Wednesday, November 12, 2008

European Commission Proposes Regulation of Credit Rating Agencies

With the financial crisis still roiling, the European Commission has proposed the strict regulation of credit rating agencies in an effort to restore confidence in the markets. The regulations are designed to ensure that the ratings issued by the agencies are independent, objective, and of the highest quality. The new regime is based on concepts of transparency, independence, and sound corporate governance. The proposal signals the failure of voluntary regulation through codes of conduct for rating agencies. According to Commissioner for the Internal Market Charlie McCreevy, the proposed regime for credit rating agencies will ensure that regulators with responsibility for oversight will have at their disposal sufficient resources and expertise to keep up with financial innovation and to challenge the rating agencies in the right areas, on the right issues, and at the right time.

But the Commission ensured that regulators under the new regime will not interfere in the content of the ratings. Credit rating agencies will be solely responsible for the methodologies, model and rating assumptions they use and the opinions they develop on that basis.

Under the proposal, credit rating agencies will have to comply with rigorous rules to make sure that ratings are not affected by conflicts of interest, that rating agencies remain vigilant on the quality of the rating methodology and the ratings, and that credit rating agencies act in a transparent manner. The proposal also mandates the registration of credit rating agencies under an effective surveillance regime whereby European regulators will oversee the rating agencies.

Under the new regulatory regime, credit rating agencies may not provide advisory services. They will not be allowed to rate financial instruments if they do not have sufficient quality information to base their ratings on. Further, they must disclose the models, methodologies and key assumptions on which they base their ratings; and will have to publish an annual transparency report. The rating agencies will also have to create an internal function to review the quality of their ratings.

With regard to governance, the rating agencies must have at least three independent directors on their boards whose remuneration cannot depend on the business performance of the rating agency. The directors will be appointed for a single term of office which can be no longer than five years. Moreover, they can only be dismissed in case of professional misconduct; and, at least one of them should be an expert in securitization and structured finance.

Credit rating agencies based in the US and other non-EU countries will be required to have a legal presence in the EU in the form of a subsidiary, which must apply for registration in the EU jurisdiction where its registered office is located. The agency will be expected to comply with all the requirements under the proposed regulations.

The new regulations seek to ensure more accurate ratings by requiring rating agencies to systematically use all data available to them and which they have declared important to their rating. They should also have measures to establish whether the information used is of sufficient quality and from reliable sources. In particular, with regard to structured finance instruments they should state to what extent they have verified the information themselves or relied on third party assessment of due diligence processes at the level of underlying assets. Further, credit rating agencies will not be allowed to rate instruments in cases where they do not have sufficient quality information to do so.

In addition, while the proposed regulations do not stipulate how the rating methodologies should be structured and reviewed, they do require that the methodologies be subject to independent internal scrutiny performed by a dedicated review function within the credit rating agency, but separate from the business lines. This function will have a direct reporting line to the independent members of the board.

The proposal embodies the principle of differentiation under which rating agencies must either differentiate rating categories for structured finance instruments so that they are not confused with rating categories for other types of financial instruments or produce a comprehensive report attached to each structured finance rating. It is envisioned that such a report would provide a detailed description of the rating methodology used to determine the credit rating and an explanation of how it differs from the determination of ratings for any other type of rated entity or financial instrument, and how the credit risk characteristics associated with a structured finance instrument differ from the risks related to any other type of rated instrument.

Very importantly, under the new regime, rating agencies will have to improve the way they deal with conflicts of interest in order to regain markets' confidence. To ensure the independence of ratings, they will be required to prevent conflicts of interest and adequately manage unavoidable conflicts. They will have to disclose conflicts of interest in a complete, timely, specific, and prominent manner and record all significant threats to the rating agency’s independence or that of its employees involved in the credit rating process, together with the safeguards applied to mitigate those threats. The rating agencies will also have to implement adequate internal policies and procedures to insulate employees involved in credit rating from conflicts of interest and ensure the quality, integrity and thoroughness of the rating and review process.

There are other more specific prohibitions and limitations in the rules designed to prevent conflicts of interest. For example, rating agencies will have to disclose to the public the names of the rated entities from which they receive more than 5 per cent of their annual revenue. Further, a rating agency will not be able to issue a credit rating or will have to withdraw an existing credit rating when itself or its analyst involved in the credit rating have ownership of financial instruments in the rated entity or control links.

Also, a rating agency will not be allowed to provide consultancy or advisory services to the rated entity or any related third party regarding the corporate or legal structure, assets, liabilities or activities. Rating agencies will only be permitted to provide ancillary services in cases that do not present conflicts of interest with its rating activity. Moreover, analysts will not be allowed to make proposals or recommendations, either formally or informally, regarding the design of structured finance instruments on which the agency is expected to issue a rating.

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