Originally published 24 April 2009

Keywords: European Regulation on Credit Rating Agencies, asset-backed securities, behavioural standards, External Credit Assessment Institution, Capital Requirements Directive, CESR, structured finance, credit institutions, disclosure,

The European Regulation on Credit Rating Agencies was approved yesterday.

First some background: in the credit crunch's early days, as complex financial structures started unravelling, many journalists and politicians pointed fingers at credit rating agencies ("CRAs"), accusing them of being the prime culprits.  "How can that ever have been rated AAA?", commentators cried as various asset-backed securities slid below investment grade.  Regulators, too, formed the view that that the importance of ratings to investors' decisions meant that CRAs should be regulated in some way.  This belief was magnified because credit ratings are deeply embedded in the European regulatory architecture. Following consultation and the EU legislative process, this has crystallised into The European Regulation on Credit Rating Agencies (the "Regulation").

The Regulation:

The Regulation aims to set behavioural standards for CRAs, such as increasing transparency and improving their standards of corporate governance.  The Regulation also puts in place a regime for registering and regulating CRAs and subjecting them to supervision.  The aim is that ratings will be qualitatively better than under current standards – "independent, objective and of adequate quality", as the Regulation puts it.1 

Main points and analysis:

1. Scope of Regulation:  Credit institutions (i.e. banks) may only use, "for regulatory purposes", ratings which have been issued by a CRA that is registered within the EU, or satisfies the equivalence criteria in the Regulation.2  "Regulatory purposes" includes for the calculation of regulatory capital.  For this reason, a CRA, unless it is registered, or meets the equivalence criteria, shall not be recognised as an External Credit Assessment Institution for the purposes of the Capital Requirements Directive (meaning that its ratings cannot be used when calculating the risk-weighting of assets).3

Analysis:  The fact that banks are required to use the ratings of registered CRAs only for regulatory purposes - and not for wider purposes - represents a favourable outcome for the banking industry.  Earlier drafts of the Regulation included a potentially much wider scope of banking activities requiring use of Regulation-compliant CRA ratings.  By linking the use of ratings under the Regulation to regulatory purposes (meaning compliance with European Community law), the scope is more certainly defined.

2. Registration and supervision of CRAs:  The Regulation establishes a mechanism for CRAs to be registered with their home member states' competent authorities, and for their EU affiliates to be supervised through a "college of supervisors" co-ordinated and moderated through the Committee of European Banking Supervisors ("CESR"). It applies to CRAs that are "legal persons established in the Community".4 CRAs will be required to pay a proportionate registration and supervisory fee.5

Analysis:  The threshold standards for registration are maximum harmonisation measures, that is, no Member States can impose additional or higher threshold requirements than are set out in the Regulations, which is appropriate given the purpose and scope of the Regulations.

3. Equivalence and endorsement:  For recognising the ratings of instruments and entities given by CRAs outside of the European Community:

  1. Registered CRAs can endorse the ratings of entities or instruments given by their affiliates outside of the European Community, provided that (amongst other things):6
    1. the registered CRA can verify on an ongoing basis that the conduct of the third country CRA operates under a no-less-stringent supervisory regime;
    2. there is an objective reason for the rating to be performed in the third country rather than within the European Community; and
    3. there is an "appropriate" co-operation agreement in place between the national regulator of the registered CRA and the third country CRA's regulator.  This way multinational CRAs may be able to endorse within the EU the ratings given by their foreign affiliates, although it is critical that the commission publishes a list of third countries with which such "co-operation arrangements" are in place.
  2. Ratings of third country CRAs relating to third country instruments or entities may be used by credit institutions for regulatory purposes provided (amongst other things):

    1. There is in effect a cooperation agreement between the Commission and the third country regulator in effect;
    2. The European Commission has adopted an "equivalence decision" confirming the standards of regulation in the third country are equivalent to EU standards; and
    3. The third country CRA has been "certified" by the CESR.

Analysis:  The endorsement approach is aimed at larger CRAs, the approach to equivalence aimed at smaller CRAs without an EU group presence.  Whilst in principle it is helpful to set out a regime for recognising third country ratings equivalence, it is not clear how endorsement criteria will be satisfied or what the actual process for putting in place cooperation agreements and making equivalence decisions will work, nor exactly what will constitute 'equivalence'.  In particular, the substantive requirements of the Regulation - against which "equivalence" will be judged - are more detailed and extensive than the international IOSCO Code of Conduct for CRAs,7 and this may restrict the ability of CRAs to obtain equivalence rulings.

4. Withdrawal of registrations and transition periods:  If a CRA's home regulator withdraws that CRA's registration (pursuant to the processes set out in the Regulations), there will be a transition period during which that CRA's ratings of any investments or entity may still be used by credit institutions for regulatory purposes. 

This period is:

  1. Ten working days, where the investment or entity rated is also rated by a different registered CRA; or
  2. Three months, otherwise – a period which may be extended by the Commission in circumstances where there is "potential for market disruption or financial instability".8

Analysis:  The automatic transition periods are welcome, as the potential regulatory capital shock of a CRA losing its registration could otherwise be immense and would generate exactly the kind of market instability that regulators and all market participants would want to prevent. 

5. Structured Finance:  Structured finance instruments will have some form of "additional symbol" to distinguish them from other ratings categories.9  CRAs will also be required to disclose information about the due diligence processes they have performed, loss information and cash-flow analysis, and their assumptions and stress scenario simulations undertaken.10  A structured finance instrument is defined as an instrument resulting from a securitisation as defined in the Banking Consolidation Directive.11

There is a further restraint on the issuance of ratings for complex products:

"where the lack of reliable data or the complexity of the structure of a new type of financial instrument or the quality of information available is not satisfactory or raises serious questions as to whether a credit rating agency can provide a credible credit rating, the credit rating agency shall refrain from issuing a credit rating or withdraw an existing rating."12

Analysis:  The additional symbol proposal has been circulating for some time, and the IOSCO Final Report of May 2008 includes a similar provision.13  Whilst it may seem politically desirable, this requirement is apt to confuse investors and suggests that there is some qualitative difference between structured finance ratings and the rest.  For regulatory capital purposes – i.e. determining the applicable credit quality step assigned to a rating – the additional symbol would appear not to make a difference (for now).  This raises the question, what does this additional symbol achieve? If the rating of a structured product is qualitatively inferior, why would this not be reflected in a lower rating itself?  If it is not inferior, why do we need the additional symbol?  Certainly, part of the overall challenge for regulators is to ensure that published ratings capture qualitative differences between types of rated entities or instruments (i.e. that structured instruments are fundamentally different to corporate entities and behave in very different ways) and the additional symbol is part of their response to this challenge.

The additional disclosure requirements specific to structured finance instruments may help some investors in their investment decisions, or they may lead to a diminished investor appetite for such instruments (based on the concern that, having been provided with this additional information, the investor would be obliged to review it, which may be an excessive operational challenge for certain investors).  Furthermore, whilst it may seem like common sense (and good business) for CRAs not to issue ratings where the structure or information available does not permit satisfactory analysis, to encode it in the Regulation may have the effect of stifling financial innovation (although the IOSCO Code of Conduct has a similar provision).14

6. CRA internal governance and transparency:  The Regulation imposes standards of internal governance to ensure (amongst other things) that CRAs manage any conflicts of interest, have independent compliance departments and review their rating methodologies periodically.  Additionally, the analysts or persons who approve ratings must not "make proposals or recommendations, whether formally or informally, regarding the design of structured finance instruments on which the credit rating agency is expected to issue a credit rating."15  The Regulation also prescribes time periods during which former analysts may not take up certain positions within entities which they have rated.16

Analysis:  It is unlikely that this will have a significant new impact since CRAs which comply with the IOSCO Code of Conduct are already prohibited from providing structuring advice in terms similar to the Regulation.17 

7. Timing and implementation:  the Regulations enter into force on the twentieth day after publication of the Regulations in the Official Journal of the EU.  The approved text of the Regulation is now presented for information to the ECOFIN meeting on 5 May.  Publication in the Official Journal is expected to take place later this year.

However, the requirement that credit institutions use only ratings from registered CRAs for regulatory purposes will apply from 12 months after that date of entry into force.  The equivalence criteria for third country CRAs will apply from 18 months after the entry into force of the Regulations.

Conclusion

From credit institutions' point of view, the final approved Regulations contain a number of improvements from initial consultations and drafts: pinning the usage of ratings to regulatory purposes, having a twelve-month window before the Regulations affect regulatory capital and putting in place transitional arrangements so that ratings can continue to be used for a period where registration is revoked are all helpful.

From the point of view of the CRAs, the Regulations impose an increased administrative, disclosure and supervisory burden, although for CRAs that already comply with the IOSCO Code of Conduct Fundamentals, the transition required to be Regulations-compliant may be less than the changes that they have already undertaken.  For third country CRAs looking to do business within the EU, and for EU credit institutions looking to buy securities rated only by third country CRAs, the impact of the Regulation may be considerably harsher.

Footnotes

1.       Recital 1.  All references are to the Regulation unless otherwise stated.

2.       Article 4(1).

3.       Article 2a.

4.       Article 12(1).

5.       Article 16.

6.       Article 4(4) - 4(6).

7.       "Code of Conduct Fundamentals for Credit Rating Agencies" issued by the Technical Committee of the International Organization of Securities Commissions ("IOSCO"), May 2008 (the "IOSCO Code of Conduct").

8.       Article 21(1a)(b).

9.       Article 8(3).

10.     Annex I, Section D part II.

11.     That is, "a transaction or scheme whereby the credit risk associated with an exposure or pool of exposures is tranched, having the following characteristics: (a) payments in the transaction or scheme are dependent upon the performance of the exposure or pool of exposures; and (b) the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme".  Directive 2006/48/EC Article 4(36).

12.     Annex I, Section D part I paragraph 3.

13.     "The Role of Credit Rating Agencies in Structured Finance Markets" Final Report of the Technical Committee of IOSCO, May 2008, p16.

14.     IOSCO Code of Conduct Article 1.7-3.

15.     Annex 1, Section B paragraph 5.

16.     Annex 1, Section C paragraph 6, for example.

17.     IOSCO Code of Conduct Article 1.14-1.

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