Explanatory Memorandum to COM(2008)704 - Credit Rating Agencies - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2008)704 - Credit Rating Agencies. |
|---|---|
| source | COM(2008)704  |
| date | 12-11-2008 |
Credit rating agencies provide independent opinions on the probability of default or expected losses of companies, governments and a wide range of financial instruments. These ‘credit ratings’ are used by investors, borrowers, issuers and governments, and so play an important role in financial markets.
In 2006 the Commission set out its regulatory approach to credit rating agencies i and stated that it would monitor the developments in this area very carefully. Credit rating agencies active in the EU are mainly governed by the International Organisation of Securities Commissions (IOSCO) code of conduct i, which is based on voluntary compliance, and are subject to a yearly assessment by the Committee of European Securities Regulators (CESR) i. The Commission stated that it would consider new proposals if compliance with existing EU rules or the IOSCO Code was clearly unsatisfactory or if new circumstances were to arise — including serious problems of market failure.
It is commonly agreed that credit rating agencies contributed significantly to recent market turmoil by underestimating the credit risk of structured credit products. The great majority of subprime products were given the highest ratings, thereby clearly underestimating the major risks inherent in those instruments. Furthermore, when market conditions worsened, the agencies failed to adapt the ratings promptly.
The current crisis has revealed weaknesses in the methods and models used by credit rating agencies. One reason may be that credit rating agencies operate in an oligopolistic market that offers limited incentives to compete on the quality of the ratings produced. The sometimes poor quality of ratings of structured finance instruments has considerably contributed to the current crisis. In addition, shortcomings in the agencies’ communication with users of credit ratings became evident. As a result, market participants’ confidence in the performance of credit rating agencies and in the reliability of ratings has suffered.
In October 2007 EU Finance Ministers agreed to a set of conclusions on the crisis (the ‘Ecofin Roadmap’) i which included a proposal to assess the role played by credit rating agencies and to address any relevant deficiencies. Specifically, the Commission was asked to examine possible conflicts of interest in the rating process, transparency of rating methods, time-lags in rating reassessments and regulatory approval processes.
To clarify the role of the agencies and assess the need for regulatory measures, in autumn 2007 the Commission requested the advice of the CESR and the European Securities Markets Expert Group (ESME) i. At around the same time, other countries also started reforms in this field (US, Japan), and since then, important reports by IOSCO i, the Financial Stability Forum i and the Committee on the Global Financial System i have addressed the issue. Meanwhile, credit rating agencies themselves have outlined some reforms they are prepared to undertake i.
Self-regulation based on voluntary compliance with the IOSCO code does not appear to offer an adequate, reliable solution to the structural deficiencies of the business. While the industry has come up with several schemes for self-regulation, most of these have not been robust and or stringent enough to cope with the severe problems and restore the confidence in the markets. Moreover, individual approaches by some of the credit rating agencies would not have the market-wide effect necessary to establish a level playing field across the EU and preferably worldwide. In terms of substantive requirements, the Commission considers the revised IOSCO code of conduct to be the global benchmark. However, the code has some limitations that need to be overcome to make its rules fully operational. Some IOSCO rules are quite abstract and generic; they need to be concretised, and consolidated in some cases, to make them easier to apply in practice and more efficient. Most importantly, the code provides no enforcement mechanism but only invites credit rating agencies to give reasons if they do not comply with it (the ‘comply or explain’ approach). The code itself is open to being complemented by enforceable rules. It explicitly states that credit rating agencies should obey the laws and regulations of the jurisdictions in which they operate and that these laws may include direct regulation of credit rating agencies that may incorporate elements of the code.
In the US, where most of the credit rating agencies with significant EU activities have their parent companies, credit rating agencies have been subject to regulation and supervision since summer 2007 i. Given the global nature of the rating business, it is important to level the playing field between the EU and the US by setting up a regulatory framework in the EU comparable to that applied in the US and based on the same principles.
In the light of these considerations, this proposal for a regulation has four overall objectives aiming at improving the process of issuance of credit ratings:
- first, to ensure that credit rating agencies avoid conflicts of interest in the rating process or at least manage them adequately;
- second, to improve the quality of the methodologies used by credit rating agencies and the quality of ratings;
- third, to increase transparency by setting disclosure obligations for credit rating agencies;
- fourth, to ensure an efficient registration and surveillance framework, avoiding ‘forum shopping’ and regulatory arbitrage between EU jurisdictions.
The Commission intends to develop the regulatory framework for the issuance of credit ratings in order to ensure a high level of investor confidence and consumer protection.
Community law addresses only two specific aspects of credit rating:
- While credit ratings are not recommendations within the meaning of Directive 2003/125/EC i implementing the Market Abuse Directive i, recital 10 of Directive 2003/125/EC states that agencies should consider adopting internal policies and procedures designed to ensure that their credit ratings are fairly presented and that they appropriately disclose any significant interests or conflicts of interest concerning the financial instruments or the issuers to which their credit ratings relate.
- The Capital Requirements Directive i (2006/48/EC) provides for the use of external credit assessments to determine risk weights and the resulting capital requirements applied to a bank or investment firm’s exposure. An external credit assessment may only be used for this purpose if the External Credit Assessment Institution (‘ECAI’) providing the risk assessment has been recognised by the competent authorities. A recognition mechanism is outlined in Annex VI Part 2 of the Capital Requirements Directive. The competent national authorities may only recognise an ECAI if the latter complies with requirements such as objectivity, independence, ongoing review, credibility and transparency. In order to promote convergence, the Committee of European Banking Supervisors (CEBS) has issued guidelines on the recognition of ECAIs i.
As stated in Section 1.1., in autumn 2007 the Commission asked the Committee of European Securities Regulators (CESR) and the European Securities Markets Expert Group (ESME) to provide advice on various aspects of credit rating agencies’ activity and role in the financial markets, especially in structured finance. Both groups widely consulted stakeholders, giving the Commission a broader view and more evidence of the role of credit rating agencies in structured finance in the context of the subprime turmoil.
As well as closely following the progress of work at CESR and ESME, the Commission has held discussions with credit rating agencies, and sought comments from other interested parties including industry associations from the insurance, securities and banking sector and information providers. An open consultation was conducted on the internet between 31 July 2008 and 5 September 2008 i. Credit rating agencies, banks, investment firms, insurance companies, fund managers, supervisory and regulatory authorities, ministries of finance, central banks and other interested parties were represented in the survey answers, through either individual or grouped responses i.
In line with its ‘Better Regulation’ policy, the Commission conducted an impact assessment of policy alternatives. Four options were considered:
- Option 1: keeping the status quo (self-regulatory approach based on the IOSCO code coupled with individual initiatives by credit rating agencies);
- Option 2: drafting a European code of conduct and setting up a body to monitor credit rating agencies’ compliance with the code, albeit with no enforcement powers;
- Option 3: issuing a (non-binding) Commission recommendation;
- Option 4: legislating to set up a registration and surveillance framework for credit rating agencies.
Each of these four policy options was assessed against four criteria: effectiveness i, certainty[18], common framework i and flexibility i. The legislative option had clear advantages over the other policy options especially with regard to its effectiveness and certainty, because the other options (self-regulatory approaches or a recommendation) cannot produce legally binding rules and an enforcement mechanism. Furthermore, legislation is the best option to ensure a common framework throughout the EU and an efficient counterbalance to other important jurisdictions, notably the US.
Contents
- LEGAL ELEMENTS OF THE PROPOSAL
- 1.1. General context, grounds for and objectives of the proposal
- 1.2. Existing provisions in the area of the proposal
- 1.3. Consultation of interested parties and impact assessment
- 1.4. Impact assessment
- 2.1. Legal basis
- 2.2. Subsidiarity and proportionality
- 2.3. Choice of instrument
- 2.4. Comitology
- 2.5. Content of the Proposal
- 2.5.1. Scope (Article 2)
- 2.5.2. Independence and avoidance of conflicts of interest (Articles 5-6 and Annex I Section A, B, C)
- 2.5.3. Quality of ratings (Article 7)
- 2.5.4. Disclosure and transparency obligations (Articles 8-11 and Annex I, Sections B, D, and E)
- 2.5.5. Registration (Articles 12-17) and surveillance (Articles 19-31)
The proposal is based on Article 95 of the EC Treaty.
The Commission proposal to regulate Credit Rating Agencies is in line with the principle of subsidiary as laid down in Article 5 i of the EC Treaty, which requires the Community to take action only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the Member States and can therefore, by reason of the scale of effects of the proposed action, be better achieved by the Community. The business of credit rating agencies is global. Ratings issued by a credit rating agency based in one Member State are used and relied upon by market participants throughout the EU. Failures or the lack of a regulatory framework for credit rating agencies in one specific Member State could adversely affect market participants and financial markets EU-wide. Therefore, sound regulatory rules applicable throughout the EU are necessary to protect investors and markets from possible shortcomings.
It is necessary to lay down a common framework of rules regarding the quality of credit ratings to be used by financial institutions regulated by harmonised rules in the Community. Otherwise, there would be a risk that Member States would take diverging measures at national level. This would have a direct negative impact on and create obstacles to the good functioning of the internal market, since the credit rating agencies issuing credit ratings for the use of financial institutions in the Community, would be subject to different rules in different Member States.
Finally, given the global nature and worldwide effects of the rating business, convergence of the rules regulating the issuance of credit ratings on a global scale ensuring a equally high level of investor confidence and consumer protection is important. Different national regulations in the EU would complicate this convergence process and could weaken the position of the EU compared to important regimes elsewhere.
The proposed regulation is also proportionate, as required by Article 5 i of the EC Treaty. It targets not all credit rating agencies but only those whose ratings are used for regulatory purposes by financial institutions, i.e. those with a potentially high impact on the financial system. Many of its substantive provisions are inspired by the IOSCO code. This will limit adaptation costs considerably, since many credit rating agencies already comply voluntarily with the code. The proposal takes into account regulation in place in major non-EU countries, to accommodate the business model of globally operating credit rating agencies, but also considers smaller agencies that follow a less complex business model i.
EU legislation appears to be the only option that could sufficiently protect investors and European financial markets against the risk of malpractice by credit rating agencies. A uniform approach is necessary in order to create a framework where Member States competent authorities can ensure that credit rating agencies apply the new set of requirements consistently across the Community. A Regulation is the best instrument to ensure a consistent and uniform approach throughout the European Union because of its direct effect.
No comprehensive registration and surveillance regime for the issuance of credit ratings currently exists in any of the Member States. A Directive, which leaves the Member States a degree of flexibility in deciding how to adapt their national legal orders to the new framework, is therefore not efficient.
Since it does not need transposition by Member States, a Regulation can immediately put in place the uniform framework needed to quickly restore the market's confidence in the credit rating activity. It is also less burdensome for the industry, as a single set of Community rules will apply throughout the European Union.
The proposal is based on the Lamfalussy process for regulating financial services. The main part of the proposed regulation introduces principles in order to ensure that (i) the issuance of credit ratings is not affected by conflicts of interest, (ii) that credit rating issued are of high quality, and (iii) that credit rating agencies act in a transparent manner.
The technical details necessary to specify the principles of the Regulation are laid down in Annex I and II of the Regulation. In order to allow a fast adaptation of the Regulation to any new developments affecting the rating activity the technical provisions contained in the Annexes can be amended by the Commission in accordance with Council Decision 1999/468/EC of 28 June 1999 is. Since those measures are of general scope and are designed to amend non-essential elements of this Regulation, they must be adopted in accordance with the regulatory procedure with scrutiny provided for in Article 5a of Decision 1999/468/EC.
The proposal introduces a legally binding registration and surveillance regime for credit rating agencies issuing credit ratings mainly intended for use for regulatory purposes by credit institutions, investments firms, insurance, assurance and reinsurance undertakings, collective investment schemes and pension funds.
2.5.2. Independence and avoidance of conflicts of interest (Articles 5-6 and Annex I Section A, B, C)
Further improvements in dealing with organisational requirements and conflicts of interest are crucial if credit rating agencies want to regain markets’ confidence. This calls for reforms to their internal governance structure, introducing sound internal controls and sound reporting lines, clearly separating the rating function from business incentives. External surveillance is strengthened by internal discipline by giving the independent, non-executive members of the administrative or supervisory board of the credit rating agency specific tasks to ensure efficient control (Article 5 and Annex I, Section A, Point 2).
To ensure the independence of ratings, credit rating agencies are required to prevent conflicts of interest and/or to manage these conflicts adequately where they are unavoidable. They must disclose conflicts of interest in a complete, timely, clear, concise, specific and prominent manner and record all significant threats to the rating agency’s independence or that of its employees involved in the credit rating process, together with the safeguards applied to mitigate those threats. They must limit their activity to credit rating and related operations, excluding consultancy or advisory services (Article 5 and Annex I, Section B).
Agencies must have adequate internal policies and procedures to insulate employees involved in credit rating from conflicts of interest and ensure the quality, integrity and thoroughness of the rating and review process at all times. Linked to this, agencies must allocate sufficient employees with appropriate knowledge and experience to their credit rating activity and make appropriate rotation arrangements for analysts and persons approving credit ratings. (Article 6 and Annex I, Section C).
The compensation arrangements of employees involved in the rating process must be determined primarily by the quality, accuracy, thoroughness and integrity of their work (Article 6(6)).
The purpose of credit rating is to provide a credible and sound analysis of the credit risk of a borrower or issuer based on the available information and economic analysis. Many investors rely on credit rating agencies because they lack the expertise and/or resources (in time and money) to undertake their own analysis of the credit risk. Moreover, credit rating agencies often possess information that is not widely available to market participants. So, in theory, the ratings issued by credit rating agencies are an efficient means for investors to measure and manage credit risk, but only if they are sound and of good quality. The proposed Regulation aims to improve the quality of credit ratings, but it does not relieve investors of the need to exercise judgment and due diligence in relying on ratings when making investment decisions; nor does it jeopardise the independence of the rating process or of the ratings themselves, for which the credit rating agency retains full responsibility.
To allow sophisticated market participants (banks and other institutional investors) to check the soundness of the methodologies used and to verify the rating issued by the credit rating agency, but also to increase market discipline, credit rating agencies must disclose the methodologies, models and key assumptions they use in the rating process. Methods must be kept up-to-date and subject to review. If the agency changes its rating methodology it must immediately disclose which ratings are likely to be affected by this change and re-rate them promptly. Credit rating agencies must also continually review ratings. This is important to keep the ratings up-to-date and responsive to changes in financial conditions. This provision should prevent credit rating agencies from concentrating their efforts and resources on the initial rating and neglecting subsequent monitoring, which can be detrimental to the ongoing quality of the ratings.
2.5.4. Disclosure and transparency obligations (Articles 8-11 and Annex I, Sections B, D, and E)
The current crisis revealed weaknesses in the methods and models used by the agencies to rate structured finance instruments that were financially engineered to give high confidence to investors, and in the agencies’ communication with the markets and investors both about the characteristics and limitation of the rating of structured finance instruments and about critical model assumptions.
The proposal obliges credit rating agencies to disclose ratings on a non-selective basis and in a timely manner, unless the ratings are only distributed by subscription. It seeks to enable investors to distinguish between ratings for structured products and for traditional products (corporate, sovereign) by requiring the use of a different rating category for structured finance instruments or the provision of additional information on their risk characteristics. Specific disclosure requirements apply to unsolicited credit ratings (Article 8).
To ensure that internal processes and procedures are sufficiently transparent, credit rating agencies must publicly disclose some important information, e.g. on conflicts of interest, methodologies and key rating assumptions and the general nature of their compensation policy. They must also periodically disclose data on the historical default rates of rating categories and give competent authorities certain elements such as the list of the largest 20 clients by revenue (Article 9 and Annex I, Section E).
To ensure that relevant, standardised data on credit rating agencies’ performance is available to allow market participants to make industry-wide comparisons, CESR is to create a publicly available central repository for such data (Article 9(2)).
To restore public confidence in the rating business, credit rating agencies must publish an annual transparency report (Article 10 and Annex I, Section E, Part III), and keep records of their activities (Articles 5-7 and Annex I, Section B, Points 7-9).
The activity of credit rating agencies whose credit ratings are intended to be used for regulatory purpose by financial institutions to comply with Community legislation will be subject to prior registration. The proposal lays down the conditions and the procedure for granting or withdrawing that registration. (Articles 12-17)
A credit rating activity performed by a credit rating agency in the European Union has consequences for all EU markets; thus all regulators in the European Union should be involved in the registration process. The proposal introduces a single entry point for the registration, the CESR, which is best placed to provide a one-stop-shop for applications and a central point for informing and coordinating all EU national regulators. Responsibility for registration and surveillance of the credit rating agency rests with the competent authority of the home Member State, i.e. that in which the credit rating agency has its registered office. That competent authority is best placed in terms of physical presence to closely supervise the credit rating agency. Specific provisions are also proposed for groups of credit rating agencies; when examining the applications for registration submitted by a group of credit rating agencies, the competent authorities concerned must consider the group structure and agree on a facilitator who will be responsible for coordinating the registration process (Article 14).
To function as a single entry point, CESR should be closely involved in the registration process from the outset and be entitled to give its advice on the granting or withdrawal of the registration by the competent authority of the home Member Stated and may request re-examination of draft decisions (Article 17). The registration will become effective after publication by the Commission in the Official Journal of the European Union (Article 14). The Commission shall publish regularly an updated list of the credit rating agencies registered.
The proposal creates a mechanism to ensure effective enforcement of the Regulation. It gives competent authorities the necessary powers to ensure that credit rating agencies comply with the Regulation throughout the Community. In carrying out their duties, competent authorities shall not interfere with the content of credit ratings (Article 20(1)). To ensure effective surveillance, the proposal requires specific forms of cooperation between Member States competent authorities, to promote a common supervisory culture. It also provides for enhanced cooperation in case of a group of credit rating agencies, through the coordination of supervisory activities by the facilitator (Articles 25). Given the international scale of the credit rating business, it is also necessary to provide for the exchange of information with non-EU countries (Article 29).
Budgetary implications
The proposal has no implications for the Community budget.