Credit rating agencies and the EU

Credit rating agencies (CRAs) are companies that assign credit ratings for issuers of certain types of debt obligations. A credit rating takes into consideration the issuer's (government or company) credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. Credit ratings are divided up into categories, going from low-risk or investment grade to high-risk or speculative grade. They are based on the revenue stream and balance sheet of the issuer being rated, as well as past financial performance.

Credit rating agencies play an important role in global securities and banking markets, as their credit ratings are used by investors, borrowers, issuers and governments as part of making informed investment and financing decisions. Credit institutions, investment firms, insurance undertakings and institutions for occupational retirement provision may use those credit ratings as the reference for calculating risks in their investment activity.

Currently, most credit rating agencies have their headquarters outside the European Union. The three most important CRAs are: Moody's Investors Service (U.S.); Standard & Poor's (U.S.); and Fitch Ratings (U.S.). Together, these three American CRAs hold more than 90% of the global credit rating market.

The views of CRAs can wipe millions off bond and share prices, as well as make credit more expensive for badly noted entities. Consequently, credit ratings have a significant impact on the operation of the markets and on the trust and confidence of investors and consumers. It is essential, therefore, that credit rating activities are conducted in accordance with the principles of integrity, transparency, responsibility in order to ensure that resulting credit ratings are independent, objective and of adequate quality.

Despite their significant importance for the functioning of the financial markets, most EU Member States do not regulate the activities of credit rating agencies or the conditions for the issuing of credit ratings. Until recently, credit rating agencies were subject to Community law only in limited areas, notably under Directive 2003/6 on insider dealing and market manipulation, Directive 2006/48 relating to the taking up and pursuit of the business of credit institutions and Directive 2006/49 on the capital adequacy of investment firms and credit institutions [see section 6.6.1].

In December 2004, the International Organisation of Securities Commissions (IOSCO) published the Code of Conduct Fundamentals for credit rating agencies. This document is aimed at reinforcing investor protection, market fairness, efficiency and transparency and reducing the risk of conflicts of interest and other internal operations damaging the integrity and quality of CRAs ratings. However, the CRAs apply the IOSCO code of conduct on a voluntary basis.

Criticism of credit rating agencies

Following several corporate accounting scandals, such as Enron and Parmalat, the European Parliament in a Resolution of February 2004, underlined how important it was that the credit rating agencies exercise their functions responsibly. It noted four main issues of concern:

·         the quality of the ratings;

·         the agencies' independence and objectivity;

·         transparent credit rating methods;

·         a high degree of concentration in credit rating activities and its possible anticompetitive effects.

The European Commission looked then into the way these agencies functioned, but concluded that there was no need for new legislation, because the abovementioned three Directives and the IOSCO Code of Conduct covered sufficiently the activities of CRAs.

CRAs contributed significantly to the global financial crisis, which started in 2007 in the United States. They clearly underestimated the risk that the issuers of certain more complicated financial instruments may not repay the debts. As they gave the highest possible ratings to many of those complex instruments, inexperienced investors felt encouraged to purchase them, even without assessing properly the risks. As market conditions were worsening, CRAs failed to reflect this promptly in their ratings. These failures by CRAs were combined with an imprudent approach of the investors. As a result, credit was granted even if it would not be justified by economic fundamentals. They were also accused of potential conflicts of interest, because they are paid as consultants by the very banks whose debt they rate.

The failure of credit rating agencies to uncover the true value of securities, which were later labelled 'junk', has resulted in calls for greater regulation of the sector. Despite some initial divergences on competence-sharing, EU governments and the European Parliament backed a tough line and supported increased oversight of a sector worth almost €4 billion and dominated by American multinationals. The European Councils of 20 June and 16 October 2008 called for a legislative proposal to strengthen the rules on credit rating agencies and their supervision at EU level, considering it a priority to restore confidence and proper functioning of the financial sector. Following this invitation, the Commission proposed and the European Parliament and Council adopted, on 16 September 2009, a Regulation on credit rating agencies [Regulation 1060/2009].

The EU Regulation on credit rating agencies

This Regulation introduces a common regulatory approach in order to enhance the integrity, transparency, responsibility, good governance and reliability of credit rating activities, contributing to the quality of credit ratings issued in the Community, thereby contributing to the smooth functioning of the internal market while achieving a high level of consumer and investor protection. It lays down conditions for the issuing of credit ratings and rules on the organisation and conduct of credit rating agencies to promote their independence and the avoidance of conflicts of interest.

The Regulation imposes rules which have a legally binding character and are largely based on the standards set in the International Organisation of Securities Commissions (IOSCO) code [see above]. As a rule, all credit rating agencies that would like their credit ratings to be used in the EU will need to apply for registration, as a condition for being recognised as an External Credit Assessment Institution (ECAI). The applications must be submitted to the Committee of European Securities Regulators (CESR) and decided upon in a consensual manner by the relevant securities regulators grouped in a college. The college of regulators must also be involved in the day-to-day supervision of credit rating agencies.

In order to be registered in the EU, credit rating agencies have to comply with rigorous rules to make sure (i) that ratings are not affected by conflicts of interest, (ii) that credit rating agencies remain vigilant on the quality of the rating methodology and the ratings, and (iii) that credit rating agencies act in a transparent manner. New rules include the following:

·         Credit rating agencies may not provide advisory services.

·         They are not allowed to rate financial instruments if they do not have sufficient quality information to base their ratings on.

·         They must disclose the models, methodologies and key assumptions on which they base their ratings.

·         They have to create an internal function to review the quality of their ratings.

·         They must have at least two independent directors on their boards whose remuneration cannot depend on the business performance of the rating agency.

Credit rating agencies registered in the EU should use rating methodologies that are rigorous, systematic, continuous and subject to validation including by appropriate historical experience and back-testing. In order to avoid potential conflicts of interest, credit rating agencies should not be allowed to carry out consultancy or advisory services, particularly regarding the design of a structured finance instrument. Credit rating agencies should disclose information to the public on the methodologies, models and key rating assumptions which they use in their credit rating activities.

Specific, albeit sufficiently exacting, treatment is envisaged and may be extended, on a case-by-case basis, to credit rating agencies operating exclusively from non-EU jurisdictions, provided that they comply with requirements which are as stringent as the requirements provided for in the EU Regulation. This Regulation introduces an endorsement regime allowing credit rating agencies established in the Community and registered in accordance with its provisions to endorse credit ratings issued in third countries. When endorsing a credit rating issued in a third country, credit rating agencies should determine and monitor, on an ongoing basis, whether credit rating activities resulting in the issuing of such a credit rating comply with requirements for the issuing of credit ratings which are as stringent as those provided for in the EU Regulation, achieving the same objective and effects in practice.

The disregard of US credit rating agencies for EU measures

Ignoring completely the EU Regulation and the financial package of  € 110 billion made available to Greece by the euro area Member States and the International Monetary Fund [see Greek crisis and European solution], Standard & Poor's, on 26 April 2010, downgraded Greek bonds down to a BB+ - or junk - status, the same level as those issued by far less stable countries, such as Azerbaijan or Egypt, which increases the interest rate investors will charge the Greek government to borrow money on the open market. Following the downgrading of Greece and Portugal, the euro collapsed more than 1.5% on 27 April.

On 28 April, Commission officials accused the markets of being out of step with reality and have warned rating agencies that Brussels is ready to intervene using new EU regulations. "We would expect that when credit rating agencies assess the Greek risk, they take due account of the fundamentals of the Greek economy and the support package prepared by the European Central Bank, the International Monetary Fund and the European Commission," said a spokesperson for Commissioner Barnier.

As the downgrades for Greece, Portugal, Spain and Ireland by the top three credit rating agencies, all of them US-based, have led to higher borrowing costs for the weaker eurozone countries, senior European politicians including Germany's Angela Merkel have indicated their support for the creation of a European credit rating agency. In a related move on 3 May, the European Central Bank decided to loosen the terms under which it lends money to Greek banks, indicating that it would in future accept Greek sovereign bonds as 'investment' grade collateral, in spite of the 'junk' status given them by S&P.

On 6 May, the leaders of France and Germany made a joint call for tough regulation of the financial sector and of credit rating agencies and greater transparency on the derivatives market. "We will press for the creation of a rating agency in Europe so that European financial markets become more stable and reactive," Merkel said. The statements of European politicians, including French Finance Minister Christine Lagarde, underlined the power of US adjudicators in a hugely influential finance sector over which Europe has no control.

On 18 May, EU Internal Market Commissioner Michel Barnier told EU finance ministers that he plans to put credit rating agencies under the centralised supervision of a new agency called the European Securities and Markets Authority (ESMA). In addition to the previous regulation, which would see rating agencies register in a central European database, the Commissioner now wants EU regulators to have access to both the agencies' methodologies and to information on past ratings. "It is not normal for these rating agencies to play such an important role and to be so few in number," the commissioner said, reiterating concerns that a market dominated by three agencies, Moody's, Standard & Poor's and Fitch, badly needed new competitors.

I believe that a European credit rating agency should be created as soon as possible and that the Regulation creating it should state clearly that from then on its ratings would be the only ones to be taken into consideration by the European Central Bank and by the central banks of the member states for the creditworthiness of European governments and companies. Let, then, Moody's, S & P and Fitch downgrade as much as they want European bonds in order to disturb the eurozone. If they disregard European legislation and policies, as they have clearly done recently, Europeans should, on their part, disregard their ratings.

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