Credit rating agencies received a lot of publicity in the financial crisis. Famously they gave glittering ratings to investments which later became worthless.

The investors who lost money included banks which had to be bailed out at public expense. International political attention quickly turned to increasing the reliability of credit ratings.

In September 2009, the EU passed the Credit Rating Agencies Regulations. These regulations have two key effects: first, agencies operating in the EU are required to be registered and supervised by regulators in their home member states. Second, from December 2010, banks will not be permitted to ause credit ratings for regulatory purposes unless they are issued or endorsed by an EU-registered credit rating agency or by an agency supervised in another country under a framework which the European Commission considers equivalent to the EU framework.

The EU is already considering amendments to these recent regulations. In a proposal first published in June 2010 it suggested that registration and supervision of rating agencies should be the responsibility of the recently created European Securities and Markets Authority (ESMA), rather than home member states. ESMA will replace the Committee of European Securities Regulators as part of a more consolidated supervisory system, and will be operational by early 2011.

Good governance

The reforms are quite far-reaching, covering both practical and procedural matters. Unsurprisingly, they are intended to lead to higher-quality ratings. For example, rating agency staff must have appropriate knowledge and experience, and credit ratings must be based on a thorough analysis of all relevant available information.
When publishing ratings, rating agencies must indicate the sources of information on which they have relied and the methodologies used. They must also make clear whether they are satisfied with the quality of information that has been provided to them by rated entities.

The reforms go to some length to eliminate conflicts of interest. For example, rating agencies are not permitted to carry out consultancy or advisory services for entities which they rate, other than certain ancillary services. Those involved in the rating process are required to be rotated every four, five or seven years, to avoid over-attachment to particular rated entities.

Rating agencies are required to maintain good governance arrangements, with an administrative or supervisory board containing independent members and an adequately resourced compliance function. These reforms will improve the management of rating agencies, but they are unlikely to be transformative since the failure to satisfy such criteria in the past was unlikely to have been by deliberate design.

Information and transparency

By contrast the reforms on information and transparency are likely to be more significant. Under the reforms, rating agencies are now subject to extensive public disclosure requirements, including requirements to disclose details of potential conflicts of interest and the methodologies, models and key rating assumptions that they use in their credit rating activities. Where they withdraw ratings, they are required to publish full reasons. Each year they are required to prepare a 'transparency report' giving details of legal structure, internal controls and compliance, and statistics relating to the allocation of staff to new credit ratings. A central EU repository is being set up to which rating agencies are required to provide their historical performance data.

Rating agencies are also required to provide information to regulators, including information about historic default rates of their rating categories and a list of their largest 20 clients by revenue. Under the EU regulations, investigations into infringements by rating agencies are currently the responsibility of regulators in home member states. However, if the June proposal is implemented, investigations would be carried out directly by ESMA. The powers of investigation would include the power for on-site inspections without prior announcement (ie. dawn raids). The European Commission has similar powers under EU competition law which it regularly uses to obtain evidence of breaches of the EU competition rules.

It is worth noting that advice given by in-house lawyers can be used as evidence by the European Commission in competition investigations. The protection of legal privilege under EU law is limited to external advisers and the same principle is likely to apply to investigations by ESMA into rating agencies.

The regulation of rating agencies reflects their importance for the financial markets. But efficient financial markets also depend on investors exercising their own judgement. In particular, investors need to be aware that a credit rating can only be as good as the quality of the information that is provided by the rated entity to the rating agency. Despite the new requirements for transparency, rating agencies will naturally be wary of stating that they received unsatisfactory information from the rated entity. Investors will therefore still need to do their own research where possible.

One solution to the problem of over-dependence on information provided by rated entities would be to put the focus on the rated entities themselves by requiring them to confirm to ESMA that they have provided adequate information to the rating agency, and presented it in a way that will best enable the rating agency to understand all relevant risks.

Steven McEwan and David Good are lawyers at Hogan Lovells International LLP, specialising in financial regulation

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter