European Commission proposes regulation of credit rating agencies

BulgariaCzech RepublicHungaryPolandRomaniaSlovakiaUnited Kingdom

The European Commission has published the proposed legislation to implement the decision earlier this year to bring credit rating agencies (CRAs) within statutory regulation. This follows the extensive consultation on this subject in the summer. As expected, the Commission has decided that the EU should legislate by directly applicable regulation rather than a directive.

Background

CRAs assess the financial strength of corporations, sovereign bodies and financial institutions and the credit risks attached to the financial securities (such as bonds) issued by them. In recent years the CRAs have expanded their activities and issued credit ratings in respect of structured financial products such as CDOs.

The role of CRAs has come under the spotlight in the last 18 months as they have been accused of underestimating the risks of sub-prime US housing loans and the complex structured credit products they were rating, thereby contributing to the current crisis in the financial markets. Commentators have also drawn attention to the potential conflicts of interest faced by CRAs who earn fees from the entities which they are rating.

Regulation of credit rating agencies

Pressure for greater regulation of the CRAs has been building for some time as CRAs and the ratings they issue have become embedded in the financial system. Capital adequacy requirements, such as Basel II, require banks to use recognised external credit rating agencies.

Although the rating agencies signed up to voluntary codes of conduct such as that published by IOSCO (International Organisation of Securities Commissions) they have not previously been subject to statutory regulation.

In the US, the Credit Rating Agency Reform Act 2006 introduced a framework for registration of CRAs. Earlier this year an SEC investigation identified a number of shortcomings to be addressed by the rating agencies, including the need for greater disclosure of the rating process.

On this side of the Atlantic, the EU rejected the self-regulation model preferred by the CRAs (and the recently enhanced code they had put in place under IOSCO), stating that legislative control was necessary and will ensure that (i) ratings are not affected by conflicts of interest (ii) CRAs monitor the quality of their rating methodology and ratings (iii) CRAs act in a transparent manner.

Registration


The EU’s proposal introduces a registration procedure for CRAs in order that European regulators can exercise greater supervision and control over the activities of the CRAs. Rating agencies will register via CESR (the Paris based Committee of European Securities Regulators) and national authorities will supervise the CRAs under European rules controlled by Brussels.

This legislation represents a shift from the traditional process of European regulation, which normally involves national rules adopted in each member state. Legislation in the form of a regulation, rather than a directive, avoids the need for local implementation by the parliament of every member state; the EU rules will be directly applicable across the EU without local variation.

New rules

In addition to the requirement that CRAs comply with the new registration procedure, the proposal introduces a number of new rules, including:

  • CRAs will not be able to provide advisory services.
  • CRAs should not rate financial instruments if they do not have sufficient information on which to base their ratings.
  • They must disclose the models and methodologies that underpin their ratings.
  • CRAs will have to publish an annual transparency report.
  • At least three independent directors must sit on the board of a CRA and the remuneration of these directors cannot depend on the business performance of the rating agency. At least one independent director should be an expert in structured finance and securitisation.
  • A CRA shall disclose the names of the rated entities or related third parties from which it receives more than 5% of its annual revenue.

Impact

Given current political pressures, it was inevitable that CRA regulation would be introduced in Europe; in retrospect, and given the key role of CRAs in the financial system, it is surprising that they have managed to avoid statutory regulation for so long. It is too early to tell how the credit rating sector will evolve following the financial crisis and the introduction of CRA regulation. Some are sceptical about the Commission’s desire to see a move from the traditional ‘issuer pays’ model to an ‘investor pays’ approach. Banks, meanwhile, have already moved to strengthen their internal rating processes.

CRAs will need to prepare for regulation and will be concerned to see how this new form of ‘euro’ regulation will work in practice. Insurers will be interested both as users of ratings and as insurers of the CRAs which may be looking for extra coverage, particularly for their directors and officers, as they move into the new regime.