Tuesday, February 07, 2012

Senior ESMA Official Outlines Credit Rating Agencies Regulation and Examines Proposed Revisions

On July 1, 2011 the European Securities and Markets Authority assumed responsibility for the day to day supervision of registered credit rating agencies. In December of 2011, ESMA conducted the first on-site inspection of the three main rating agencies, for which ESMA expects to publish an examination report by the end of the Q1 2012. According to remarks by Verena Ross, ESMA Executive Director, during 2012 ESMA will finalize the establishment of the reporting data tools provided by the Credit Rating Agencies Regulation and of the central database, an essential disclosure facility for investors. ESMA is also in the process of performing the assessment of the regulatory framework of several non-EU countries and agreeing to suitable cooperation arrangements with the respective regulators in order to ensure the endorsement of the overwhelming majority of third-country ratings currently used for regulatory purposes in the EU.

Regarding proposed revisions to the Regulation, the senior official allowed that some of them would have a positive effect on the overall framework for rating agency supervision, starting with the new disclosure provisions. Issuers, sponsors, and originators of structured finance instruments would have to disclose information on the credit quality and performance of underlying asset pools. Also, rating agencies would disclose to ESMA the fees received from each of their clients and their general pricing policy.

Another important contribution of the new proposal, said the Director, concerns the prevention of conflicts of interest. For example, rating agencies could not issue credit ratings when their major shareholders have interests in the rated entity or when the rated entities are major CRA shareholders themselves. Major CRA shareholders would also be limited in their ability to provide consultancy or advisory services to the rated entity. While it will be important to get the exact provisions right, said the senior official, reducing any real or apparent conflicts of interest between rating agencies and their shareholders is an important step in the right direction.

Another positive proposal would require ESMA to introduce a harmonized rating scale to be used by all CRAs registered in the EU. The uniform rating scale would establish comparable metrics for all existing rating scales. Such metrics would contribute to the transparency, interoperability, and comparability of the rating process and could enhance competition in the sector.

However, a problematic proposal would require ESMA to assess new draft methodologies as a condition for their entry into force. In the Director’s view, this new proposed role for ESMA could create serious tensions with the requirement of non-interference and independence. One possible alternative could be to have detailed principle-based industry standards for rating processes, whose application could then be monitored by ESMA as part of its on-going supervision process to ensure that rating agencies respect these commonly agreed industry standards.

The proposal requires ESMA to renew by June 1 2014 the assessment of compliance of third countries with the amendments. The Regulation currently in force already requires ESMA to judge dynamically the adequacy of the regulatory framework in non-EU countries when compared to the EU Regulation, namely that the third-country legal framework achieves similar regulatory effects and meets the same objectives as the EU Regulation.

By adding a tight deadline and by making a direct reference to the amendments, noted Director Ross, the proposed assessment would not only run into difficulties since at the moment several of the new proposals are not part of the G20 and IOSCO framework, but might also create incredulity around ESMA's intentions and good faith in the continuing ongoing third-country assessment process that it is currently engaged in under the existing Regulation.