Global regulation of credit rating agencies

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See also credit rating agencies for US regulation.

Contents

Committee of European Securities Regulators oversight


I. INTRODUCTION

1. Background

  1. On 12 November 2008, the European Commission published a Draft Regulation on credit rating agencies (CRAs)1. The amended version of this Regulation was approved on 23 April 2009 by the European Parliament2. The jurist linguistic revision took place and the European Council approved the document on the 27 July 20093. The European Council4 signed the Regulation on the 16th September 2009. It is expected to enter into force 20 days after it will be officially published in the Journal Official of European Commission by November 2009 and to apply by May 2010.
  2. According to the Regulation, CESR will be required to discharge important co-ordination and advisory functions alongside its traditional role of promoting convergence through Level 3 guidelines and recommendations.
  3. The Commission‟s proposals article 21 requires CESR to issue guidance, among others, on: The registration process and coordination arrangements between competent authorities and with CESR, including on the information set out in Annex II, and regime for applications submitted to CESR; The operational functioning of the colleges, including on the modalities for determining the membership to the colleges, the application of the criteria for the selection of the facilitator referred to in points (a) to (d) of Article 29.5, the written arrangements for the operation of colleges and the coordination arrangements between colleges; The application of the endorsement regime under Article 4.3 by competent authorities; Information that the credit rating agency must provide for the application for certification and for the assessment of its systemic importance to the financial stability or integrity of financial markets referred to in Article 5.
  4. CESR has to provide this guidance within 6 months of the entry into force of the Regulation, i.e. by April/May 2010.
  5. A CESR Expert Group (EG) has been set up to assist in preparing CESR for these new tasks relating to CRAs. Three subgroups have been set up within the EG to deal with the different topics on which CESR is requested to issue guidance. The 3 subgroups work in parallel and with full transparency and the CESR Secretariat and the Chair of the EG ensure coordination between the three groups. Subgroup 1 focuses on the registration process, colleges, co-operation, and mediation; Subgroup 2 focuses on applications, surveillance and enforcement and Subgroup 3 deals with disclosure by CRAs of historical performance data and the Central Repository database.
  6. The EG has decided to establish a consultative working group (CWG) composed of senior practitioners from the industries concerned by the Regulation to continuously support it in its work program by advising on all matters relating to the implementation and application of the future legal framework. In particular, the CWG is to be asked to comment on draft documents prior to public consultation.
  7. CESR asked the CWG to comment on Pre-Consultation Papers by September 2009. Based on the feedback it received, CESR has produced this Consultation Paper.


A. Background

  1. On 12 November 2008, the European Commission published a Draft Regulation on credit rating agencies (CRAs)1. The amended version of this Regulation was approved on 23 April by the European Parliament2. It is expected to enter into force by October 2009 and to apply by March 2010.
  2. According to this Draft Regulation, CESR will be required to discharge important co-ordination and advisory functions alongside its traditional role of promoting convergence through Level 3 guidelines and recommendations.
  3. Amongst other tasks, the Commission’s proposal article 9(2) and 18(2) lit. c). requires CESR to:
    1. Establish a central repository (CRep) where credit rating agencies shall make available information on their historical performance data including the ratings transition frequency and information about credit ratings issued in the past and changes thereto.
    2. Define a standardised form which the credit rating agencies shall use to provide information for this repository.
    3. Make the information provided accessible to the public and publish summary information on the main developments observed on an annual basis (Art. 9 (2)).
    4. Issue guidance on common standards on the presentation of the information, including structure, format, method and period of reporting, which credit rating agencies shall disclose in accordance with Article 9(2) and Annex I, Section E, Part II, Point 13 of the proposed Regulation.
  4. CESR has to provide guidance on common standards on the presentation of historical performance data within 6 months of the entry into force of the proposed Regulation, i.e. by March 2010. There is no deadline with regard to the implementation of the central repository. This step will largely depend on the need for a public tender process and IT development work.
  5. A CESR expert group (EG) has been set up to assist in preparing CESR for these new tasks relating to CRAs. Three subgroups have been set up within the EG to deal with the different topics on which CESR is requested to issue guidance. The 3 subgroups work in parallel and with full transparency and the CESR Secretariat and the Chair of the EG ensure coordination between the three groups. Subgroup 1 focuses on the registration process, co-operation, and mediation; Subgroup 2 focuses on applications, surveillance and enforcement and Subgroup 3 deals with disclosure by CRAs of historical performance data and the CRep.
  6. The EG has decided to establish a consultative working group (CWG) composed of senior practitioners from the industries concerned by the Regulation to continuously support it in its work program by advising on all matters relating to the implementation and application of the future legal framework. In particular, the CWG is to be asked to comment on draft documents prior to public consultation.
  7. As an initial step in the analytical process to develop common standards and the technical specifications for the CRep, CESR gathered information on the historical and performance data available from CRAs by means of questionnaires. These questionnaires related specifically to the 3 large classes of ratings, i.e. corporate, sovereigns/public and structured finance. CESR submitted the questionnaires to the largest CRAs as well as to smaller players 4.
  8. In a second step, CESR asked the CWG to comment on a Pre-Consultation Paper by 29 May 2009. Based on the feedback it received, CESR has produced this Consultation Paper.5


3. This final report focuses on whether a CRA’s code of conduct is compliant with, or deviates from, the IOSCO Code. CESR’s analysis is exclusively based on a CRA’s code and does not take into account other documents that are on the CRA’s website. In addition, CESR does not opine on the practical application of a CRA’s own code. This means that CESR does not check whether a CRA complies in practice with what is stated in its code. Equally, where a CRA’s code deviates from an IOSCO provision, CESR does not check whether the CRA nevertheless complies with the IOSCO provision in practice.

4. CESR’s overall conclusion with respect to the codes of conduct of the larger, global CRAs (S&P, Moody’s, Fitch, DBRS and AM Best) is that they are broadly compliant with the IOSCO Code. It also notes that they have updated their codes of conduct to take into account most, but not all, of the revisions made to the IOSCO Code in May 2008, in particular with respect to structured finance products. However, there are also a number of provisions detailed within this report on which these CRAs deviate from the IOSCO Code and therefore CESR believes room for improvement exists.


CESR’s Second Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance.


A body representing Europe's 9,200 listed companies said on Friday it wants all references to credit ratings stripped from European Union law, mirroring an initiative from the Obama administration in the United States.

Credit rating agencies have been accused of being too generous in their ratings of products that sank in value or became untradeable during the credit crunch.

"Rating agencies have argued repeatedly that their function is merely to provide 'opinions'," EuropeanIssuers, a campaigning body based in Brussels, said in a statement.

"Thus, although inaccurate and unreasonable credit ratings were a primary cause of the recent crisis, rating agencies remained largely free of any responsibility," it said.

The EU has adopted a law that takes effect in 2010 that will require credit rating agencies to be authorised to operate in the 27-nation bloc and be directly supervised.

"However, the stronger supervision that will be achieved herewith does not remove the need to address the excessive reliance on ratings," EuropeanIssuers said.

"We therefore urge the European Commission to continue the work it started when consulting the market on this subject in July 2008, and to come forward soon with concrete proposals to eliminate references to credit ratings in the European legislation," it added.

Investors use ratings to decide on which shares or bonds to buy. Ratings also play a key role in how much capital banks set aside to cover risks.

The Obama administration has proposed that U.S. laws are purged of requirements to use credit ratings but earlier this week a U.S. congressional committee began watering this down. Obama's proposal could be restored next week as the credit rating legislation proceeds through Congress.

IOSCO Report on Due Diligence for Structured Products

Good Practices in Relation to Investment Managers´ Due Diligence When Investing in Structured Finance Instruments July, 2009

ESMA to supervise EU rating agencies

The latest amendments to the rules regulating credit rating agencies (CRAs) were approved by Parliament on Wednesday. These changes were needed to effectively entrust ESMA with the direct supervision of the agencies. MEPs, with Member State support, empowered ESMA, rather than the Commission, to impose fines on CRAs.

  • European Securities and Markets Authority (ESMA) to directly supervise agencies by July 2011
  • ESMA empowered to make dawn raids, impose fines, and ensure agencies evaluate the accuracy of their past ratings
  • All credit rating agencies to be checked by July 2014

The amendments were approved with 611 votes in favour, 15 against and 26 abstentions.

Fining power

The Commission's initial proposal argued that the Commission itself was best placed to impose fines, upon a recommendation from ESMA. However, the final text agreed in negotiations and approved by Parliament gives this role to ESMA. A range of fines, reflecting the type of infringement, the size of the CRA, and possible aggravating or attenuating conditions, is laid down in the rules. ESMA will be able to impose fines of up to 20% of a CRA's turnover for the previous year.

Stronger investigative powers

The new rules will allow ESMA to conduct "dawn raids" (unannounced checks), at the premises of a CRA. At Parliament's insistence, ESMA is also specifically responsible for ensuring that CRAs comply with their "back testing" obligation, a task that involves comparing performance predictions for a rated financial instrument with its actual performance. Finally, ESMA is given a mandate to carry out checks on all CRAs by 2014.

Competition, transparency and dependence issues

Parliament had initially pushed to facilitate access to information for CRAs wishing to produce unsolicited ratings on the grounds that this would increase competition, allow for more transparency and give investors more information on which to base their decisions. This idea was dropped because Member States were reluctant to accept it, but the text still asks the Commission to table legislative proposals to this end. This is set to become a key issue on which Parliament is expected to focus on when further changes to this regulation are hammered out in the latter part of 2011.

Next steps

The Council will now need to officially approve the text adopted today. Parliament's Economic Affairs Committee has meanwhile begun working on the next financial supervision reform, and is to set out its priorities in a paper likely to be approved in February.

Proposed regulation by the European Parliament

European Parliament Committee on Economic and Monetary Affairs - Rapporteur: Jean-Paul Gauzès

ESMA regulations

EU Commissioner questions US rating agency dominance

The European Union’s financial services commissioner, Michel Barnier, vented his frustration with American-based credit ratings agencies Wednesday as Moody’s Investors Service put Portugal on review for another possible downgrade that could make it more difficult for the country to service its debt, James Kanter reports in The New York Times.

Mr. Barnier was briefing reporters before his first official visit to the United States, where he will meet next week with Ben S. Bernanke, the Federal Reserve chairman, and Timothy F. Geithner, the Treasury secretary. He will also meet with Wall Street leaders like Lloyd C. Blankfein, the chief executive of Goldman Sachs, and Jamie Dimon, the chief executive of JPMorgan Chase.

Mr. Barnier complained that there were too few debt rating agencies, and he suggested that they were dominated by American owners.

“There are not enough ratings agencies, not enough competition and not enough diversity,” he said. “Why should there not be an agency that is more European than those that exist today?”

A decision by Standard & Poor’s, also based in the United States, to downgrade Greece’s debt to junk status last month enraged European officials, who questioned whether the ratings agencies were accurately assessing how likely it was that countries in the euro zone would default on their sovereign debts.

Mr. Barnier said it was “an open question” whether such an alternative agency should be run by the private sector or by a public body.

UK authorities oppose Euro public credit rating agency

The U.K. Treasury, the Bank of England and the Financial Services Authority have told the European Commission that they "strongly oppose any issuance of credit ratings by a public European Credit Rating Agency, Central Banks, or a public-private partnership."

The U.K. authorities made the comments in their response to the European Commission's consultation on credit rating agencies.

The Treasury, the BOE and the FSA said the "use of such ratings would potentially heighten scope for moral hazard and harm the independence of these institutions," and could damage competition among rating agencies.

"A European Credit Rating agency could face heavy political pressure when rating institutions important to EU governments, and also when downgrading an institution a member state may have to provide government support to or that is considered nationally important," they said.

They also oppose proposals for sovereigns to be given three days' notice before publication of rating changes. The proposal "seriously amplifies" worries about market abuse, increases the risk of leaks and would allow sovereigns time to alter their debt issuance plans or take other action that pre-empts the announcement, they said.

FSA reports

Various reports from the Financial Services Authority (FSA, the UK regulator) which cover credit rating agencies.

India proposes overhaul for rater oversight

  • Source: [Panel seeks strict regulation of rating agencies] Business Standard, Mumbai, January 24, 2010

A committee appointed by financial regulators has recommended an overhaul of regulatory norms governing credit rating agencies (CRAs) and sought a host of disclosures from them to make the system more transparent.

The panel, headed by KP Krishnan, a joint secretary in the finance ministry, has suggested that the Securities and Exchange Board of India be designated as the lead regulator with whom rating agencies should be registered.

The registered agencies would also require accreditation from other regulatory bodies such as the Reserve Bank of India and insurance and pension regulators for rating instruments that came under their domain, said the committee, whose report was made public on the finance ministry website today. In addition, the regulators should also conduct joint inspections of the agencies, it added.

The regulators have already decided to make internal audit mandatory for rating agencies. Besides, the Krishnan committee said while only five agencies were registered with Sebi, a few others were using the words credit rating agency in their names. It has called for an immediate ban on non-registered entities from using credit rating in their names.

The other focus area is potential conflict of interest. To avoid this, the committee has advocated stringent disclosure norms for subsidiaries floated by rating agencies. These disclosures should include the details of the fee received from a company by it, its subsidiaries or its promoters over the preceding three years.

“CRAs should not be allowed to enter into any business that may directly or indirectly have conflict of interest with the job of rating. Internal Chinese Walls are porous mechanisms to prevent such conflict of interest, as other businesses such as consultancy and advisory services should not be undertaken by CRAs,” the committee said.

Agencies such as Crisil and Icra have floated subsidiaries providing advisory services.

There is special reference to structured finance and structured products, which had triggered a review of the rating mechanism. The committee suggested that an agency or its subsidiary should be barred from providing advisory services — either formal or informal – on the design of a structured finance instrument and also rate the product.

Also, if the recommendations are accepted, the entities will have to differentiate the ratings for structured products, improve their disclosure of rating methodologies and assess the quality of information provided by the originators, arrangers and the issuers of such structured products. “It may be made mandatory that the CRAs make a clear distinction between credit ratings of structured finance instruments and other credit ratings,” the committee said.

After reviewing the issuer pays payment model, it has suggested that the system be continued, though the system be made more transparent by mandating disclosure of the compensation arrangements with the rated entities. Analysts should not be part of any fee discussion with the issuer, and added that employee involvement in the rating process should not come into conflict with ownership pattern.

There are suggestions to also publish the information about the assumptions underlying their rating methodologies and the committee said that internal records, including working paper, should be retained by the agencies.


Australian oversight


"CREDIT rating agencies could face far-reaching regulatory changes aimed at making the so-called three horsemen of the financial apocalypse -- Moody's, Standard & Poor's and Fitch -- more accountable, transparent and liable for their ratings.

In a statement yesterday, the Australian Securities and Investments Commission announced that from January 1 agencies would need to obtain an Australian Financial Services (AFS) licence. They also face the removal of an exemption that protects them from liability for their ratings in product disclosure documents (PDS).

ASIC will also consider withdrawing an existing class order relief for issuers to cite credit ratings without consent from the credit rating agencies in a PDS.

These and other proposals were outlined in a consultation paper released yesterday. Comments are due on October 22, and a final decision will be made in November.

Ratings agencies have been accused of playing a key role in the global financial crisis, in particular the favourable ratings given to complex structured products. Some of these products, such as collateralised debt obligations, were sold to unwitting investors locally and globally, and have now been exposed as worthless.

The ratings agencies were recently labelled "hopelessly conflicted" by Kevin Rudd in The Monthly magazine.

"Dependent as they were on the banks for their revenue, the agencies were hopelessly conflicted by the lure of big profits in return for easy ratings," the Prime Minister said.

Those regulations, which relate to management of conflicts of interest and the quality and integrity of the ratings processes, are contained in the recently updated International Organisation of Securities Commissions' code of conduct for credit rating agencies.

Litigation funder IMF's Hugh McLernon said the question was not whether ASIC should now lift the protection from liability it gave to the ratings agencies, but rather why it gave that protection in the first place.

Mr McLernon said ASIC posed the question in its consultation paper as to whether credit ratings were important to unsophisticated retail investors.

"Why does ASIC need to seek advice on this question? Why does ASIC think the agencies have been paid billions of dollars by issuers to rate their products?

"Surely the answer is obvious: because all concerned including the issuer and the rating agency know that without the rating the investing public will not touch the product."

John Bailey, managing director of Standard & Poor's Australia & New Zealand, said he was reviewing the consultation paper.

But he said on the issue of licensing, S&P had lodged a licence application with ASIC.

"Regulation will supplement the changes we have made independently," he said.

Moody's said in a statement that it had "always sought to maintain an active dialogue with policymakers and regulatory authorities in Australia and elsewhere". It said it wanted to provide as much transparency as possible with regard to Moody's policies and practices.

Currently, ASIC gives relief to S&P, Moody's and Fitch from the requirement to hold an AFS licence. From January 1, holding an AFS licence will require all agencies to complete an annual report on compliance; disclose their methodologies, assumptions and procedures resulting in a credit rating; have adequate processes for keeping a credit rating current; and consent to ASIC sharing information about the credit rating agency with regulators overseas."

Australian 2008 report

Published in 2008 a report from the Australian securities regulator on credit rating agencies

Australia assigns liability to raters

"THE Australian Investments and Securities Commission has drawn credit rating agencies into the firing line, trying to make them more accountable for their actions.

From next year ASIC will remove the exemption that protected the big rating agencies - Standard & Poor's, Moody's, and Fitch - from any liability for their ratings published in prospectus documents. ASIC said the changes would make the agencies accountable for the ratings published in product disclosure statements, prospectuses, or takeover documents.

The Federal Government will also require rating agencies to hold Australian Financial Services (AFS) licences from next year, forcing them to manage conflicts of interest in line with others in the industry.

The changes are the latest step in a wider crackdown on rating agencies, often blamed as the unsung villains of the global financial crisis.

Until now, rating agencies in Australia have operated largely outside of the regulatory net.

As well as not holding an AFS licence, issuers of financial products could quote ratings without the agencies' consent, which ASIC said protected the agencies from liability.

Under the new rules, issuers will have to obtain the consent of the rating houses before publishing their ratings, giving the agencies more control over how their products are used.

The regulator also revealed special licence conditions for rating agencies, including a rule that agencies must disclose the methodologies and assumptions behind credit ratings.

Standard & Poor's said yesterday that it was reviewing ASIC's policy announcement and the impact on its business. Moody's said it was in active dialogue with the regulator, and it expected to receive a licence by January.

The crackdown on rating agencies has come after aggrieved investor claims that rating agencies profited by helping to spread toxic debt through the financial system.

Through its new ratings regime, the Government is aiming to expose credit ratings to greater scrutiny, and deter investors from relying on ratings as a simple gauge of risk.

John Walker, the managing director of the litigation funder IMF Australia, described it as a positive move that would bring more scrutiny to the industry. However, he said it had come too late for investors who had incurred losses by buying AAA-rated products that had plunged in value.

A whole lot of capital was misallocated not only in Australia but around the world as a result of the ratings which did not adequately assess the risks of the debt instruments, Mr Walker said.

IMF is considering targeting rating agencies through a possible class action on behalf of dozens of local councils and charities that have lost millions through AAA-rated products.


New Zealand Reserve Bank report

Report from the New Zealand Reserve Bank

Hong Kong regulator issues Consultation Paper on ratings

In keeping with the recent global trend towards subjecting credit rating agencies (CRAs) to enhanced regulatory oversight, Hong Kong’s Securities and Futures Commission (SFC) has announced a proposed regulatory regime requiring the licensing and supervision of CRAs. The Consultation Paper Concerning the Regulatory Oversight of Credit Rating Agencies, released on July 19, 2010, outlines the proposed regime, which is intended to both “mandate minimum conduct standards for CRAs, including requirements that credit rating activities be conducted in accordance with principals of integrity, transparency, responsibility and good governance” and “ensure that ratings prepared in Hong Kong continue to be serviceable in other jurisdictions, including for regulatory purposes.”

The Consultation Paper proposes making “providing credit rating services” a new type of regulated activity under the Securities and Futures Ordinance to be known as a “Type 10” regulated activity. The proposed legislation would define “credit ratings” as “opinions ‘primarily regarding the creditworthiness’ of the rating target” and would define “providing credit rating services” to include “the preparation of credit ratings for dissemination or distribution by subscription, whether in Hong Kong or elsewhere, or with a reasonable expectation that they will be so disseminated or distributed.” Excluded from the definition of “providing credit rating services” would be activities connected with the operation of internal credit ratings systems; private credit ratings prepared in accordance with an individual order; the gathering, collating, disseminating or distributing of information concerning the indebtedness or credit history of commercial enterprises; and the sharing or analyzing of personal consumer credit information. The proposed legislation would also permit the SFC or the Financial Secretary to exempt the activities of certain individuals from the definition of “providing credit rating services.”

As proposed, the legislation would amend Schedule 1 of the Securities and Futures Rules to impose minimum capital requirements for all Type 10 regulated activity. A draft Code of Conduct for Persons Providing Credit Rating Services, which would require CRAs to both operationally and legally separate their credit rating business from other types of business, and a draft list of Recognized Industry Qualifications and Local Regulatory Framework Papers are appended to the Consultation Paper. Existing ratings analysts would be grandfathered into the proposed regulatory regime, provided that they complete a course relating to the legal and regulatory framework for Type 10 regulated activity within six months of being licensed under the new regime.

It is intended that the new regime be implemented by the end of January 2011. Comments on the Consultation Paper are due by August 20, 2010.

References

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