Despite the barrage of criticism they have attracted in the wake of the financial crisis, credit rating agencies still play a pivotal role in financial markets. The ESMA's Steven Maijoor argues that stricter regulation will improve the effectiveness and efficiency of agencies and help restore confidence in their ratings.

Talking about credit rating agencies (CRAs) these days has become a rather delicate task. Given the scale of attention on their role in a crisis that continues to evolve, CRAs have become a highly politicised issue. At the beginning of the crisis, CRAs were heavily criticised for being by far too optimistic: this related to their role regarding structured products. Currently, they are being criticised for their pessimism in relation to sovereign debt ratings. One thing that has been agreed is that they will be more heavily regulated going forward, and their supervision will be the responsibility of the European Securities and Markets Authority (ESMA). So, how will ESMA go about doing this?

One thing should be made clear: CRAs provide a vital service to the financial markets and they will continue to do so in the future. Through research and industry expertise, CRAs rate the riskiness of companies, governments and financial products and by doing so, allow investors to factor risks in. ESMA is not there to do this job, nor does regulating them mean that ESMA will second guess ratings issued. Rather, the role of ESMA is to assure that the procedures and methodologies used by CRAs are sound, and to ensure ratings are being issued in a consistent and transparent manner over time. ESMA is not there to rate ratings, but to ensure transparency and consistency in CRAs’ business.

A solid framework

In order to achieve this, the EU decided to establish a solid regulatory and supervisory framework for CRAs. Different initiatives are either being discussed or put in place in other regions too. Looking back, it seems surprising that until recently we relied on very light regulations, or no regulations at all, for a player that has such an important role in financial markets.

CRAs have been supervised within the EU since 2010. As from July 1, 2011, ESMA is the sole supervisor to do this job. National European supervisors will remain responsible for the supervision of the use of credit ratings by EU financial institutions, and can request ESMA to withdraw the registration of a CRA.

The first main EU regulatory initiative was the CRA regulation of September 2009, which in December 2010 was amended further to transfer the responsibility of supervision to ESMA itself. This new regulation is a major change in the European framework of CRA supervision. The so called CRA II that came into force on July 1 substantially increased the regulatory and supervisory powers of ESMA regarding CRAs established in the EU. ESMA is exclusively responsible for the registration, certification and supervision of CRAs in the union. So how will ESMA tackle this? There are three main elements that are key, namely: the registration requirements, rules of conduct for registered CRAs, and the supervision of registered CRAs.

Registration and certification

Between June and September 2010, 24 existing CRAs applied for registration and certification within the EU. So far, nine CRAs have been officially registered; others are to follow. The globally important CRAs are anticipated to complete their registration process very soon. 

Since July 1, CRAs have had to go through a registration procedure with ESMA. The EU regulation applies to credit ratings issued by CRAs registered in the EU and ratings that are disclosed publicly or distributed by subscription. In order for a CRA with a registered office outside the EU to be able to qualify for registration, it has to set up a subsidiary in the EU and thus use the endorsement system of the EU or, for a CRA without a physical presence in the EU, to use the certification procedure also foreseen in the regulation. This ensures an effective and efficient supervision of the activities of CRAs located outside the EU.

Playing by the rules 

Once registration has been granted by ESMA, CRAs will have to comply with different rules of conduct. The EU regime builds on a combination of specific rules of conduct and, more generally, enhanced transparency and prevention of conflicts of interest between CRAs and their most important clients.

Generally, registered CRAs are obliged to disclose to the public the methodologies, models and key rating assumptions used, as well as any material changes. The CRA must immediately disclose any change in methodologies, models or key rating assumptions if the likely scope of credit ratings might be affected by this change, and review and possibly re-rate them promptly.

Credit ratings for structured finance products must be clearly and differently flagged to enable investors to distinguish them from rating categories used for any other entities, financial instruments or financial obligations. Conflicts of interests are also to be disclosed in a complete, timely, clear, concise, specific and prominent manner. These threats to independence must be published together with the safeguards applied to mitigate those threats. Crucially, CRAs may no longer provide consultancy or advisory services to rated entities or related third parties.

Last but not least, the regulation seeks to address potential conflicts of interests in the rating process by obliging CRAs to introduce adequate internal policies and procedures to insulate rating analysts, employees and other persons involved in the rating activities from conflicts of interest and ensure appropriate rotation arrangements for analysts and persons approving ratings.

Supervision role

Once agencies are registered, ESMA will look into their compliance with the EU rules, and has the power to conduct on-site inspections, fine CRAs in cases of non-compliance or even withdraw certifications. Overall, ESMA aims at improving the transparency of CRAs, including transparency regarding their past performance.

The EU regulation provides ESMA with a significant range of supervisory tools and measures, including temporarily prohibiting a CRA from issuing ratings. Other tools include the suspension of the use of credit ratings for regulatory purposes with effect throughout the EU, the issuing of public notices when a CRA breaches the obligations set out in the regulation, the possibility to refer matters for criminal prosecution to the competent jurisdiction and, ultimately, the withdrawal of a CRA’s registration.

In this regard, the new regulation requires ESMA to conduct at least one verification of all registered CRAs falling under its supervisory competences by July 1, 2014. Moving forward from the registration phase, inspections will start in the final third of 2011. Finally, ESMA can impose a periodic penalty payment or a fine to put an end to an infringement by a CRA.

Outside the EU

No doubt a substantial share of the activities of the largest CRAs occurs outside the EU with European investors remaining heavy users of these ratings. Consequently, ESMA has decided that ratings used in the EU but issued outside it, need to be subject to the same requirements. It will therefore be essential that third-country systems meet the same objectives as envisaged by the EU regulation.

Regarding credit ratings issued in non-EU countries, in May, ESMA issued guidelines on how to implement these. An essential element of the guidelines is that European users of ratings should have the same level of protection, regardless of whether the rating is issued inside or outside the EU. At the same time, we will need to avoid any market disruptions when we move to these new requirements for ratings issued outside the EU, and to ensure that sufficient ratings continue to be available for European users such as financial institutions.

ESMA has been mandated by the European Commission to review the equivalence of related legislation of various countries, including Australia, Canada, Japan and the US. Japan was found to be fully equivalent and the European Commission has established this equivalence through a formal decision in September 2010. Regarding the US, it was found to be broadly equivalent in May 2010, however, ESMA is monitoring the improvements to the legislation anticipated by the Dodd-Frank Act and will be able to finalise its assessment as soon as the draft secondary legislation is disclosed by the US Securities and Exchange Commission. Work is continuing, though, on the regimes of Canada and Australia.

These measures are not the end to the debate about the role of CRAs. While ESMA is still implementing the new regulation, the European Commission is already discussing new initiatives regarding CRAs. One issue is the need to limit the mechanistic reliance on ratings. There is broad support for this need, although one should realise that CRAs are simply an important and inevitable element of well-functioning financial markets. Hence, there is a limit on reducing reliance.

Steven Maijoor is chair of the ESMA

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