I. INTRODUCTION
As the events associated with the recent financial crisis amply demonstrate, globalized financial markets suffer from acute failures of global governance which today require urgent action. Even before the crisis, the recognition that globalized financial markets exceeded the reach of individual states had led some countries to push for greater reliance upon non-state actors to perform public regulatory functions. Nowhere is this better illustrated than with regard to Credit Rating Agencies (CRAs) and their deployment internationally as a mechanism of global governance, in particular through the use of ratings in the Basel II banking framework.Footnote 4 As such, CRAs, with their ‘relatively standardised, harmonised, easy to understand, independent (third party) [assessments] of credit quality’,Footnote 5 became ‘important private makers of global public policy’Footnote 6 and were widely seen as key drivers of global governance within the then pre-crisis international regulatory settlement. However, the use (and abuse) of credit ratings for asset-backed securities generally, as well as those collateralized by and associated with sub-prime residential mortgages in particular, has today cast a long shadow over the ability of these ‘gatekeepers’Footnote 7 to provide reliable signals upon which parties—investors, financial institutions and regulators—can make informed decisions.Footnote 8 Moreover, it has sparked an intense global debate about their continuing role within the newly emergent global governance structures in the wake of the recent crisis.Footnote 9
Significantly, the role of CRAs in this latest episode comes on the back of long-running criticism of such agencies.Footnote 10 This criticism has centred, for example, on claims that ratings are compromised by acute conflicts of interest;Footnote 11 that CRAs provide little informational value, especially for more complex asset-backed securities, where downgrades tend to be reactive rather than proactive;Footnote 12 and that CRA's are largely unaccountable given the market power they exert.Footnote 13 What is more, the role of CRAs in the subprime mortgage debacle, follows recent legislative measures adopted in the USFootnote 14—where many of the leading CRAs are headquartered—as well as international self-regulatory efforts through the work of the International Organisation of Securities Commissions (IOSCO)Footnote 15 designed to address at least some aspects of these claimed weaknesses.Footnote 16
The aim of this article is to provide a critical appraisal of CRAs as a mechanism of global governance in the light of their role in the subprime mortgage debacle and to evaluate the case for stricter regulation of CRAs. In this respect, special emphasis is placed on the recent European Union attempt—by way of a new Regulation on Credit Rating Agencies—to bring rating agencies within the regulatory fold.Footnote 17 At a broader level, the discussion not only illustrates that the EU Regulation has serious implications for the operation of CRAs within the Community, but that the reform measure is arguably illustrative of a growing dissonance between EU and US responses to issues of global governance more generally.
II. WHAT ARE CREDIT RATING AGENCIES AND WHAT DO THEY DO?
According to one estimate, there are more than 130 CRAs operating world-wide, each varying in size, focus and the methodologies used.Footnote 18 However, the three largest CRAs—Standard and Poor's, Moody's, and Fitch—despite having been founded in the US, today have a significant cross-border presence in all financial markets, including the UK and Europe more generally.Footnote 19 In essence, CRAs provide standardized assessments of the future probability that a debtor will default on the liabilities owed to creditors.Footnote 20 That is to say, CRAs assess the credit risk associated with holding specific debt or debt-like securities.Footnote 21 Issuers of such securities include private entities (such as companies), as well as public institutions (such as national or local governments), though issuers may also constitute cities or non-profit organizations. In view of the fact that an issuer may issue more than one form of debt security, each with differing risk characteristics, CRAs typically assign ratings to specific securities rather than specific issuers.Footnote 22 Broadly speaking, the ratings used by these three global players are based on a similar, albeit not identical, alphabetical system. Thus, a designation of AAA represents the highest rating, followed by AA, then A, then BBB and so on. Sometimes ratings are accompanied by a+or a−or some other modifying designation. Ratings ranging from AAA to BBB – represent ‘investment grade’, a designation which has significant consequences for a security's marketability, particularly with regard to institutional investors.
In assessing the credit risk associated with a security, CRAs collate and analyse both public and private information about the issuer.Footnote 23 For new issues, this process is initiated by a request from an issuer, or from the underwriter underwriting the issue, for a credit rating. Although various agencies specialize in different approaches and methodologies to provide ratings, the leading CRAs adopt similar procedures for similar securities.Footnote 24 The overriding aim of the ratings process is to ensure analytical consistency and exploit comparative expertise. For the leading agencies a ratings committee is established, typically comprising the lead analyst, managing directors/supervisors and more junior analysts.Footnote 25 The lead analyst requests information from the issuer, meets with its senior management (or where the issuer is a government entity, with government officials) and then prepares a draft report. The decision as to which rating is to be assigned, is then taken by the majority vote of the ratings committee.
Having decided on the rating, the issuer is informed and given the opportunity to check the press release or preliminary report for factual inaccuracies and to ensure that it contains no proprietary information which the issuer has decided to keep confidential.Footnote 26 Where an issuer decides to challenge a rating, CRAs are typically reluctant to reopen assessments unless new material information is forthcoming or there is some factual error or misunderstanding that has adversely affected the preliminary rating.Footnote 27 In relation to the larger CRAs, a press release is issued outlining the rating and the rationale for it.Footnote 28
A favourable assessment—or ‘rating’—is not meant to signify the desirability of an investment nor to verify the security's market price, still less to proffer a view on the liquidity of, or the market price for, any given security.Footnote 29 Instead, a rating indicates the likelihood that the repayments associated with holding a particular debt security (ie the return of the principal amount plus interest payments) will be made in a timely manner in accordance with the terms upon which the agreement was entered into by the parties. Furthermore, CRAs provide continuous assessments of securities they have already rated, by upgrading, downgrading, or confirming a rating, or even placing the securities on an early-warning ‘watch list’ so as to indicate that the agency is considering a review of the existing rating.Footnote 30 However, as Schwarcz warns: ‘[b]ecause rating agencies make their rating determinations based primarily on information provided by the issuer of the security, a rating is no more reliable than [the quality and veracity] of the information [supplied].’Footnote 31
CRAs are widely thought to afford potential benefits to investors, issuers and regulators alike. Since informational problems abound in financial markets, investors are exposed to severe information asymmetries in making investment decisions. This is especially true in relation to illiquid and/or difficult to value instruments, such as asset-backed securities. Here, the absence of a liquid market for such securities renders the market less transparent and thus makes risk assessment more complex. CRAs help reduce such information asymmetries by providing information (ratings) which can ‘help investors better to understand the risks and uncertainties they face’ when deciding where and how much they should invest.Footnote 32 What is more, investors have historically relied upon credit ratings in investment mandates so as to establish parameters within which investment by the investment manager is to take place. Accordingly, ratings provide investors with some measure of assurance that higher yield is not being secured as a result of higher risk. Securities which have been rated as meeting a minimum threshold for use in an institutional investor's portfolio are referred to as ‘investment grade’.Footnote 33 Inevitably the granting or otherwise of this imprimatur has an impact on the investment decisions of non-institutional investors. The downgrading of a security acts as a benchmark for decision-making and in some instances can act as a potential trigger for the sale of the asset.
Issuers are also said to benefit from CRA ratings inasmuch as good ratings enable them to lower their cost of capital and provide them with a competitive advantage with regard to other issuers.Footnote 34 Consequently, an issuer which secures a triple A-rating for its securities can offer ‘a lower interest rate on those securities, and still attract investors, than can a company with the lower rated securities.’Footnote 35 This is said to ensure that assets are assigned to their highest value uses on the basis of demand backed by willingness to pay, thus facilitating allocative efficiency.Footnote 36 Moreover, in assessing credit risk, and thus in helping investors to know more about the credit risk associated with holding particular securities, CRAs are thought to play an important role in fostering a ‘robust’ secondary market for those securities.Footnote 37
Regulators have also sought to harness the informational value attached to CRA ratings by ‘enrolling’ them, in effect, as ‘surrogate regulators’ and by using their ratings as a proxy for making regulatory judgments. More specifically, regulators have sought to harness the informational value of ratings by devising frameworks which enable regulated entities—particularly banks—to rely on external credit ratings to help calculate risk exposures and thus meet capital adequacy requirements (the so-called ‘standardised approach’).Footnote 38 For example the Basel Committee on Banking SupervisionFootnote 39 permits banks to use ratings from certain accredited CRAsFootnote 40 to determine minimum credit risk capital requirements under Pillar I of the new Basel Capital Accord (Basel II). These principles have also been embedded in legal rules as part of the EU's Capital Requirements Directive 2006/48/EC (CRD)Footnote 41 which, inter alia, implements Basel II. Consequently, provided the FSA or another regulatory authority has formally recognized a CRA as being eligible, the CRA's credit assessments can be used for capital requirement purposes in determining the risk weighing associated with a range of assets held by banks on their balance sheets.Footnote 42
Modern-day CRAs have their roots in America's mercantile past. According to Partnoy:Footnote 43
The precursors to twentieth-century credit rating agencies were mercantile credit agencies … . During the seventeenth and eighteenth centuries, colonial importers customarily extended up to a year of credit to their retail customers, shopkeepers, and general stores. Payments were often late, and it was difficult for sellers to gather credible information about the reputation of buyers: letters of reference were faked or forged, detailed financial data were not available, and the process was tediously slow. As markets and trade evolved during the nineteenth century, it became clear that there were economies of scale associated with gathering and disseminating credit information in a systematic, organized way.
The success of these mercantile rating agencies was not lost on John Moody, founder of Moody's, who, in 1909, published his first railroad bonds bulletin. Not long afterwards others followed suit, with Poor's Publishing Co established in 1916, Standards Statistical Company in 1922, and Fitch Publishing Company in 1924. By the time the US had entered into the Second World War, the market for rating credit risk was already veering towards oligopoly, with Standard's merging with Poor's in 1941 to form Standard & Poor's (S&P).Footnote 44 Today, despite their North American origins, Moody's, Standard & Poor's, and Fitch provide ratings for issuers throughout the world, as well as having spawned a number of overseas imitators.Footnote 45 Indeed, as of 2007, the total amount of debt rated by S&P alone, globally, was approximately US$34 trillion, covering 100 countries.Footnote 46
Yet the growing influence of CRAs and the move by the larger agencies towards an ‘issuer pays’ model during the mid 1970s, also brought sustained criticism, namely: that ratings were polluted by acute conflicts of interest;Footnote 47 that ratings tended to be reactive rather than proactive;Footnote 48 and, CRAs were not sufficiently accountable for the market power they exerted.Footnote 49 As we shall see, much of this historic criticism has resurfaced with regard to the role of CRAs in the recent financial crisis.
III. CREDIT RATING AGENCIES AND THE SUBPRIME MORTGAGE DEBACLE
A. The Coming Storm
Perhaps somewhat surprisingly the barrage of criticism directed at CRAs over the last decade or more has had, at least up until recently, little discernable adverse impact on their role as gatekeepers. If anything, throughout much of this period the leading CRAs succeeded in enhancing their influence. Yet, as Partnoy observed as early as 1999, this increased influence is not linked to ‘good reputations based on the informational content of their credit ratings.’Footnote 50 Rather, it is associated with the fact that CRAs have, by virtue of the promulgation of regulatory rules which are dependant on credit ratings, ‘begun selling regulatory licenses’.Footnote 51 By this, Partnoy was referring to the fact that CRAs have been given a powerful discretion by their ratings decisions to make it easier for financial institutions and institutional investors, to comply with regulations (in the case of the former) and investment mandates (in the case of the latter). Indeed, as we have already seen, this discretion now has a global impact in that it applies to international banks which, under Basel II, are permitted to rely on ratings to demonstrate that they are compliant with capital adequacy requirements under Pillar I of the Accord.
However, the recent and unfolding link between CRAs and the implosion of the market for structured products generally and the subprime mortgage market in particular, has reignited interest in the operation and accountability of CRAs and in their continuing role as key agencies of global governance. The effect of this interest has been to cast a long shadow over their alleged reputational capital (the putative source of their legitimizing power) and the exact nature of their future operations. More specifically, for the purposes of this article, it has lead to the enactment of EU legislation, in the form of a Regulation, regulating the operation of CRAs within the EU.
B. The ‘Originate and Distribute’ Model of Banking
It is widely accepted that the growth of the market for asset-backed securities, such as subprime mortgages and so-called structured products, represents a ‘fundamental shift’Footnote 52 in the business model utilized by many modern banks.Footnote 53 The traditional ‘originate and hold’ model of banking, where banks held loans to maturity (and where, as a result, credit risk was dangerously concentrated), has today given way to the so-called ‘originate and distribute’ model.Footnote 54 Under this model, banks make loans which are ‘pooled’ and then sold on to investors through a process of securitization. In this way, highly illiquid assets are transformed into more marketable securities. In the case of ‘simple’ securitization there exists a ‘pooling of reasonably homogenous assets with a given (and generally lower) risk profile’.Footnote 55 However, more complex securitizations (so-called second-tier and higher-tier securitizations) involve a pool of bank loans being sold by the bank (as the ‘originator’) to a bankruptcy remote, off-balance sheet special purpose vehicle (SPV).Footnote 56 The SPV is usually a thinly capitalized single purpose company whose shares are held by someone other than the originator. Since the SPV is not a subsidiary of the bank, it does not appear as part of the bank's consolidated accounts (hence off-balance sheet). Moreover, in view of the fact that the SPV is a separate legal entity, the originator is not legally responsible for its obligations (hence bankruptcy remote). A primary motivation behind the use of such structured investment vehicles by banks is to avoid regulatory requirementsFootnote 57 under which they must ordinarily operate, such as ‘minimal capital requirements, liquidity requirements, other constraints on permissible liabilities and assets, reporting requirements and governance requirements.’Footnote 58
Having purchased the pool of bank loans/assets, the SPV is then entitled to the interest payments and the principal sum made by the original borrowers. To pay the bank for the loan pool, the SPV parcels together these newly acquired loans (which can include securitized mortgages, credit card receivables, car loan receivables etc) into securities which are backed by the cash flows (interest and principal payments) from the parcelled loans (hence the term asset-backed securities). Additional finance is typically secured via short term loans, which makes such vehicles highly vulnerable in the event that loan providers lose confidence.Footnote 59 Acting on behalf of the SPV and in return for a fee, the originating bank collects the stream of cash flows associated with the re-packaged assets. In an attempt to make the newly issued asset-backed securities more attractive to investors various tranches are issued, each exhibiting different risk-return characteristics.Footnote 60 In the event that losses occur, these are, in effect, apportioned on a sliding scale according to investors' appetite for risk. According to the House of Common Financial Stability and Transparency Report:Footnote 61
In a common three-tranche, the least risky, or ‘senior’, tranche has the first claim on payments from the pooled mortgages. The ‘senior’ tranche has the highest credit rating, often triple-A investment grade, but receives a lower rate of interest than the other tranches. After the senior claims are paid, the middle or mezzanine tranche receives its payments. Mezzanine represents greater risk and usually receives below-investment grade credit ratings and a higher rate of return. The lowest, or equity, tranche receives payments only if the senior and mezzanine tranches are paid in full. The equity/first-loss tranche absorbs initial losses. Equity tranches are therefore the most risky tranche and consequently often unrated, but as a consequence offer the highest rate of return. This process, whereby losses are applied to more ‘junior’ tranches before they are applied to more ‘senior’ tranches, is known as subordination and is one, albeit important, form of credit enhancement.
In other words there exists a ‘credit cushion’ whereby the pool of mortgages or other securitized assets are structured so as to ‘absorb a certain amount of losses before there are any losses at the triple-A level.’Footnote 62
C. The Role of CRAs
CRAs occupied a critical role in facilitating the spectacular growth of the market for structured products.Footnote 63 Much of this was to do with their supposed superior ability to assess the credit risk associated with complex credit instruments. As Coffee points out:Footnote 64
while a sophisticated debt purchaser might be able to evaluate the creditworthiness of the bonds of a major corporation by examining the corporation's financial statements, the debt purchaser has no corresponding ability to assess the risk level of a mortgage pool backing an issue of collateralized debt obligations (‘CDOs’) and so must rely on a ‘gatekeeper’—here, the credit rating agency.
Because of the claimed ability of CRAs to decode the special credit risks associated with structured products (a skill upon which their global governance role was predicated), the rating of such securities became an increasingly lucrative and important source of revenue for CRAs, sometimes generating fees that were four and perhaps even five times that which could be earned by rating equivalent sums of traditional bonds.Footnote 65 According to Coffee, ‘[b]y 2006 structured finance accounted for 54.2% of Moody's revenues from its ratings business and 43.5% of its overall revenues.’Footnote 66 What is more, issuers also had strong incentives to seek ratings for their structured products based on the same scales used to rate more traditional products. With many institutions embedding ratings within their operating procedures, or with minimum ratings thresholds contained within investment mandates, issuers were heavily reliant on ratings to maximize the pool of potential purchasers of their securities. As a result, there was pressure on issuers to secure, and an incentive for rating agencies to award, over-inflated ratings.
The meltdown in the market for residential backed mortgage securities, which was triggered by the slump in the US housing market, resulted in an increase in the rate of defaults on subprime loans. This in turn led to a significant reduction in the amount of monthly principal and interest payments derived from the underlying pools of assets (subprime residential mortgages etc). Although the junior tranches were hit first, this resulted in a loss of credit enhancement for the more senior tranches, which in turn precipitated ratings downgrades on a huge scale. The ultimate effect of these events was a massive loss of confidence in credit ratings for structured finance instruments and vehicles more generally.Footnote 67 Moreover, because of the existence of minimum quality thresholds in investor mandates, downgrades also had the effect of triggering—through ‘forced’ selling—the more widespread problems currently afflicting the global financial markets.Footnote 68
D. Criticisms of CRAs
These events have spawned a wave of renewed criticism of CRAs, much of which mirrors earlier attacks on the integrity of their operations, and an intensification of the debate about whether and if so how CRAs are to be regulated.Footnote 69
1. Conflicts of interest
First, observers have again seized on the acute conflicts of interest associated with the ‘issuer pays’ model, whereby both the issuer and the ratings agencies have an economic interest in ensuring the success of the issue—the issuer, in ensuring the sale of its securities; and the CRA, because of scale of fees at stake, in securing lucrative future business from the issuer.Footnote 70 Conflicts of this nature are especially acute where CRA analysts proffer suggestions with regard to the design of a structured finance instrument, since in such a situation the CRA ‘both advises the issuer/arranger on how to structure a product and rates the probability of default of such a product.’Footnote 71 In this sense, ratings became almost a matter of negotiation rather than one of arm's length commercial judgement.Footnote 72 In addition, there is a risk that the issuer will seek to exert some form of economic pressure to ensure a high rating. According to a survey carried out by the Chartered Financial Analysts Institute (CFA Institute) in June 2008, 211 of the 1,959 members surveyed reported that they ‘witnessed a CRA changing a rating as consequence of pressure or influence from an investor, issuer or underwriter.’Footnote 73 When asked to specify how this pressure was manifested, over 50 per cent stated that it involved a threat to take future ratings business to other CRAs and 17 per cent mentioned the offer to deliver more business to the agency.Footnote 74
Concerns about the impartiality of ratings also exist where CRAs provide additional advisory services to the issuer. Insofar as these ‘non-rating services give rise to significant, high-margin revenues from a rated client, a CRA has a clear incentive to continue this lucrative relationship and look more favourably at the client's creditworthiness for rating purposes.’Footnote 75 By contrast, an issuer may wish to ‘ratings shop’ so as to choose—whether it be on a deal-wide or tranche-by-tranche basis—which rating to use based on the preliminary rating provided by the agency's ratings committee.Footnote 76 As the European Commission acknowledges, this situation can easily result in ratings inflation, since CRAs have an incentive to keep issuers happy in the hope of securing future business from them.
2. Flawed models and tardy downgrades
Secondly, criticism has also centred on the methodologies and assumptions used by CRAs to rate structured products.Footnote 77 Although CRAs have claimed that the meltdown in the structure finance market was ‘unprecedented’,Footnote 78 attention has nevertheless focused on the models used by CRAs to determine ratings and the inability of these models to reflect fully, or even adequately, the credit risk associated with the innovative financial products to which ratings were assigned. By definition, models rest on assumptions. These assumptions may prove overly sanguine and may result in forecasts that are highly subjective and which, in turn, are open to question.Footnote 79 Yet, perhaps of more importance—certainly more concern—is the extent to which CRAs are capable of providing truly impartial ratings for many of the types of asset-backed securities they rate. As Buiter, in his evidence to the House of Commons, notes:Footnote 80
The complexity of some … structured finance products [CRAs] are asked to evaluate makes it inevitable that [they] will have to work closely with the designers of the structured products. The models used to evaluate default risk will tend to be the models designed by the clients.
The risk of misleading ratings inherent in such relationships (where the private interests of parties is likely to be at odds with the public good in ensuring that credit risk is accurately priced) is obvious. The fact that, in theory, private interests can be aligned to the public good by way of market incentives, does not seem to have worked in practice.
The current crisis has also seen CRAs castigated for being overly reactive to events associated with the implosion in the markets for securities backed by US subprime mortgages.Footnote 81 As a recent House of Commons Report concluded:Footnote 82
We note with concern that the credit rating agencies appear to have been slow to downgrade their ratings for securities backed by sub-prime mortgages. Additionally, the ratings downgrades they made over the summer of 2007 were large-scale in nature and appear to have been ‘unexpected’ by many market participants. Large, belated and unexpected shocks can only serve to exacerbate the problems in credit markets. The very fact that the credit rating agencies began reviewing their methods during this period is an implicit admission that they got it wrong and that they did not have the appropriate models to rate such securities during a time of stress.
‘Tardy’ downgrading may, however, have an economic explanation. As the FSA acknowledges:Footnote 83
Historically, CRAs have often derived proportionally greater amounts of income from their initial rating activities for structured finance products rather than ongoing monitoring fees. This may have contributed to a lack of focus and resource on ensuring timely and accurate review of issued ratings. It therefore remains vital for CRAs to ensure an appropriate quantity and quality of resource is dedicated to the ongoing monitoring of ratings as well the initial credit assessment.
This economic explanation is developed further by Coffee who explores the idea that a CRA has no real incentive to downgrade bonds already rated by it. He observes that ‘[a] rating agency earns no additional revenues from downgrading outstanding securities, but it does risk offending powerful clients—the issuer, its investment bank, and the institutional investors that hold the rated securities in their portfolio.’Footnote 84 Indeed, as he goes on to explain, although ‘debt purchasers want the truth at the outset before they purchase … . once they have placed the issuer's bonds in their portfolios, institutions are unhappy with any downgrading of the issuer's debt.’Footnote 85
3. Lack of accountability
Thirdly, and finally, and echoing long-standing concerns about a lack of accountability associated with the activities of CRAs, the recent crisis underscores the inadequacy of existing—largely market-based—mechanisms as a means of rendering CRAs accountable for their undoubted market and regulatory power. Indeed, if recent events regarding the market for ratings have shown us anything, it is that this is a market which suffers from demonstrable market failures that are not likely to be self-correcting. What is more, events have also made clear that the full costs of these failures are not confined to the parties immediately affected. Rather, they are borne by all of us by way of public sector bailouts. These bailouts occur because of the collateral damage which financial collapses are capable of inflicting on a wide range of financial actors, principally banks, and because of the adverse impact which financial sector dislocations are likely to have on ‘real’ economy.
IV. THE EUROPEAN UNION'S REGULATORY RESPONSE
A. International Standard-Setting and Monitoring or Direct Regulation?
Although EU (and thus UK) law addresses certain activities incidentally associated with the way in which CRAs conduct their business,Footnote 86 and requires certain conditions to be met before CRA ratings may have regulatory effect,Footnote 87 CRA operations in Europe have not hitherto been subject to a separate regulatory regime.Footnote 88 This is perhaps surprising in view of the economic power which CRAs have been able to exert and the use to which ratings have been put. Nevertheless, since 2004 the operations of CRAs were firmly on the FSA's radar as a focus of regulatory concern. In view of the global nature of CRA activity, the FSA advocated a solution rooted in non-legislative voluntary action. At the global level, this was to be achieved through the work of IOSCO's Code of Conduct Fundamentals for Credit Rating Agencies, originally published in December 2004, the purpose of which was to ‘promote investor protection by safeguarding the integrity of the rating process’.Footnote 89 According to the FSA, IOSCO's early work demonstrated that IOSCO was capable of engaging with an industry that was largely unregulated ‘to develop a number of criteria which the ratings agencies have [embedded] within their own codes of practice.’Footnote 90 This work has since been updated to take into account developments in the wake of the recent financial crisis.Footnote 91 Moreover, IOSCO has also recently published work to ‘determine the extent to which credit rating agencies have incorporated the [newly revised] IOSCO Code … into their own Codes of Conduct.’Footnote 92
In Europe, opinion regarding the question of how best to regulate CRAs in the aftermath of the recent financial crisis has been divided. One of the most influential groups is the Committee of European Securities Regulators (CESR), a Level 3 committee under the new Lamfalussy law-making process, comprising the national securities regulators of member states.Footnote 93 In September 2008, CESR, in opposition to the Commission's preference for direct regulation of CRAs, reaffirmed its earlier commitment of May 2008, for ‘an international CRAs standard-setting and monitoring body to develop and monitor compliance with international standards in line with the steps taken by IOSCO, using full public transparency and acting in a ‘name and shame’ capacity to enforce compliance with these standards via market discipline.'Footnote 94
The supposed strengths of such a market-based approach are, of course, well known. In essence, this approach is premised on the idea of harnessing private interests to promote the public good. The interplay of market forces by way of more informed investor decision-making is said to sanction inappropriate or suboptimal behaviour by CRAs and to incentivize them to alter their conduct and operational arrangements. Furthermore, an approach based upon ‘standards’ is arguably more in keeping with the modern preference for ‘outcomes-focused regulation’Footnote 95 which eschews a detailed rule-bound approach, and offers greater scope for compliance issues to be embedded within the overall decision-making processes of a CRA. Finally, unlike prescriptive rules which risk being overly burdensome and which may not achieve stated goals at the lowest cost, a standards-based/outcomes-focused approach is arguably sufficiently flexible to accommodate changing market circumstances—something which could be particularly important in a sector which is renowned for innovation. Consequently, the different operational and structural needs of individual CRAs may be more readily accommodated within such a regime than would typically be the case in one based upon more prescriptive rules. This discretion is accompanied by the existence of a ‘comply or explain’ approach which, in theory at least, enables investors (and investment managers) to enter into agreements which best suit their needs and for the market to judge the relative merits of these arrangements.
However, reliance upon international standards to regulate CRAs is also likely to pose serious problems, as recent events have highlighted. By definition, standards make greater use of imprecise words and expressions than do more detailed rules. For example, the IOSCO Revised Code—which would be the basis of any international code—refers to terms such as ‘sufficient’ (eight times), ‘reasonable’ (four times), and ‘appropriate’ (13 times). Thus, the lack of prescription associated with standards, and the characterization of this as a major strength, is also apt to be considered a significant weakness, affording CRAs undue discretion over the means by which to implement best practice standards. These problems are further compounded by the difficultly in ensuring that those CRAs which claim to be complying with standards are in fact doing so. Indeed, not all aspects of any given set of standards will be capable of being verified, whether by investors (even those who are considered sophisticated) or by an international monitoring agency (an approach initially favoured by CESR). And an incentive to shirk claimed obligations is likely to persist both when competition is weak (because of the absence of any effective market sanction) and when CRA ratings are subject to more competitive pressures (when firms, in an attempt to reduce costs, seek to ‘steal a march’ on compliant rivals).
Furthermore, claims regarding the merits of market optimality and of the ability of market discipline to best ensure that CRAs abide by an internationally mandated norms are dependent upon standard neo-classical assumptions about economically rational motivation, competitive market conditions, the availability of full information, and the absence of transaction costs.Footnote 96 Although the greater market scrutiny which internationally monitored standards promise, combined with better educated and more circumspect investors, may help to reduce the existence of some market deficiencies—eg information asymmetries—significant market failures are nevertheless sure to remain. This is because of the highly complex and novel nature of many of the financial products that CRAs rate, the speed with which market innovations occur, and the inability of raters to keep fully up to date with these developments. Consequently, it is likely (and perhaps even inevitable), that significant credit risks will continue to be mispriced by rating agencies. In turn, this mispricing has, as we have seen of late, serious implications for the stability of financial markets more generally. Moreover, to the extent that CRAs have the power to sell the right for banks and investment managers to be compliant with their legal obligations (capital requirements under the CRD in the case of banks, and investment mandates in the case of mangers) the market for ratings is unlikely to accurately price the risks associated with holding any complex instruments being rated.
In the absence of more interventionist measures there is, then, a serious risk that CRAs will not act in such a way as to ensure that their private interests are fully, or even adequately, aligned with the public good.Footnote 97 As the European Commission has pointed out:Footnote 98
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.
Furthermore, although the Commission recognizes that the revised IOSCO Code of Conduct represents a global benchmark, it is nevertheless of the view that the Code suffers from critical limitations, in particular that certain rules lack clarity and precision and that enforcement is reliant on a ‘comply or explain’ approach.Footnote 99
Accordingly, although the actions of the leading CRAs during the recent crisis are unlikely to result in legal culpability,Footnote 100 their moral irresponsibility in the events associated with the implosion of the subprime market for structured products has effectively resulted in these agencies forfeiting their ‘right’ to remain free from the grip of regulatory control.Footnote 101 As private entities whose decisions have the potential to give rise to significant adverse public consequences (a state of affairs which has been exacerbated by the fact that regulatory authorities the world over have vested in CRAs the power to render banks and investment mangers compliant with their legal obligations),Footnote 102 the case for greater regulatory scrutiny of these organizations now seems irresistible.
B. Regulation (EC) No 1060/2009 on Credit Rating Agencies
At the European level, in July 2008, European Commissioner McCreevy confirmed the Commission's intention for the EU to propose formal legislation directed at the authorization, operation and supervision of rating agencies within the EU. Draft legislative proposals were made available for consultation in July 2008, and in November 2008 a draft Regulation on credit rating agencies was published. Following amendments, the regulation was approved by the European Parliament and the Council in April 2009 and published in the Official Journal in November 2009.Footnote 103 To a significant extent, the Regulation seeks to build on the work of the IOSCO, by giving those rules a ‘legally binding character’.Footnote 104 Moreover, where the standards set by IOSCO are deemed insufficient to ‘restore market confidence and ensure investor protection’ the new Regulation goes further.Footnote 105 The Commission's new Regulation resonates with more recent work undertaken by the FSAFootnote 106 and seeks to give greater definition to the G20's policy recommendations.Footnote 107
1. Scope
In essence, Regulation (EC) No 1060/2009 on Credit Rating Agencies requires the registrationFootnote 108 and supervision of EU rating agenciesFootnote 109 to be carried out by the competent authority of the Member State in which the relevant rating agency has its registered office. In an attempt to protect the integrity of the ratings process (and thus protect investors and the stability of the financial system), only ratings issued by such agencies, or which satisfy the equivalence criteria set out in the Regulation, or which have been certified, may be used by financial institutionsFootnote 110 for ‘regulatory purposes’Footnote 111 (eg to calculate regulatory capital under the CRD). Private credit ratings are not covered; nor are credit scores or similar assessments related to obligations arising from consumer, commercial or industrial relationships.Footnote 112
2. Registration and supervision
The application for registration is governed by article 15 and Annex II. Article 15 establishes that, in the first instance, CESR should receive applications for registration, after which CESR should then inform the relevant competent authorities.Footnote 113 In this way, CESR acts as a central hub for the purposes of informing and coordinating all national regulators. The actual assessment of the application for registration is then carried out at the national level by the relevant competent authority,Footnote 114 albeit that CESR may in certain circumstances provide both advice and guidance to them.Footnote 115 The latter are then under a duty to consider CESR's advice before taking any final decision under the Regulation.Footnote 116 Ironically, then, given CESR's initial preference for an international ‘soft law’ standard-setting approach, the new Regulation places CESR centre stage in the new regulatory regime; indeed, it represents the ‘first legislative instrument to endow it with substantial day-to-day supervisory functions.’Footnote 117
Competent authorities must have all the supervisory and investigative powers that are necessary for the exercise of their functions under the Regulation.Footnote 118 In particular, they must be capable of demanding information and carrying out on-site inspections.Footnote 119 Furthermore, ‘in order to efficiently deal’ with CRAs and to ensure effective surveillance, the Regulation stipulates that competent authorities should set up ‘operational networks’ (ie ‘colleges’ of competent authorities) as the means of exchanging information and coordinating their supervisory activities.Footnote 120 In particular, the college should ‘facilitate the monitoring of the fulfilment of conditions for endorsement of credit ratings issued in third countries, certification, outsourcing arrangements, and exemptions’ for a credit rating agency referred to in the Regulation.Footnote 121 Moreover, to ‘enhance the practical coordination of activities of the college, its members should select among themselves a facilitator’,Footnote 122 the role of which is to ‘chair … meetings of the college, establish its written coordination arrangements, coordinate its actions’ and liaise with CESR.Footnote 123
3. Endorsement of ratings from non-EU agencies and equivalent regimes
a) Endorsement:
In order to foster what the Commission claims is a globally consistent and non protectionist approach, the Regulation makes provision for an endorsement regime. This is aimed at non-EU CRAs affiliated to, or which work closely with, CRAs established in the European Community, but which themselves do not wish to become established here. In essence, the regime allows CRAs established in the Community, and registered in accordance with the Regulation, to endorse credit ratings issued by CRAs in third countries provided certain conditions are met. These conditions include the following:Footnote 124
• credit rating activities resulting in the assignment of a credit rating which is to be endorsed, are undertaken partly or entirely by the endorsing CRA or by CRAs belonging to the same group;
• requirements for credit ratings issued in third countries are, in substance, as stringent as those provided for under the Regulation (eg measures in relation to independence and conflicts of interests, rating analysts, methodologies and disclosure);
• the endorsing CRA makes available on request to its competent authority all information necessary to enable the competent authority to supervise on an ongoing basis compliance with the requirements of the Regulation;
• there is an objective reason for the credit rating to be issued in a third country;
• the credit rating agency established in the third country is authorized or registered and is subject to supervision in that third country;
• the third country regulatory regime prevents interference of the competent authorities and other public authorities in that country with the content of credit ratings and methodologies (unless the equivalence provisions set out below have been established); and
• there is an appropriate cooperation arrangement between the competent authority of the endorsing CRA and the relevant competent authority of the third country CRA, including arrangements for the exchange of information between the competent authorities concerned and procedures with regard to the coordination of supervisory activities for monitoring purposes.
The upshot of the endorsement regime is that, subject to certain conditions, EU financial institutions may rely on ratings issued by non-EU registered CRAs (and thus on non-EU ratings) for regulatory purposes provided the rating derives from a regulatory regime which has been endorsed by an EU registered CRA. The endorsing agency is, first, responsible for determining and, then, subsequently, for monitoring whether the rating activities of the non-EU CRA comply with the Regulation's requirements on an on-going basis (that is to say, whether the credit ratings of such entities are subject to regulatory requirements that are as stringent as those provided for by the Regulation and which achieve the same object and effects in practice).Footnote 125 In this way, the EU regime establishes a global benchmark which third country regimes need to meet in order for ratings produced by third country regimes to have regulatory effect within the EU.
b) Equivalence and certification based on equivalence:
Furthermore, and with the purpose of catering for CRAs that are ‘not systemically important for the financial stability of the financial markets of one or more Member States’ the Regulation establishes a special certification regime for non-EU agencies which have no presence in the EU.Footnote 126 The effect of certification is to enable ratings issued by such entities to be used for regulatory purposes by financial institutions within the Community without the need for endorsement.Footnote 127 The conditions for certification are stipulated in article 5(1):
• the CRA is authorized and subject to ongoing supervision requirements by a supervisory authority in a third country;
• the Commission has adopted an ‘equivalence decision’ recognising the legal and supervisory framework of that third country as equivalent to the requirements of the Regulation;
• cooperation arrangements between the third country supervisor and the EU competent authorities are operational; and
• the ratings in question do not raise systemic risk or integrity issues for the financial markets of one or more Member States.
Accordingly, article 5(6) the Commission is vested with powers to specify or, if necessary, amend the criteria used to determine whether the regulatory and supervisory legal frameworks which have been established in third countries are equivalent to those established by the Regulation.
By itself, a favourable equivalence assessment (and a resulting equivalence determination by the Commission) does not automatically entitle CRAs from such third countries to issue ratings which can be used for regulatory purposes by financial institutions within the Community (eg to satisfy capital requirements under the CRD). However, pursuant to article 5(2) non-EU CRAs may, in the first instance, submit an application to CESR for certification provided the above listed conditions are fulfilled. The process for certification is similar to that for the registration of CRAs under the Regulation (as discussed above), involving the establishment of a supervisory college of the competent authorities from participating Member States.Footnote 128 In certain circumstances, the college may exempt such a CRA from complying with certain, primarily, organizational requirements stipulated in the Regulation, or from the requirement of having a physical presence in the Community.Footnote 129 The Regulation also requires the facilitator to establish cooperation arrangements between the competent authorities of home Member States and the relevant competent authorities of third country CRAs so as to ensure the exchange of information and the coordination of supervisory activities.Footnote 130
4. Independence and avoidance of conflicts
As discussed above, concerns about the impartiality of credit ratings have featured high on the list of regulators' concerns about the integrity of the ratings process. Accordingly, article 6 of the Regulation places an obligation on registered CRAs to ensure that credit ratings are not affected by any existing or potential conflicts of interest. Additional guidance, outlined in Annex I: Independence and Avoidance of Conflicts of Interest, stipulates further organizational and operational requirements with which CRAs must comply. With regard to the former, Annex I, section A, outlines various requirements regarding the existence, composition, expertise, and remuneration of an administrative/supervisory board. In particular, the role of this board is to ensure:Footnote 131
• the independence of the rating process;
• conflicts of interest are properly identified, managed and disclosed; and
• all general matters pertaining to the Regulation are complied with.
With regard to the latter—operational requirements—Annex I, section B, requires CRAs to identify and eliminate or, where appropriate, manage and subsequently disclose, any actual or potential conflicts of interest which may influence the analyses and judgments of their analysts when determining or approving credit ratings.Footnote 132 CRAs must also disclose the names of any rated entities or related third parties from which it receives more than 5 per cent of its annual revenue.Footnote 133 Furthermore, a CRA is prohibited from issuing a credit rating (or must withdraw an existing rating) where:
• a CRA, or an analyst who has participated in determining a credit rating, or any person who has approved a credit rating, directly or indirectly owns financial instruments of the rated entity or any related third party, or has any other direct or indirect ownership interest in that entity or party;Footnote 134
• the credit rating is issued with respect to a rated entity or any related third party directly or indirectly linked to the credit rating agency by control;Footnote 135 or
• an analyst who has participated in determining a credit rating, or the person approving the credit rating, is a member of the administrative, management or supervisory bodies of the rated entity or any related third party;Footnote 136 or
• a rating analyst who participated in determining a credit rating, or a person who approved a credit rating, has had a relationship with the rated entity or a related third party which may cause a conflict of interests.Footnote 137
Significantly, CRAs are also prohibited from providing consultancy or advisory services to any rated entity (or any related third party) regarding the corporate or legal structure, assets, liabilities or activities of the rated entity (or any related third party), though they may provide what are referred to as ‘ancillary services’, on condition that these do not give rise to conflicts of interest.Footnote 138 In addition, and somewhat controversially, according to Annex I, section B, point 5, a CRA must ensure that analysts do not make proposals or recommendations, whether formally or informally, regarding the design of structured finance instrumentsFootnote 139 on which a CRA is expected to issue a credit rating.
According to article 7, CRAs must ensure that anyone who is directly involved in the credit rating process is not allowed to initiate or participate in negotiations regarding fees or payments with any rated entity, related third party or any person directly or indirectly linked to the rated entity by control. Moreover, those employees who are directly involved in the credit rating process must meet the requirements set out in Annex I, section C (concerning additional rules pertaining to analysts and other persons directly involved in credit rating activities). Subject to size restrictions, employees providing rating services to the same rated entity or its related third parties must be rotated.Footnote 140 Furthermore, compensation and performance evaluation of analysts and persons approving credit ratings must not be contingent on the amount of revenue that a CRA derives from rated entities or related third parties to which the analyst or persons approving the credit ratings provide services.Footnote 141
5. Transparency and accompanying disclosures
Since significant asymmetries exist with regard to ratings, it comes as no surprise that much of the new Regulation is directed at improving transparency through timely disclosures.
a) Rating quality: methodologies, models and key ratings assumptions:
According to article 8, CRAs must disclosure and keep under ongoing review the methodologies, models and key ratings assumptions used to assign ratings. In particular, the methodologies employed must be ‘rigorous, systematic, continuous and subject to validation based on historical experience’.Footnote 142 Furthermore, the information used by CRAs to assign ratings must be ‘of sufficient quality and from reliable sources’.Footnote 143 CRAs must also disclose any credit rating, as well as any decision to discontinue a rating, on a non-selective basis and in a timely manner.Footnote 144 And credit ratings must be ‘presented and processed’ in accordance with the requirements set out in Annex I, section D.Footnote 145 For example, CRAs must indicate the sources of information and methodologies used in conducting ratings, and ensure that any limitations associated with assigning a credit rating are clearly indicated.
Article 8 is further supplemented by article 9 which stipulates that the outsourcing of important operational functions must not be undertaken in such a way as to ‘impair materially’ the quality of a CRA's internal controls or the ability of a competent authority to supervise compliance with obligations by a CRA as established under the Regulation.
b) Structured finance instruments:
A key concern which the new Regulation is designed to address is to enable investors to distinguish clearly between ratings for structured products and those for traditional products (eg corporate ratings). It seeks to achieve this by requiring CRAs to use an ‘additional symbol’ when assigning ratings to structured instruments.Footnote 146 Further disclosures are also required in relation to structured finance ratings.Footnote 147 Thus, for example, a CRA must state what level of assessment it has performed concerning the due diligence processes carried out at the level of underlying assets of structured finance instruments. In particular, the credit rating agency must disclose whether it has undertaken any assessment of such due diligence processes or whether it has simply relied upon a third-party assessment, indicating how the outcome of such assessment impacts on the rating.Footnote 148
c) Unsolicited ratings
A credit rating agency must also disclose its policies and procedures regarding unsolicited credit ratings,Footnote 149 and such ratings must be identified as unsolicited.Footnote 150 What is more, the CRA must state in the rating that the rated entity or related third party did not participate in the rating process and that the CRA did not have access to the accounts and other relevant internal documents of the rated entity or its related third party.Footnote 151
d) Other disclosures
With the aim of further enhancing transparency, article 11(1) requires CRAs to disclose and update immediately all information on matters set out in Annex I, Section E, Part I. For example, a CRA must make general disclosures as to any ancillary services it provides, the general nature of its compensation policies, and its methodologies, models and key rating assumptions (as well as any material changes to them). In addition, according to article 11(2) CRAs must disclose, to a central repository established by CESR (and which is to be available in summarized form on an annual basis for market participants to make industry-wide comparisons), standardized performance data and information about past credit rating activities. Furthermore, article11(3) stipulates that a CRA must provide annually, both to the relevant competent authority and to CESR, information relating to matters set out in Annex I, section E, Part II, point 2 (eg a list of its largest 20 clients by revenue). Finally, CRAs must publish an annual transparency report,Footnote 152 as well as keep up-to-date records of their activities.Footnote 153
6. Assessment of the Regulation
From a global governance perspective, the Regulation has both strengths and weaknesses. Despite concerns about the Regulation's lack of clarity in respect of some of its key terms, and charges that it represents a disproportionate and overly burdensome regulatory response, the Commission's new initiative provides an opportunity for EU competent authorities, acting under the aegis of CESR, to subject CRAs to more intense regulatory scrutiny and to ensure that conflict of interest problems, though not eliminated, are at least more effectively managed through more appropriate organizational and operational requirements. Further, it raises the prospect that greater market transparency, and more effective disclosure requirements will render CRAs and their ratings activities not only more accountability to the market generally, but also to public regulators (competent authorities) and to CESR. Finally, by building on IOSCO's Code with respect to CRAs, and by incorporating elements of endorsement and equivalence, the new Regulation acknowledges that the market for ratings is truly international. In time, these aspects of the new Regulation could help facilitate convergence and promote mutual recognition of substantively similar regimes.
V. CONCLUSION
The global financial crisis has served to highlight serious weaknesses in global governance, revealing fault lines in the international financial architecture and its accompanying regulatory apparatus. Most acutely, the spotlight has fallen on CRAs—key governance agencies in the pre-crisis domestic and international regulatory structures, and ones directly linked to the subprime mortgage debacle. Although the assignment of a rating does not operate as a recommendation, much less a guarantee, rating agencies nevertheless played a pivotal role in promoting the global market for structured finance products. At best, CRA assessments of these instruments proved overly sanguine, paying insufficient regard to remote but highly adverse events. At worse, CRA judgements were badly compromised by their conflicted relationships with issuers and by their search for increased profits. The use of ratings in private investment mandates and in global regulatory rules, as well as lax regulatory oversight by both domestic and international regulatory authorities compounded problems.
In the aftermath of the crisis, despite widespread disenchantment with the use of self regulatory codes to constrain the power of CRAs,Footnote 154 a uniform global assault on rating agencies still awaits. While in the US, the SEC has chosen to make what in substance amount to relatively modest changes to the way in which CRAs operate,Footnote 155 favouring the introduction of greater competition for ratings and a scaling back of the use of ratings as a means of regulatory compliance, the EU has, by contrast, sought to adopt a more aggressive regulatory posture involving detailed registration requirements and ongoing supervision.Footnote 156 In this respect, the EU's Regulation on CRAs may be characterized as part of more ambitious plan by the EU to ‘lead by example’Footnote 157 in an attempt to position itself at the vanguard of ‘an emerging, rules-based, global order’ of which it is the author.Footnote 158
However, paradoxically, by taking such a forceful lead, the EU risks being out of step with the US response to CRAs, and of exacerbating problems associated with the global regulation of these agencies. It risks doing so, by fracturing more incremental moves to devise and embed better harmonized, global measures which create a level playing field and which seek to foster open and integrated financial markets. By pursuing its own agenda, the EU leaves itself open to the charge that its new legislation will introduce unnecessary barriers to competition and that, ultimately, it will prove unduly protectionist. In an important sense, then, variations in the approach adopted by both the US and European authorities to the issue of how to regulate CRAs are arguably illustrative of a growing dissonance between these two power blocs about how to respond to the problems of globalization more generally:Footnote 159 one the one hand, a US preference for a unilateral, ‘ad hoc’ globalization, which leaves it essentially unconstrained by ‘binding’ multilateral rules and which provides—at least in the short term—maximum room for manoeuvre; and, on the other, a European preference for rule-based ‘managed’ globalization, which is, in fact, typified by its own CRA reform measures. Ironically, as CRAs downgrade the sovereign debt of the Eurozone's weakest members,Footnote 160 the European project (including its philosophy towards globalization more generally) finds itself under assault from the very agencies it now seeks to regulate.
VI. POSTSCRIPT
In June 2009, the European Commission proposed that the existing supervisory structure for CRAs, as set out in Reg (EC) No 1060/2009, should be amended. In essence, under the new proposal, the European Securities Market Authority (ESMA)—a proposed new supervisory authority which is part of a new European supervisory architecture—will have direct responsibility for CRAs. This centralised model, which was envisaged by Recital 51 of the CRA Regulation, will bypass the need for the current college arrangements, and help to further consolidate the supervisory framework. Under the new proposal, CRAs will apply to ESMA for registration. In turn, ESMA will monitor on an ongoing basis whether registered CRAs comply with applicable rules as set out in the CRA Regulation. ESMA will also be vested with a full set of supervisory powers (eg information gathering and enforcement powers), albeit that the transfer of some of these to national competent authorities (eg the power to conduct on-site inspections) is foreseen as a possibility. In essence, the claimed benefits of the proposed new centralized arrangements are threefold: first, that it will establish a single point of contact for registered CRAs; secondly, that it will offer the prospect of a more consistent application of the relevant rules to CRAs throughout Europe; and finally, that it will lead to significant efficiency gains as a result of a more stream-lined system of registration and supervision.
