ESMA Publishes Final Credit Rating Agency Rules & Extends Transitional Period for Non-EU Ratings
Christopher Bernard | Bloomberg Law
ESMA extends transitional period for use of non-EU credit ratings, Australian CRA regime endorsed – First binding standards on CRAs sent to European Commission – European Securities and Markets Authority Press Release ESMA/2011/460 of 22 Dec. 2011
The European Securities and Markets Authority (ESMA) has issued final Regulatory Technical Standards (RTS) for credit rating agencies (CRAs) operating in the EU.1 The RTS cover the information that CRAs must provide when applying for registration and certification and on an ongoing basis, as well as the rules that ESMA will use to assess the credit rating methodologies used by CRAs. The final RTS reflect comments received by ESMA on drafts published in September 20112 and have now been sent to the European Commission for endorsement.
ESMA has also extended the initial three-month transitional period for credit ratings issued outside the EU. Credit ratings issued in non-EU countries may now continue to be used in the EU until 30 April 2012, giving ESMA more time to assess which third country regulatory frameworks it should endorse. To date, only the credit rating regimes of Japan and Australia have been approved.
The CRA Regulation
In the wake of the financial crisis, the Commission adopted Regulation 1060/2009 (CRA Regulation), as amended by Regulation 513/2011, which introduced a common framework of rules for CRAs with a view to enhancing the transparency, internal governance, and surveillance of CRAs and improving the quality of their credit ratings. Pursuant to the CRA Regulation, CRAs must be registered in the EU in order for their ratings to be used for regulatory purposes,3 and ESMA has been given exclusive responsibility for the registration and supervision of CRAs in the EU.
The CRA Regulation permits registered CRAs to endorse credit ratings issued outside the EU provided that, among other things, they can demonstrate that the non-EU CRA is subject to a regulatory regime at least as stringent as that of the EU and ESMA has entered into a co-operation arrangement with the third country supervisor.
Alternatively, a credit rating relating to a non-EU entity or financial instrument and issued by a CRA registered or authorised in a third country may be used in the EU without endorsement if ESMA has:
- Recognised the legal and supervisory framework of the third country as equivalent to the requirements of the CRA Regulation;
- Entered into a co-operation agreement with the third-country supervisor;
- Certified the CRA; and
- Determined that the CRA’s credit ratings are not systemically important to the stability or integrity of the financial markets of any Member States.
The Regulatory Technical Standards
Article 21(4) of the CRA Regulation requires ESMA to develop RTS for endorsement by the Commission on the following topics:
- The information that a CRA must provide in its applications for registration and certification and for ESMA to assess its systemic importance to financial markets within the EU;
- Procedures for the disclosure of historical performance and default data by CRAs;
- ESMA’s assessment of compliance of credit rating methodologies with the requirements set forth in Article 8(3) of the CRA Regulation; and
- The ratings data that CRAs will be expected to report periodically as part of ESMA’s ongoing supervision.
ESMA has addressed these topics in four separate RTS documents. The draft RTS published in September 2011 revised earlier guidelines produced by the Committee of European Securities Regulators (CESR), ESMA’s predecessor.4 Among other things, the RTS reflect the fact that ESMA now has exclusive powers for registering and supervising CRAs in the EU, whereas these responsibilities were previously conferred on competent authorities of the Member States and co-ordinated by CESR.
— Registration, Certification, & Assessment of Systemic Importance
The RTS include detailed informational requirements regarding the ownership, organisation, governance, financial resources, staffing, outsourcing, conflicts of interest, and credit rating methodologies and procedures of CRAs applying for registration.5 Additional information is required from non-EU CRAs applying for certification, including systemic importance indicators based on the volume of outstanding credit ratings and revenues generated in Member States and other countries. These RTS will not apply to CRAs already registered in the EU.
— Disclosure of Historical Performance & Default Data
Each CRA that is registered or certified in the EU must supply to a central repository (CEREP) maintained by ESMA information on its historical performance data, including ratings transition frequency and information about past credit ratings and their changes. CRAs must also provide updated disclosures every six months about the historical default rates of their rating categories. This information is made available through a publicly available website, with an annual summary of key developments published by ESMA.
The RTS describe the technical features required for a CRA to report to the CEREP, with additional instructions regarding the structure, format, method, and period of reporting.6 Under the RTS, CRAs will provide raw ratings data and explanatory information to the CEREP, which will calculate and publish aggregated statistics. The formulas and methodologies for these calculations will be presented on the CEREP webpage. In order to promote standardisation, some classes of ratings will be excluded, and many aspects of the rules are broadly framed in order to accommodate different methodologies and definitions, which will raise interpretational issues and limit the usefulness of the data. ESMA has indicated that this is work in progress and that further clarification will be provided in due course.
— Assessment of Compliance of Credit Rating Methodologies
The rating methodologies used by CRAs must be “rigorous, systematic, continuous and subject to validation based on historical experience, including back-testing.” The RTS provide for the regular review by ESMA of credit rating methodologies to ensure that they reflect changes in market conditions with a view to ensuring transparency and disclosure of material modifications.7 The RTS are also intended to prevent unreasonably frequent changes to methodologies that could lead to instability.
Although the final RTS are largely consistent with the earlier draft,8 ESMA has made some amendments in order to comply with Article 23 of the CRA Regulation, which prohibits ESMA from interfering with the content of credit ratings and methodologies. The final RTS also include a new allowance for cases where CRAs lack data to support the predictive power of a ratings methodology.
— Periodic Reporting
The fourth RTS document addresses the content and format of the ratings data that CRAs must periodically report to ESMA in order for it to carry out its supervisory responsibilities.9 Unlike the data supplied to CEREP, which focuses on issuer ratings, the periodic reporting covers all independent ratings assigned by a CRA. Reporting is required for each action encompassed by the RTS and for each rating affected by that action.
The earlier CESR guidance10 required CRAs to submit some operational data to the competent authorities of Member States, but precise standards were never specified. In the draft RTS,11 ESMA recommended that CRAs provide detailed information regarding individual reporting actions directly to ESMA on a monthly basis. ESMA also sought feedback on whether the reporting of actions taken in respect of outlooks and “watchlist” designations of credit ratings raised any concerns, and whether the identification of non-structured covered bonds in a category separate from corporate ratings would impose an undue burden.
A number of amendments were made to the final RTS in response to comments received. In particular, small local CRAs will be permitted to provide ratings data on a bi-monthly basis in light of the disproportionate burden of monthly reporting on these firms. The placing of a rating on watchlist will now only require an indication of the general circumstances underlying the action rather than reasons specific to the CRA Regulation, in order to accommodate non-EU CRAs. The requirement to include non-structured covered bonds in a separate category, however, has not changed.
In order to give CRAs time to update their IT systems, the new reporting requirements will not become mandatory until six months after the final RTS are published by the Commission. In the meantime, CRAs will continue to report in accordance with the CESR guidance.
Permitted Use of Non-EU Ratings
In order for a credit rating issued outside the EU to be endorsed for use within the EU, ESMA must verify that the regulatory framework of the non-EU country is “as stringent” as the CRA Regulation and must enter into a co-operation agreement with that country’s regulators.12 In making this determination, ESMA will take a “global and holistic” view of the country’s legal framework in assessing whether it meets the same objectives as the CRA Regulation. A determination of equivalence is not a prerequisite for endorsement, but endorsement decisions can be made on the basis of equivalence decisions that have already been reached. The Japanese framework was deemed equivalent in September 2010,13 and on 20 December 2011, ESMA entered into a co-operation agreement with its Australian counterpart, endorsing Australia’s regulatory framework for purposes of the CRA Regulation. ESMA is currently in the process of assessing the regimes of the U.S. and various other non-EU countries.
According to the CRA Regulation, as interpreted by ESMA, credit ratings may continue to be used for regulatory purposes unless registration is refused or the conditions for endorsement are not met. In that case, the credit ratings may still be used for a transitional period of three months, which ESMA can extend for a further three months “in exceptional circumstances relating to the potential for market disruption or financial instability.” Given that the vast majority of non-EU credit ratings are issued in regimes that have not yet been endorsed, in particular the U.S., ESMA has taken the decision to extend the transitional period until 30 April 2012. While it is working to complete its assessments and enter into co-operation agreements by that time, ESMA warns that not all regimes may be endorsed during the first quarter, and that market participants should take precautionary measures in the event that some non-EU credit ratings are no longer permitted to be used.
ESMA’s approach to the endorsement of third country regimes has been highly criticised by market participants, who argue that the authority is not being flexible enough and worry about the consequences if non-EU securities no longer meet prudential requirements.14 ESMA has responded that a strict approach is necessary to ensure ratings quality. The authority has a lot of work to do between now and the end of April. If it fails to meet this deadline, it may have to extend the transitional period yet again.
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