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Western EuropeJune 1 2011

Will ESMA succeed with the credit rating agencies?

New European regulation on credit rating agencies will soon come into force. And while everyone is in agreement on the need for improvement, opinion is divided on the best way to achieve this. So will ESMA make a difference?
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What is it? 

The EU's upcoming regulation on credit rating agencies (CRAs) – the so-called CRA II. It is the latest in a slew of activity from regulatory bodies around the world focused on credit rating agencies.

Who’s been doing what? 

In October 2010, the Financial Stability Board (FSB) published its 'Principles for Reducing Reliance on CRA Ratings', endorsed by the G-20, which hopes to reduce the “mechanistic” reliance on ratings.

In November, the European Commission launched a consultation on the FSB’s proposals and added a few ideas to the mix, including a proposal for central bank-backed ratings or a new independent European ratings agency, and a range of different business models to mitigate the perceived conflicts of interest in the current ‘issuer pays’ model.

In December, the European Parliament passed into law tough new rules that require CRAs to comply with codes of conduct to minimise conflicts of interest, ensure higher quality ratings and greater transparency of ratings and process. Crucially, the legislation will pass sole supervisory responsibility for CRAs to the newly established European Securities and Markets Authority (ESMA) in July 2011.

Editor's choice 

It is not just Europe taking aim at the CRAs. In March, Singapore put forward proposals to regulate CRAs, followed, in April, by the introduction in Hong Kong of CRA regulation. 

What are the main provisions? 

Of the European regulation’s three main elements – registration requirements, rules of conduct and supervision – the latter two are the most important. The new rules of conduct will oblige CRAs to disclose data on the historical default rates of rating categories and to report past performance data to a central repository. They will have to make available a list of the largest 20 clients by revenue and will be obliged to disclose conflicts of interest in a timely and “prominent” manner. They will no longer be able to provide consultancy or advisory services to a rated entity or a related third party.

Unlike its predecessor, the Committee of European Securities Regulators, ESMA will have teeth. It has a range of supervisory tools and measures, including the ability to impose fines – up to 20% of a CRA’s turnover for the previous year – and stronger investigative powers, such as the right to conduct 'dawn raids' and to compare performance predictions with actual performance.

Did MEPs get what they wanted? 

While the final shape of CRA II is unknown, members of the European Parliament (MEPs) are unlikely to get everything they wanted. MEPs called on the European Commission to establish a 'public' European CRA that would produce impartial ratings without being constrained by commercial considerations. Virtually every response opposed this, and other suggestions that the European Central Bank or national central banks should issue ratings, saying this would simply heighten the scope for moral hazard and harm the independence of those institutions.

The consultation also contained a proposal to introduce EU-wide civil liability. The difficulties of deciding an appropriate standard of fault means this is unlikely to be implemented. In May, the US Circuit Court of Appeals in New York dismissed civil suits against ratings agencies Moody’s, Standard & Poor’s and Fitch.

In a letter to ESMA in mid-May, MEP Jean-Paul Gauzes suggested delays related to the first CRA regulation in 2009 did not bode well for the second version. "It would be very difficult for our citizens to understand why, nearly two years after the first regulation on [CRAs] was adopted, these agencies are still not supervised at European level,” he wrote.

What does the industry say? 

A quick look through the 93 responses received to the consultation shows that improving the ratings process is an absolute quagmire. Everyone thinks it should be improved. Everyone wants greater competition, more transparency and greater accountability. Then everyone points out the difficulties of achieving any of those things, and the weaknesses or unintended consequences of alternative proposals.

“We all know that the ratings agencies did a bad job; but can we, or someone else, do a better job?” says one banker. “It’s easy to criticise their model and their practices, but it’s much more difficult to think of a replacement model.”

Could we live without it?

More to the point, will it make any difference?

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