preserve the independence of the credit rating process from the business interests of the agency as a company, agencies will have to ensure that at least one third, but no less than two, of the members of the administrative or supervisory board are independent. Furthermore, the compensation of independent members of the administrative or supervisory board shall not depend on the business performance of the agency.
It is expected that agencies adopt not only sound corporate governance, but also internal policies and procedures in relation to employees and other persons involved in the credit rating process in order to “prevent, identify, eliminate or manage, and disclose any conflicts of interest and ensure at all times the quality, integrity and thoroughness of the credit rating and review process” (§26). Any conflicts of interest should be disclosed in a timely manner.
 
Finally, the Regulation also provides for measures to ensure the quality of credit ratings. For example, agencies should use independently audited financial statements and public disclosures, verification by reputable third-party services, random sampling examination of the information received and contractual provisions clearly stipulating liability for the rated entity or its related third parties (in case the information turns out to be false or misleading or not conducted with due diligence).

 

[1] Therefore, the regulation reminds that such an endorsement regime should be applied to credit rating agencies which are affiliated or work closely with Community registered rating agencies. “Nevertheless, it may be necessary to adjust the requirement of physical presence in the Community in certain cases, notably as regards smaller credit rating agencies from third countries with no presence or affiliation in the Community” (§14). A specific regime of certification for such credit rating agencies will also need to be established, as it might impede the financial stability of a member state’s financial market.
[#_ftn2">[2] In November 2008, the Commission set up a group charged with examining the future European supervisory architecture in the field of financial services, including the role of CESR. The new architecture is to be enforced in 2010. Indeed, the supervisory architecture as it was when the regulation was enforced in 2009 was not the long-term solution for the oversight of credit rating agencies. Colleges of competent authorities are not a substitute for the advantages of more consolidated supervision of the credit rating industry. A broader reform of the regulatory and supervisory model of the European Community’s fincial sector is therefore in process. Cf. Jacques de Larosière’s Conclusions of 25 February 2009.
[#_ftn3">[3] ‘The level of detail concerning the disclosure of information concerning models should be such as to give adequate information to the users of credit ratings in order to perform their own due diligence when assessing whether to rely or not on those credit ratings’.

[4] ‘[http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//TEXT+IM-PRESS+20081117IPR42160+0+DOC+XML+V0//EN->http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//TEXT+IM-PRESS+20081117IPR42160+0+DOC+XML+V0//EN]

[#5<-][5] Summit on financial markets and the world economy, November 14-15, 2008.

[#6<-][6] See Marie-Anne Frison Roche’s definition of regulatory law : a reasoning which aims at ensuring -or restoring-, a certain balance between the principle of competition and another principle(s). D.2004, chron., pp.126-129

 

 

Brief commentary

 

For European institutions to have enacted such rules of supervision, registration and transparency illustrates how regulatory measures and regulatory framing are more and more often the natural recourse (not to say remedy) in complex situations, such as that of credit rating agencies – complex because of its numerous links to the economy, financial markets, insurance markets, investors and governments. Indeed, the European Regulation underlines that rating agencies play an important role in global securities and banking markets, as their credit ratings are used by investors, borrowers, issuers and governments as part of making informed investment and financing decisions. They are therefore involved with economic, political and legal issues –which explain why they were blamed, inter alia, for the financial crisis. It therefore comes as no surprise that the highest European bodies enacted measures which provide for a better transparency of rating agencies, supervised, for the time being, by the Committee of European Securities Regulators (CESR). This European Regulation is the direct consequence of the Member States’ political decision to firmly react to the crisis’ aftermath, a discussion launched in 2008, following the G20 Summit(4). Indeed, when, in October 2008 the French Parliament started debating the financial and economic crisis in light of the Washington G20 summit(5), many European Parliament political group leaders stressed the need for regulatory reform, in particular that of credit rating agencies, private equity and hedge funds. The Parliament also took into account some groups which criticized not only speculators but also the European Commission for its role in inciting the crisis by concentrating too much on industry's concerns. The Parliamentary Act and the European Council's Regulation being the legal outcome of this, it is typically regulatory for 2 reasons: First, the Act of Parliament provides for more rules on supervision and transparency, while not hindering the impact of rating agency on the operation of the markets, i.e. it simply improves the market’s functioning and incentive structures, including the role of credit rating agencies. Thus, by adopting an act which on one hand promotes the financial services provided by rating agencies, while, on the other hand, putting into the balance the principles of investor protection and systemic risk prevention, the European bodies embrace a rationale true to the definition regulatory law. Secondly, through the adoption of this Regulation, the EU shouldered responsibilities for European legislation and used regulation as the tool to fulfill the political will of the Union - and its Member States - to react to the financial crisis’ effects on the global economy. The present European Regulation is therefore no less than a political decision at the offset – the regulation of all those involved in financial industry-, which was taken in order to achieve an economic effect in fine - through reforming and dealing with credit rating agencies’ accountability and responsibility. Therefore, the result of the Act of Parliament is itself regulatory by essence since it endorses, through a legal tool, a political goal aimed at restoring the balance in a flawed market. In a nutshell, the Act of Parliament and the European Council's Regulation llustrate how the regulatory law method works as a triangle between law, politics and economics.

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