Draft Legislation Designates CESR as Single EU Regulator for Credit Rating Agencies
A committee of the European Parliament has reported out legislation providing for the regulation of credit rating agencies under a single EU-wide regulator, the Committee of European Securities Regulators (CESR). Rejecting the European Commission’s proposal for national regulation, the Economic and Monetary Affairs Committee designated CESR as the sole registration and
supervisory body over EU rating agencies. Parliament will now take up the legislation.
Under the draft legislation, CESR would be in charge of registering credit rating agencies, checking their compliance with the rules and ultimately withdrawing an agency's registration should the rules be breached. CESR would inform Member State authorities once all registration steps are accomplished. On an ongoing basis, CESR would also be in charge of monitoring the past performance of rating agencies and publishing statistical data on the reliability of ratings issued. To that end, credit rating agencies must make available in a public central repository, to be established by CESR, information on their historical performance data and information about past credit rating activities.
The committee referred to credit rating agencies as a de facto oligopoly that clearly underestimated the credit risk inherent particularly in structured credit products and did not adapt their ratings when the markets fell. Given this background, the committee concluded that ratings agencies should be subject to strict regulation. The legislative effort signals the failure of voluntary regulation through codes of conduct for rating agencies
A major issue dealt with in the draft is how to let European investors use non-EU ratings while maintaining the same criteria as for EU ratings. Embracing an equivalence regime, the legislation provides that non-EU ratings would have to be endorsed by an EU credit rating agency and comply with equivalent criteria to those in the EU legislation. A list of third country legislation and regulation considered equivalent to the EU credit rating agency regulatory regime will be prepared by the European Commission and regularly updated by the Commission.
Pending harmonized global rules, stated the committee report, ratings issued by credit
agencies not subject to European regulation could be used as long as these ratings are confirmed
and endorsed by an agency based within the European Union, in the sense of its assuming
responsibility and certifying that the agency that issued the rating is bound by regulation
equivalent to that which exists in the EU. The report emphasized that this is an opportune moment to promote healthy competition in the field of credit rating agencies by favoring the establishment of credit rating agencies with a head office in Europe. To this end, Member States will encourage entities to be rated to use agencies which have their head office located in the EU for a proportion of the ratings to be obtained.
The European Commission proposed the strict regulation of credit rating agencies in an effort to restore confidence in the markets. The legislation is 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 and independence. 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.
The legislation provides for a rotation mechanism to avoid conflicts of interest. A key goal of the reforms is to avoid conflicts of interest between the agency issuing the rating and the rated organization. The draft requires that a rotation mechanism be implemented to ensure that rating agency analysts who are in direct contact with the rated entity be rotated out after five years. In order to avoid negative effects on rating agency performance, the draft stresses that rotation should be on an individual basis rather than changing the entire team.
Other reforms would require rating agencies to disclose the compensation arrangements with their clients. In addition, compensation and performance evaluation of analysts providing the credit ratings cannot be contingent on the amount of revenue that the credit rating agency derives from the rated entities. Further, analysts and other employees who are directly involved in the credit rating process must not be allowed to participate in negotiations regarding fees or payments with any rated entity.
Incorporating the concept of differentiation, the legislation provides that credit rating agencies should use different rating categories when rating structured finance instruments and provide additional information on the different risk characteristics of these products. They should also indicate when rating a product for the first time and when rating a newly-created product.