Tuesday, May 29, 2012

Pending EU Legislation Would Require Mandatory Rotation of Credit Rating Agencies

Pending EU legislation amending the regulation of credit rating agencies would introduce  several provisions on mandatory rotation for rating analysts and credit rating agencies with the aim of achieving greater competition in that sector, said Stephen Maijoor, Chair of the European Securities and Markets Authority. In recent remarks, he noted that the regulatory framework for rating agencies will probably be soon amended by the CRA 3 Regulation, which is currently being negotiated at the European Parliament and at the Council. Since July 1, 2011 ESMA has been the exclusive regulator of credit rating agencies in the EU.

The CRA 3 legislation also includes a proposal for a new disclosure platform to be run by ESMA to improve the level of transparency of the credit rating market. As regards the prevention of conflicts of interest, the proposed legislation states that rating agencies must not issue credit ratings when their major shareholders have interests in the rated entity, or when the rated entities are major rating agency shareholders themselves. The legislation also provides that EU Member States must ensure civil liability for the infringements of the CRA Regulation made with intent or through gross negligence.

With regard to current CRA Regulation, Chairman Maijoor noted that ESMA conducted a first round of on-site inspections of the three main rating agencies in December of  2011. This was done in order to get a better understanding of the rating process and to assess the regulatory compliance by rating agencies in this area.

An ESMA report with the main findings of these initial examinations, issued on March 22, 2012, identified several shortcomings and areas for improvement that apply, to a varying extent, to all three credit rating agencies relating to such topics as transparency and disclosure of rating methodologies and ratings, controls over IT systems, the recording of core internal processes, and the resources devoted to internal control functions and analytical business lines. ESMA is now following-up on the observations through risk mitigation plans for each individual rating agency, said the Chair.

As part of its on-going regulation, ESMA is required to ensure that methodologies are rigorous, systematic, continuous, and subject to validation based on historical experience, including back testing. However, the CRA Regulation prevents ESMA from interfering with the content of credit ratings or methodologies. This also applies to the European Commission and any public authority of a Member State.