Saturday, November 26, 2011

European Commission Proposes Enhanced Regulation of Credit Rating Agencies

The European Commission proposes enhanced credit rating agency regulations around sovereign debt issuances and to reduce conflicts of interest in the ratings process. Less than two years after the adoption of the EU Regulation on Credit Rating Agencies, Regulation (EC) No 1060/2009, recent developments in the context of the euro debt crisis have shown that the existing regulatory framework is not good enough. So, the Commission has set out proposals to toughen that framework further and deal with outstanding weaknesses by increasing the transparency and frequency of the rating of sovereign debt. The proposals now go to the European Parliament and the Council for negotiation and adoption.

Internal Market Commissioner Michel Barnier expressed surprise at the timings of some sovereign ratings, such as ratings announced in the middle of negotiations on an international aid program for a country. The Commission will not allow ratings to increase market volatility further. The Commissioner’s first objective is to reduce the over-reliance on ratings, while at the same time improving the quality of the rating process. Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes, he said.

With regard to sovereign debt, Member States would be rated every six months rather than 12 months and investors and Member States would be informed of the underlying facts and assumptions on each rating. Rating agencies would also have to provide more information on the reasons behind sovereign ratings, explaining why it took a specific rating action. To avoid market disruption, sovereign ratings should only be published after the close of business and at least one hour before the opening of trading venues in the EU. Thus, rating agencies would have to publish those sovereign debt ratings outside the European working hours of the stock exchanges, so that traders have some time to assess them before starting to trade. The possible suspension of sovereign ratings is a complex issue which the Commission will consider further.

In order to reduce conflicts of interest, the Commission would require issuers to rotate every three years between the agencies that rate them. The general rule would be that rating agencies must not rate corporate issuers for a period exceeding three years. However, when an issuer has employed more than one rating agency to rate its creditworthiness or its instrument, only one of the agencies would have to respect the three years' limitation. The Commission cautioned that this exception should not lead to any contractual relationship exceeding a total duration of six years. The rotation rule would 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.

Noting that many structured finance instruments rated with the highest ratings have become toxic assets, the Commission proposed measures reinforcing the regulations regarding the rating of structured finance. First, two ratings from two different rating agencies would be required for complex structured finance instruments. The two ratings would have to be parallel and independent from each other, and the two rating agencies would have to be independent from each other in terms of ownership and management.

Second, issuers of structured finance products would have to provide more information 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 securitization exposure on their products to the market, so that investors can make their own judgments and not rely mechanically on ratings to assess the creditworthiness of those instruments

Also, cross-shareholdings in rating agencies would be limited in that a shareholder with a sizeable stake, more than 5 percent, in a credit rating agency could not simultaneously be a major shareholder in another credit rating agency unless both rating agencies belong to the same group. Rating agencies would also be prohibited from rating an entity in which its largest shareholders, those holding more than 10 percent of the capital or the voting rights, have a financial interest.

The existing Credit Rating Agency Regulation focuses on registration, conduct of business and supervision. In order to be registered, a credit rating agency must fulfill a number of obligations on the conduct of its business intended to ensure the independence and integrity of the rating process and to enhance the quality of the ratings issued.

The European Securities and Markets Authority (ESMA) is entrusted since July 2011 with the responsibility for registering rating agencies in the EU. ESMA also has comprehensive investigative powers, including the power 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. Credit rating agencies are currently the only financial institutions directly supervised by a European supervisory authority. Further, shareholders with more than 5 percent of the capital or the voting rights in a rating agency or otherwise in a position to exercise significant influence over its business activities would not be allowed to provide consultancy services to the rated entities.

Moreover, the Commission proposes to allow investors 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. 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 rating agency, the Commission proposes that it will be for the rating agency to prove that it applied the necessary care. The investor only has to provide facts that suggest that there was an infringement.

The existing Regulation requires rating agencies to avoid conflicts of interests. For example, rating analysts employed by an agency should not rate an entity in which they have an ownership interest. Further, in order to ensure the quality of ratings, the Regulation requires the ongoing monitoring of credit ratings and rating methodologies, which must be rigorous and systematic, and a high level of transparency.

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