European Union Approves Legislation Regulating Credit Rating Agencies

The Council of the European Union has approved legislation providing for the regulation of credit rating agencies under a regime of sound corporate governance that includes registration, surveillance, transparency, differentiation, and monitoring duties for independent board members. The legislation is aimed at ensuring that credit ratings used in the EU for regulatory purposes are of the highest quality, and issued by agencies that are subject to stringent requirements. Currently, credit rating agencies are only to a limited extent subject to EU legislation and most Member States do not regulate their activities, although their ratings are used by financial institutions which themselves are subject to EU rules.

The legislation is also designed to ensure that credit rating agencies avoid conflicts of interest in the rating process, or at least manage them adequately. It also seeks to improve the quality of methodologies used by rating agencies and the quality of their ratings, as well mandating disclosure obligations for credit rating agencies.

As the financial crisis unfolded, credit rating agencies were seen to have failed to reflect early enough in their ratings the worsening market conditions and to adjust their credit ratings in time. Gradually, legislation was seen as necessary to correct those failures that involved conflicts of interest, lack of transparency and the internal governance of the credit rating agencies. In essence, credit rating agencies had become a de facto oligopoly that underestimated the credit risk inherent in structured and securitized products and did not adapt their ratings when the markets fell. Given this background, the European Commission 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

The legislation provides that 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 the ratings issued. To that end, credit rating agencies would 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 new regime embodies the important concept of differentiation. Under certain circumstances, structured finance instruments, such as asset-backed securities, may have effects which are different from traditional corporate debt instruments. It could be misleading for investors to apply the same rating categories to both types of instruments without further explanation. Thus, credit rating agencies must clearly differentiate between rating categories used for rating structured finance instruments on the one hand, and rating categories used for other financial instruments on the other.

The new regime also embodies sound corporate governance. In order to ensure the independence of the credit rating process from the business interest of the credit rating agency as a company, credit rating agencies must ensure that at least one third, but no less than two, members of its supervisory board are independent and not involved in credit rating activities. Further, the compensation of the independent board members cannot be linked to the business performance of the credit rating agency and, indeed, must be arranged to ensure the independence of their judgment. The independent board members must also be charged with monitoring the development of the credit rating policy and of the methodologies used by the rating agency in its credit rating activities, as well as the effectiveness of internal controls relating to rating activities and procedures to ensure the identification and management of conflicts of interest.

The new regime also embodies enhanced transparency. Thus, credit rating agencies must publish annually a transparency report and ensure that the report remains available on the website of the agency for at least five years. The transparency report must include detailed information on legal structure and ownership of the credit rating agency, a description of the internal control mechanisms ensuring quality of its credit rating activities; a description of its record-keeping policy and its rating analyst rotation policy, and financial information on the revenue of the credit rating agency divided into fees from credit rating and non-credit-rating activities with a comprehensive description of each.

Credit rating agencies should use rating methodologies that are rigorous, systematic, continuous and subject to validation by appropriate historical experience and back-testing. Such requirements should not, however, provide grounds for interference with the content of credit ratings and methodologies by the authorities. Similarly, the requirement that credit rating agencies review credit ratings at least annually should not compromise the obligation on credit rating agencies to monitor credit ratings on a continuous basis and review credit ratings as necessary. Also, those requirements should not be applied in such a way as to prevent new credit rating agencies from entering the market.

Credit rating agencies should disclose information on the methodologies, models and key rating assumptions which they use in their credit rating activities. The level of detail concerning the disclosure of information concerning models should be such as to give adequate information to the users of credit ratings in order to perform their own due diligence when assessing whether to rely or not on those credit ratings. Disclosure of information concerning models should not, however, reveal sensitive business information or seriously impede innovation.

Credit rating agencies should establish appropriate internal policies and procedures in relation to employees and other persons involved in the credit rating process in order to prevent or manage and disclose any conflicts of interest and ensure at all times the quality, integrity and thoroughness of the credit rating and review process.

Credit rating agencies should avoid situations of conflict of interest and manage those conflicts adequately when they are unavoidable in order to ensure their independence. Credit rating agencies should disclose conflicts of interest in a timely manner. They should also keep records of all significant threats to the independence of the credit rating agency and that of its employees and other persons involved in the credit rating process.

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