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Brussels, 15 November 2011
Frequently asked questions: legislative proposal on credit rating agencies (CRAs)
I. GENERAL CONTEXT AND APPLICABLE LAW
1. What is a credit rating?
A credit rating is an opinion issued by a specialised firm on the creditworthiness of an entity (e.g. an issuer of bonds) or a debt instrument (e.g. bonds or asset-backed securities). This opinion is based on research activity and presented according to a ranking system (e.g. AAA, BBB. For full list, please refer to the annex attached to this memo.)
2. What is a credit rating agency?
A credit rating agency (CRA) is a service provider specialised in the provision of credit ratings on a professional basis. The three biggest rating agencies are Standard & Poor's, Moody’s and Fitch. They cover approximately 95% of the world market. Smaller rating agencies make up the remaining part. For a list of all European CRAs already registered under the CRA Regulation, see:
3. Why do we need to regulate credit rating agencies?
CRAs have a major impact on today's financial markets, with rating actions being closely followed and impacting on investors, borrowers, issuers and governments: e.g. sovereign ratings play a crucial role for the rated country, since a downgrading has the immediate effect of making a country's borrowing more expensive. A downgrading also has a direct impact for example on the capital levels of a financial institution.
The financial crisis and recent developments in the context of the euro debt crisis have revealed serious weaknesses in the existing EU rules on credit ratings. In the run up to the financial crisis, CRAs failed to appreciate properly the risks inherent in more complicated financial instruments (especially structured financial products backed by risky subprime mortgages), issuing incorrect ratings that were far too high.
The market for structured finance products grew rapidly, and CRAs were happy to both advise the issuer on the design of these innovative structures and afterwards rate them. These conflicts of interest were poorly managed, contributing further to rating inflation.
The 2008 crisis highlighted how far many of these instruments had been overrated.
The large majority of the ratings that large CRAs made on instruments linked to subprime in 2006 had to be downgraded between mid-2007 and mid-2008 causing substantial losses for investors.
In this context a number of legal proceedings have been launched in particular in the US by investors accusing CRAs of issuing misleading ratings.
4. What do applicable EU rules on credit rating agencies say?
The G20 summit in Washington (2008) aimed to ensure that no institution, product or market was left unregulated at EU and international levels.
The EU Regulation on Credit Rating Agencies (CRA Regulation)1, in force since December 2010, was part of Europe's response to these commitments. The Regulation was amended in May 2011 to adapt it to the creation of the European Securities and Markets Authority (ESMA)2.
The current CRA Regulation focuses on:
- registration: in order to be registered, a CRA must fulfill a number of obligations on the conduct of their business (see below), intended to ensure the independence and integrity of the rating process and to enhance the quality of the ratings issued. ESMA is entrusted since July 2011 with responsibility for registering and directly supervising CRAs in the EU;
- conduct of business: the existing Regulation requires CRAs to avoid conflicts of interest (for example, a rating analyst employed by a CRA should not rate an entity in which he/she has an ownership interest), to ensure the quality of ratings (for example, requiring the ongoing monitoring of credit ratings) and rating methodologies (which must be, inter alia, rigorous and systematic) and a high level of transparency (for example, every year the CRA should publish a Transparency Report); and
- supervision: ESMA has comprehensive investigatory powers including the possibility to demand any document or data, to summon and hear persons, to conduct on-site inspections and to impose administrative sanctions, fines and periodic penalty payments. This centralises and simplifies the supervision of CRAs at European level. Centralised supervision ensures a single point of contact for registered CRAs, significant efficiency gains due to a shorter and less complicated registration and supervisory process and a more consistent application of the rules for CRAs. CRAs are at present the only financial institutions which are directly supervised by a European supervisory authority.
The current CRA Regulation, however, does not regulate the use of credit ratings and their impact on the market. The use of external ratings by financial institutions is regulated in sectoral financial legislation (e.g. in the Capital Requirements Directive).
5. What has already been proposed to reduce the risk of overreliance in the banking sector?
The Commission's proposal for a new Capital Requirements Directive (CRD IV) of July 2011 proposed measures to reduce reliance on ratings. In that proposal (IP/11/915) it is envisaged to reduce to the extent possible reliance by credit institutions on external credit ratings by:
II. THE INTERNATIONAL CONTEXT
6. What is the situation at international level? Are the proposed measures in line with regulatory approaches of other jurisdictions and international standard setting bodies?
The Commission's efforts are broadly in line with the policy developed by our international partners within the Financial Stability Board (FSB) and the Basel Committee.
The Financial Stability Board (FSB) endorsed in October 2010 principles to reduce authorities’ and financial institutions’ reliance on CRA ratings. The G20 approved the FSB's principles on reducing reliance on external credit ratings (Seoul Summit, 11‑12 November 2010).
The FSB principles cover five types of financial market activity: 1) prudential supervision of banks; 2) policies of investment managers and institutional investors; 3) central bank operations; 4) private sector margin requirements; and 5) disclosure requirements for issuers of securities. The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles call on authorities to do this through:
The Basel Committee on Banking Supervision has also proposed to reduce reliance on credit rating agencies ratings in the regulatory capital framework.
In the USA, the Dodd-Frank Wall Street Reform and Consumer Protection Act3 has strengthened rules on CRAs. Among other things section 939A of the Dodd-Frank Act requires federal agencies to review how existing regulations rely on ratings and remove such references from their rules as appropriate. As a consequence, the Securities and Exchange Commission (SEC) is currently exploring ways to reduce regulatory reliance on external credit ratings and replace them with alternative criteria. Some references have already been replaced in US legislation.
Apart from over-reliance, there are other areas of change being proposed by the European Commission which are also being reviewed by third country regulators, including in the US. This concerns, for example, the question of how conflicts of interests due to the "issuer-pays" model can be efficiently mitigated or how transparency of structured finance instruments can be improved. The debate on some of the issues has not yet been finalised at the global level. However, the Commission believes that the measures it proposes are a suitable way to tackle the problems identified and that its proposal can provide an important contribution to the international debate.
III. THE PROPOSAL: WHY IS IT NEEDED
7. Why is a reform of the CRA Regulation needed?
Because there are weaknesses in the existing EU rules on credit ratings that have been highlighted both by the financial crisis and more recent euro debt crisis:
- non-transparent sovereign ratings: Downgrading sovereign ratings has immediate consequences on the stability of financial markets but CRAs are insufficiently transparent about their reasons for attributing a particular rating to sovereign debt. Given the importance of ratings on sovereign debts, it is essential that ratings of this asset class are both timely and transparent. While the EU regulatory framework for credit ratings already contains measures on disclosure and transparency that apply to sovereign debt ratings, further measures are needed such as access to more comprehensive information on the data and reasons underlying a rating, in order to improve the process of sovereign debt ratings in EU;
- investors' over-reliance on ratings: European and national laws give a quasi-institutional role to ratings. For example, the amount of capital that banks must hold is determined in some cases by the external ratings given to it. Furthermore, some investors rely excessively on the opinions of CRAs, and don’t have access to enough information on the debt instruments rated or the reasons behind the credit rating which would enable them to conduct their own credit risk assessments. Measures are needed to reduce references to external ratings in legislation and to ensure investors carry out their own additional due diligence on a well-informed basis;
- conflicts of interest threaten independence of CRAs and high market concentration: CRAs are not independent enough from the rated entity that contract (and pays) them: e.g. as a rating agency has a financial interest in generating business from the issuer that seeks the rating, this could lead to assigning a higher rating than warranted in order to encourage the issuer to contract them again in the future. Furthermore, a small number of large CRAs dominate the market. The rating of large corporates and complex structured finance products is conducted by a few agencies that also happen to have shareholders that sometimes overlap;
- (absence of) liability of CRAs: CRAs issuing credit ratings in violation of the CRA Regulation are not always liable towards investors that suffered losses. National differences in civil liability regimes could result in credit rating agencies or issuers shopping around, choosing jurisdictions under which civil liability is less likely.
8. What is the Commission proposing to address these issues?
The Commission is proposing targeted, but nevertheless far reaching amendments to the current CRA Regulation. The major initiatives are the following:
- More transparent and timely sovereign ratings:
CRAs will need to provide more information on the reasons behind sovereign ratings, explaining why it takes a specific rating action, and will need to update the ratings every six months (rather than 12 months at the moment)). This will make sovereign ratings more transparent and reliable. CRAs will have to publish those ratings outside the European working hours of the stock exchanges, so that traders have some time to assess them before starting to trade. The rule in the current CRA Regulation requiring CRAs to inform the issuers in advance of the rating and of the principle grounds on which the rating is based is specified in order to grant issuers appropriate time to react to the rating notification. CRAs shall inform issuers during working hours and at least one working day before publication of the rating.
- More transparency and less investors' reliance on ratings:
Investors will have to conduct their own assessment on the creditworthiness of the debt instruments in which they invest. For this, they will have access to more information from issuers (issuers will have to disclose specific information on structured finance products on an ongoing basis) and rating agencies (e.g. guidance explaining methodologies and underlying assumptions will be extended from structured finance products to all asset classes).
A horizontal provision in the CRA Regulation will oblige all regulated financial institutions (banks, insurance companies, investment fund managers…) to make their own credit risk assessment without solely or mechanically relying on credit ratings.
Changes to UCITS and the Alternative Investment Fund Managers Directive introduce the principle that investment managers should not rely solely and mechanically on external credit ratings in those sectoral legislations and empower the Commission to further specify this principle in delegated acts.
A general provision will require the European Supervisory Authorities (ESMA, EBA and EIOPA) to avoid external ratings in their guidelines where those would enhance the risk of overreliance and to review and if possible remove existing references. A similar provision is addressed to the European Systemic Risk Board (ESRB).
- More diversity and independence of CRAs
CRAs will have to become more independent vis-à-vis the entities they rate, in particular:
- Liability of CRAs
Investors will be able to sue a credit rating agency which, intentionally or with gross negligence, fails to respect the obligations set out in the CRA Regulation, thereby causing damage to investors.
In this context, and given that it would often be difficult, for the investor, to prove what the reason for the breach of the Regulation was and whether this breach was due to gross negligence of the CRA, we are also proposing that it will be for the CRA to prove that it applied the necessary care. The investor only has to provide facts that suggest that there was an infringement.
IV. WHAT WILL CHANGE?
9. Who will be affected by the proposed changes and how?
The following categories of market participants will directly be affected by the proposed changes:
They will benefit from more choice of rating providers which may lead to lower rating fees in the medium term. Sovereign issuers (e.g. states and municipalities) will benefit from the improved transparency and process of issuing sovereign ratings.
From now on, a corporate issuer should regularly change CRA (maximum period for using the services of a certain CRA would be three years). However, where the issuer – voluntarily or because it is legally obliged to do so – mandates more than one CRA to rate its creditworthiness or its instrument, only one of the CRAs will have to rotate. Nevertheless, the maximum contractual relationship with any CRA should in these cases never exceed six years.
All issuers, including sovereigns, will enjoy additional time to react to ratings before they are being made public. The current rules already provide for ratings to be announced to the rated entity 12 hours before their publication. In order to avoid that this notification takes place outside working hours and to leave the rated entity sufficient time to verify the correctness of data underlying the rating, the new rules will require that the rated entity should be notified a full working day before publication of the rating or of a rating outlook. This information shall include the principal grounds on which the rating or outlook is based in order to give the entity an opportunity to draw attention of the credit rating agency to any factual errors.
The publication of sovereign ratings will be done in a manner that is least distortive on markets: these ratings will only be published after the close of stock exchanges and at least one hour before their opening in the EU.
They will be in a better position to evaluate the credit risk of financial instruments themselves, including complex structured instruments. They will have free access to a European Rating Index (EURIX) and harmonised rating scale developed by ESMA where all ratings regarding a specific company or financial instruments can be found and compared. In addition, investors will benefit from an increase in the quality of ratings as conflicts of interests due to the "issuer-pays" model and the shareholder structure will be reduced. Investors' right of redress against credit rating agencies having infringed the CRA Regulation will be enhanced.
Its role will be reinforced regarding supervision of sovereign ratings. In addition, ESMA will be entrusted with new tasks e.g. it will have to draft a number of new technical standards for adoption by the Commission.
For instance, ESMA should establish a European Rating Index (EURIX) so as to allow investors to easily compare all ratings that exist with regard to a specific rated entity and provide them with average ratings. ESMA will need to develop draft regulatory technical standards to specify the content and the presentation of the information to be provided by CRAs to EURIX as well as to specify a harmonised rating scale to be used by CRAs when providing such information.
- Regarding the new rating methodologies:
ESMA will have to verify that methodologies and changes to methodologies comply with regulatory requirements set out in Art 8 (3) and the ESMA technical standards, i.e. methodologies must be rigorous, systematic, continuous, and subject to a validation test based on historical experience, including back-testing before they are applied. However, ESMA will not be allowed to second guess specific ratings or to interfere with the content of methodologies.
CRAs shall inform ESMA of detected errors in methodologies and/or their application. This should facilitate ESMA's oversight.
- Regarding existing ratings: EURIX
CRAs will have to communicate to ESMA all credit ratings they issue. ESMA will make them available to the public on a website. ESMA will also disclose an aggregated rating index for any rated debt instrument (EURIX). As a result, investors, issuers and other interested parties should have an easy access to up to date rating information enabling them to compare all existing ratings with regard to a specific rated entity. EURIX should also help smaller CRAs to gain visibility.
- Regarding rating scales
ESMA will develop a harmonised rating scale to be used by CRAs for the publication of ratings on EURIX. This will ensure that ratings can be compared more easily by investors. This measure will make EURIX more useful.
10. Why is the Commission proposing specific rules for sovereign ratings?
11. Will ESMA have a veto power on CRAs methodologies?
No. ESMA already carries out this verification in the registration process and as part of the ongoing supervision. However, in the interest of legal certainty and the stability of the markets, it should be ensured that these methodologies comply with legal requirements before they can be used to issue ratings.
12. Why is the Commission not proposing to set up a European CRA?
13. The rotation rule will undermine quality of ratings. Why is the Commission proposing it?
Credit rating agencies provide a service of particular importance to investors. Therefore, it is important that they are, and are seen as being, independent from the entity they rate or the entity that issued the financial instrument they rate. This independence is even more important in a business environment where the rated entity selects and pays the credit rating agency (so-called "issuer-pays" model).
Limiting the time period during which a CRA can be engaged and paid by a rated entity will mitigate the following risks:
These threats are, by nature, less important where an issuer – voluntarily or because the applicable legal provisions require it to do so – uses two or more CRAs in parallel to rate its creditworthiness or its instrument(s). In such cases, only one CRA shall rotate. However, also in these cases the business relationship with one particular CRA should not be permanent. We are proposing a maximum duration of six years. In addition, lead analysts should not be involved in the rating of an entity for more than 4 years.
14. How will the rotation rule work in practice?
The general rule is that CRAs shall not rate corporate issuers for a period exceeding three years.
Concerning the rating of a debt instrument, the same rule would normally apply. However, the period after which the CRA should stop issuing credit ratings may be shorter in the following case: once the CRA has rated 10 consecutive debt instruments of the same issuer, it should also stop issuing credit ratings on this issuer's instruments. However, if the rating of the 10 debt instruments was completed in less than 12 months, the CRA can continue its activity until 12 months of engagement have been completed).
Where an issuer has employed more than one CRA to rate its creditworthiness or its instrument, only one of the CRAs would have to respect the three years' limitation. However, this exception should not lead to any contractual relationship exceeding a total duration of six years.
That CRA could rate this issuer again after a cooling-off period of four years has elapsed.
The rotation rule does not apply in the case of unsolicited ratings, or in the case of sovereign ratings, where the issuer-pays model is less common and therefore conflicts of interests are less relevant.
15. Rotation is not workable, in particular where you have an issuer issuing a high number of structured finance instruments.
The exception from the rotation rule in case of multiple ratings for the same issuer or products mitigates the effects of the rule for these issuers (see also reply to question 17 above).
In addition, we ensure that the contract between the issuer and the CRA should not be shorter than one year, independently from the number of credit ratings issued on the financial instruments of that issuer within that year (see also reply to question 17 above).
Furthermore, the objective of any proposal on rotation is in the first place to increase the independence of CRAs and therefore the quality of ratings. However, a second objective is to make the credit rating market more dynamic and increase the number of participants and the choice for issuers.
The proposal will be accompanied by other measures to reach that aim (such as the support for the creation of a network of smaller CRAs.) We therefore expect the market to develop in the future. ESMA and the Commission will monitor that development. If the market does not develop as expected, appropriate transition rules relating to rotation could be put in place.
Some issuers already use multiple ratings for their structured finance products. This is something we support as it improves information for investors and the quality of the overall information available for these complex products. It is consistent with our intention to propose double ratings for such products as an obligation for issuers. As explained above, if an issuer has employed more than one CRA on the same matter, only one of them would have to respect the short rotation period.
The quality of rating will not be undermined because of the use of small CRAs. Given the new market opportunities, small CRAs will grow and develop their capacity and expertise. They will be tightly monitored and supervised. In any event, given their records regarding the rating of structured products, large CRAs cannot really pretend that their quality is above market standards.
16. What will happen when issuing complex structured finance instruments?
In recent years, many structured finance instruments rated with the highest ratings have become toxic assets. For example, a major CRA had to downgrade 83% of its AAA ratings issued in 2006 on mortgage-backed securities. The subsequent downgrades of these products meant that investors such as pension funds incurred massive losses, in some cases billions of euros.
Therefore the present proposal reinforces the rules and requires issuers of complex structured finance instruments to substantially change the way they provide investors with information on the creditworthiness of those instruments. The ratings of CRAs will no longer be the only channel to assess such creditworthiness. Issuers will need to be more transparent towards the market, to enable investors better to judge, by themselves, the creditworthiness of these complex instruments
Two provisions in the proposal will deal with this matter:
- Issuers of structured finance products shall provide more information (e.g. on the credit quality and performance of the individual underlying assets of the structured finance instrument, the structure of the securitization transaction, the cash flows and any collateral supporting a securitisation exposure) on their products to the market, so that investors can make their own judgements and not rely systematically and mechanically on ratings to assess the creditworthiness of those instruments. This will also allow other CRAs to issue unsolicited (and independent) ratings;
- Issuers of structured finance products will have to engage two CRAs to rate their products in parallel and independently from each other, to provide more reliable ratings to investors. The two CRAs will need to be independent from each other in terms of ownership and management.
17. What rules does the Commission propose to mitigate possible conflicts of interest of a CRA with regard to its shareholders?
The Commission proposes that a credit rating agency should abstain from issuing credit ratings (or should disclose that the credit rating may be affected) where a shareholder who is in a position to significantly influence the business activity of that agency:
Where a shareholder of a CRA is in a position to influence the business activity of the CRA, he shall not provide consultancy or advisory services to an entity rated by this CRA or its related third party.
18. Why does the Commission propose to extend certain rules of the CRA Regulation to rating outlooks?
A rating outlook provides an opinion regarding the likely direction of a credit rating in the short and medium term. Rating outlooks can be 'stable', 'negative' or 'positive'. A negative outlook means that the CRA is considering downgrading the rating in the short to medium term. The relevance of credit outlooks for investors and issuers and their effects on markets can be comparable to the effects of any "normal" rating decision. Therefore, the procedural requirements of the CRA Regulation which ensure that ratings are accurate, transparent and understood by investors should also apply to rating outlooks.
19. What does the proposal say about the possibility of investor pays models?
The proposal allows the investor pays models but the use of the investor pays model is not compulsory; it will continue to coexist with the prevalent issuer pays model. Making the investor-pays model compulsory risks resulting in a lower number of credit ratings issued, therefore leaving the market without credit ratings on certain issuers or financial instruments.
20. Are all ratings going to be disclosed? If so, why not just wait for others to pay them?
Ratings issued under the investor pays model are only disclosed to the investors who pay for them. But all ratings under the issuer pays model will be disclosed and aggregated on Eurix.
Fitch Ratings and Standard & Poor's use a system of letter sliding from the best rating "AAA" to "D" for issuers already defaulting on payments.
Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on credit rating agencies , OJ L 302, 17.11.2009. Regulation (EC) No 1060/2009 is often referred to as CRA I Regulation.
Regulation (EU) No 513/2011 of the European Parliament and of the Council of 11 May? 2011 amending Regulation (EC) No 1060/2009. Regulation (EU) No 513/2011 is often referred to as CRA II Regulation.: