EU Looks To Strengthen Credit Rating Framework
Friday, November 18, 2011

Despite the adoption of European Union (EU) legislation on credit rating agencies (CRAs) in 2009 and 2010, the European Commission (EC) believes that recent developments in the context of the euro debt crisis have shown the existing regulatory framework is not sufficient, and it has has put forward proposals to deal with perceived outstanding weaknesses.

The EC points out that CRAs are major players in today's financial markets, with rating actions having a direct impact on the actions of investors, borrowers, issuers and governments. For example, a corporate downgrade can have consequences on the capital a bank must hold and a downgrade of sovereign debt makes a country's borrowing more expensive.

Internal Market Commissioner Michel Barnier said that CRAs "have made serious mistakes in the past. I have also been surprised by the timings of some sovereign ratings – for example ratings announced in the middle of negotiations on an international aid programme for a country. We can't let ratings increase market volatility further.”

He confirmed that his “first objective is to reduce the over-reliance on ratings, while at the same time improving the quality of the rating process. CRAs should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes. I also want to see increased competition in this sector."

Firstly, a proposed draft EU Directive and draft Regulation will try to ensure that financial institutions do not have to rely only on credit ratings for their investments. While the proposals in July 2011 on the Capital Requirements Directive reduce the number of references to external ratings and require financial institutions to do their own due diligence, similar changes will now be made with regard to rules relating to fund managers.

This will be completed by changes to rules on insurance next year, and a general obligation for investors to do their own assessment is also included in the current proposal.

In addition, more and better information underlying the ratings would need to be disclosed by CRAs and by the rated entities themselves, so that professional investors will be better informed in order to make their own judgments, and CRAs will have to consult issuers and investors on any intended changes to their rating methodologies.

Under the proposed Directive, EU member states would be rated more frequently (every six months rather than 12 months), and investors and member states would be informed of the underlying facts and assumptions on each rating. To avoid market disruption, sovereign ratings should only be published after the close of business and at least one hour before the opening of trading venues in the EU.

The EC is also looking at the possible suspension of sovereign ratings, which is said to be a complex issue, but one which it believes merits further consideration.

In order to eliminate what are called conflicts of interest for the CRAs, issuers would have to rotate every three years between the agencies that rate them. In addition, two ratings from two different rating agencies would be required for complex structured finance instruments, and a big shareholder of a CRA should not simultaneously be a big shareholder in another CRA.

Finally, to make CRAs more accountable for the ratings they provide, a CRA should be liable in case it infringes, intentionally or with gross negligence, the CRA Regulation, thereby causing damage to an investor having relied on the rating that followed such infringement. Such investors should be able to bring their civil liability claims before national courts, and the burden of proof would rest on the CRA.