Commission proposal on improving EU supervision of Credit Rating Agencies

Credit rating agencies (CRAs) issue opinions on the creditworthiness of companies, governments and sophisticated financial products. The three most important CRAs, Moody's Investors Service, Standard & Poor's and Fitch Ratings are American and hold more than 90% of the global credit rating market. These private agencies play an important role in the stability of financial markets and in the availability and the cost of credit for companies and governments. However, they are more and more severely criticized. They contributed significantly to the global financial crisis, which started in 2007 in the United States by underestimating the risk that the issuers of certain more complicated financial instruments might not repay their debts. As market conditions were worsening, CRAs failed to reflect this promptly in their ratings. They were also accused of potential conflicts of interest, because they are paid as consultants by the very banks whose debt they rate. More recently, their ratings have aggravated the Greek crisis, in spite of the European solution to the problem of the Greek debt.

The Regulation on credit rating agencies

The failures and unreliability of credit rating agencies has resulted in calls for greater regulation of the sector. In the EU the Commission proposed and the European Parliament and Council adopted, on 16 September 2009, a Regulation on credit rating agencies [Regulation 1060/2009], in order to enhance the integrity, transparency, responsibility, good governance and reliability of credit rating ratings issued in the European Union [see Credit rating agencies and the EU].

Under the European rules, which will become fully applicable in December 2010, all CRAs that would like their credit ratings to be used in the EU now need to apply for registration. The risks of conflicts of interest affecting ratings are also addressed (for example, when a CRA offers consultancy services) CRAs will need to be more transparent as they will need to disclose the methodology and internal models and key rating assumptions they use to make their ratings. This should allow investors to perform better their due diligence.

Ignoring completely the EU Regulation and the financial package of € 110 billion made available to Greece by the euro area Member States and the International Monetary Fund [see Greek crisis and European solution], Standard & Poor's, on 26 April 2010, downgraded Greek bonds down to a BB+ - or junk - status, the same level as those issued by far less stable countries, such as Azerbaijan or Egypt. As the downgrades for Greece, Portugal, Spain and Ireland by the top three credit rating agencies, all of them US-based, have led to higher borrowing costs for the weaker eurozone countries, The European Parliament and the Council requested the Commission to put forward by 1 July 2010 a report and any legislative proposal needed to tackle the shortcomings identified as regards supervisory coordination and cooperation arrangements.

The proposal on amending the 2009 Regulation

On 2 June 2010, the Commission proposed a Regulation amending Regulation 1060/2009 on credit rating agencies [COM(2010) 289 final]. The proposal aims principally at a more centralised system for supervision of credit rating agencies at EU level. The key elements of the reform proposed by the Commission are:

A new supervisory authority of credit rating agencies operating in the EU - the European Securities and Markets Authority (ESMA) - would be entrusted with exclusive supervision powers over CRAs registered in the EU. ESMA is to assume general competence in matters relating to the registration and on-going supervision of registered credit rating agencies as well as matters related to ratings issued by rating agencies established in third countries that operate in the EU under the certification or endorsement regimes. The supervision would include also the European subsidiaries of American CRAs such as Moody's, Standard & Poor's and Fitch.

The ESMA would have powers to launch investigations, to perform on-site inspections and to propose penalties. Issuers of structured finance instruments such as credit institutions, banks and investment firms would have to provide information also to CRAs with which they do not work, in order to enable them to issue unsolicited and independent ratings. The centralized monitoring of the credit rating agencies should reinforce the transparency of the operations, the protection of the investors and competition in the sector of credit notation.

As a result of introduction of the new, single supervisory authority for the oversight of credit rating agencies, existing provisions, which envisage a college type of supervisory co-ordination and ultimate, formal decision-making by a competent authority of the home Member State, are to be eliminated. The transfer to ESMA of supervisory competences is expected to better address in the EU framework the challenge of ensuring effective and efficient oversight of those entities that often develop multi-jurisdictional presence and have wide-ranging cross border impact.

In order to ensure sufficient supervisory and enforcement capacity, ESMA is to be empowered to require all necessary information from CRAs and other persons related to credit rating activity. It will be able to start investigations into the potential breaches of the Regulation and in the remit of those it must be able to exercise supervisory powers such as examining records and other relevant material and taking copies/extracts thereof, requiring oral explanations, hearing a person, requiring records of telephone and data traffic. The ESMA must also be able to conduct on-site inspections.

Competent authorities are to keep the oversight responsibilities regarding the use of credit ratings by the supervised entities (like credit institutions, or insurance undertakings) which employ those credit ratings for regulatory purposes. Those national authorities remain best placed to examine how the supervised entities use credit ratings in their day-to-day activity and to take appropriate action, where necessary.

National supervisory authorities must also contribute to the supervisory activity of ESMA, by ensuring all necessary information exchange and co-operation, which may be required in the exercise of supervisory and enforcement powers of ESMA. ESMA may also delegate specific supervisory tasks to competent national authorities e.g. when supervisory measures have to be undertaken at the remote premises of a CRA or would require knowledge and experience with respect to local conditions, including foreign language skills. Delegation of tasks will not affect the responsibility of ESMA which may give instructions to the authority to which it has delegated a task.

ESMA shall also be empowered to adopt supervisory measures where a credit rating agency has committed a breach of the Regulation. Those measures include the temporary prohibition of the issuing of credit ratings and the suspension of the use of the credit ratings concerned until the infringement has been put to an end. In addition, ESMA has the power to require the credit ratings agencies to bring an infringement to an end and to issue public notices. As the necessary underpinning to its supervisory authority, ESMA may propose to the Commission to impose periodic penalty payments. As a last resort measure, ESMA is empowered to withdraw the registration of a credit rating agency.

In order to align the Regulation with the new proposal for a Directive on Alternative Investment Fund Managers, alternative investment funds will be treated in the same way as the other EU financial institutions with regard to the use of credit ratings. This implies that in case alternative investment funds use credit ratings for regulatory purposes, those credit ratings must have been issued by a credit rating agency registered or certified under the Regulation.

In order to avoid possible conflicts of interest arising for the CRA under the issuer-pays model which are particularly virulent regarding the rating of structured finance instruments, to enhance transparency and to increase competition among CRAs, issuers of structured finance instruments or related third parties should be required to give access to the information which they have given to the CRA they hired for the purpose of rating structured finance instruments to competing CRAs. All registered credit rating agencies will have the possibility to access the information necessary for issuing unsolicited ratings of structured finance instruments. This will lead to more competition in the rating market and increase the number of ratings per instrument so that users of ratings will be able to rely on more than one rating for the same instrument.

A European Systemic Risk Board (ESRB) shall monitor and assess potential threats to financial stability that arise from macro-economic developments and from developments within the financial system as a whole. To this end, the ESRB would provide an early warning of system-wide risks that may be building up and, where necessary, issue recommendations for action to deal with these risks.

The Commission notes that the US (SEC Rule 17g-5 published on 4 December 2009 and coming into force in June 2010) has also introduced a similar system. Given the global role and activities of CRAs, it is necessary to ensure that similar rules are applied to CRAs operating in multiple jurisdictions in order to maintain a level playing field and a sufficient level of competition between CRAs. Furthermore, these new provisions are expected to mitigate conflicts of interests due to the issuers-pay model.

Criticism of the proposal of the Commission

It is important to note that this proposal does not introduce any changes to the Regulation of September 2009 on credit rating agencies concerning the substantive conditions that CRAs have to fulfil in order to be registered and later on an ongoing basis. Similarly, the conditions under which ratings issued from credit rating agencies located in third countries may be used in the Union (via the endorsement and certification mechanisms, will remain as provided for in the 2009 CRA Regulation. However, the important CRAs, Moody's, Standard & Poor's and Fitch, have clearly demonstrated in the meantime that they are not concerned at all by European regulations [see Credit rating agencies and the EU].

To which agencies is, then, addressed the 2009 Regulation and the present proposal for its amendment? The worldwide known credit rating agencies are the following (in declining importance):

·         Moody's Investors Service (U.S.)

·         Standard & Poor's (U.S.)

·         Fitch Ratings (U.S.)

·         Dun & Bradstreet (U.S.)

·         A. M. Best (U.S.)

·         Egan-Jones Rating Company (U.S.)

·         Dominion Bond Rating Service (Canada)

·         Baycorp Advantage (Australia)

·         China Credit Information Service (China)

·         Japan Credit Rating Agency (Japan)

·         NKC Independent Economists (South Africa)

·         Rating Agency Malaysia (Malaysia)

It is obvious that there is not any important European credit rating agency. Does the Commission really believe that supervision of the European subsidiaries of American CRAs such as Moody's, Standard & Poor's and Fitch would break the world oligopoly that these agencies hold? Supposing that the European subsidiaries would abide by European rules, who would prevent their mother companies operating in New York to fix the credit ratings of European companies and governments with the rules set by them alone? And in this (very probable) case, which rating would have more weight, that of the European subsidiary or that of its mother company?

Hopefully, during the discussion of the proposal of the Commission, the European Parliament and the Council will ask answers to these questions and will request that the Commission puts forward a proposal that will break the monopoly of the American CRAs. This proposal cannot be other than the establishment, with private and/or public funds, of a European credit rating agency. The decision on the institution of this agency may affirm that this will be based on the rules of Regulation 1060/2009, with its eventual amendments, but should declare that, as of its establishment, the European Central Bank, the central banks of the Member States and the public financial institutions in Europe will base their assessment of the creditworthiness of a European company or government on the notations of this agency alone.

N.M.

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