Credit Rating Agencies
Paola Lucantoni
 The G20 summit in Washington (2008) aimed to ensure
that no institution, product or market was left
unregulated at EU and international levels. The EU
Regulation on Credit Rating Agencies (Regulation
1060/2009), in force since December 2010, was part of
Europe's response to these commitments.
 The Regulation was amended in May 2011 to adapt it
to the creation of the European Securities and Markets
Authority (ESMA) which has been attributed all
supervisory powers over credit rating agencies since
July 2011.
 The new regulatory package, which reinforces the existing rules on
credit rating agencies, consists of a Regulation and a Directive:
 Regulation 462/2013 of the European Parliament and of the
Council of 21 May 2013 amending Regulation (EC) No 1060/2009
on credit rating agencies
 Directive 2013/14/EC of the European Parliament and of the
Council of 21 May 2013 amending Directive 2003/41/EC on the
activities and supervision of institutions for occupational retirement
provision, Directive 2009/65/EC on the coordination of laws,
regulations and administrative provisions relating to undertakings
for collective investment in transferable securities (UCITS) and
Directive 2011/61/EU on Alternative Investment Funds Managers
in respect of over-reliance on credit ratings
What is a credit rating?
 A credit rating is an opinion issued by a specialised firm
on the creditworthiness of an entity (e.g. an issuer of
bonds) or a debt instrument (e.g. bonds or assetbacked securities). This opinion is based on research
activity and presented according to a ranking system.
Why is it necessary to regulate credit
rating agencies?
 CRAs have a major impact on today's financial
markets, with rating actions being closely followed and
impacting on investors, borrowers, issuers and
governments: e.g. sovereign ratings play a crucial role
for the rated country, since a downgrading can have the
immediate effect of making a country's borrowing more
expensive. A downgrading also has a direct impact for
example on the capital levels of a financial institution.
 The financial crisis and developments in the context of
the euro debt crisis have revealed serious weaknesses
in the existing EU rules on credit ratings. In the run up
to the financial crisis, CRAs failed to appreciate
properly the risks inherent in more complicated
financial instruments (especially structured financial
products backed by risky subprime mortgages), issuing
incorrect ratings that were far too high.
What did previously applicable EU
rules on credit rating agencies say?
 The EU Regulation on Credit Rating Agencies (CRA I
Regulation)1, in force since December 2010, was part
of Europe's response to these commitments. The
Regulation was amended in May 2011 to adapt it to the
creation of the European Securities and Markets
Authority (ESMA) by the so called CRA II Regulation
These CRA Regulations
focused on:
 registration: in order to be registered, a CRA must
fulfill a number of obligations on the conduct of their
business (see below), intended to ensure the
independence and integrity of the rating process and to
enhance the quality of the ratings issued. ESMA is
entrusted since July 2011 with responsibility for
registering and directly supervising CRAs in the EU;
 conduct of business: the previous Regulation (CRA I)
required CRAs to avoid conflicts of interest (for
example, a rating analyst employed by a CRA should
not rate an entity in which he/she has an ownership
interest), to ensure the quality of ratings (for example,
requiring the ongoing monitoring of credit ratings) and
rating methodologies (which must be, inter alia,
rigorous and systematic) and a high level of
transparency (for example, every year the CRA should
publish a Transparency Report);
 supervision: ESMA has comprehensive investigatory
powers including the possibility to demand any
document or data, to summon and hear persons, to
conduct on-site inspections and to impose
administrative sanctions, fines and periodic penalty
payments. This centralises and simplifies the
supervision of CRAs at European level. Centralised
supervision ensures a single point of contact for
registered CRAs, significant efficiency gains due to a
shorter and less complicated registration and
supervisory process and a more consistent application
of the rules for CRAs.
 The CRA II Regulation, however, did not regulate the
use of credit ratings and their impact on the market.
The use of external ratings by financial institutions was
previously regulated in sectoral financial legislation
(e.g. in the Capital Requirements Directive).
What has already been proposed to reduce
the risk of overreliance in the banking sector?
 The new rules on capital requirements (Capital Requirements
Directive IV) include measures to reduce overreliance on ratings
(MEMO/13/272). Possible overreliance by credit institutions on
external credit ratings is to be reduced to the extent possible by:
 requiring that all banks' investment decisions are based not only
on ratings but also on their own internal credit opinion,
 that banks with a material number of exposures in a given portfolio
develop internal ratings for that portfolio instead of relying on
external ratings for the calculation of their capital requirements.
CRD IV rules will apply as from the January 2014.
What is the situation at international level? Are the new rules in line with
the regulatory approaches of other jurisdictions and international
standard setting bodies?

The new rules are broadly in line with the policy developed by our international partners within the Financial Stability
Board (FSB) and the Basel Committee.

The Financial Stability Board (FSB) endorsed in October 2010 principles to reduce the overreliance of authorities and
financial institutions on CRA ratings. The G20 approved the FSB's principles on reducing reliance on external credit
ratings (Seoul Summit, 11-12 November 2010).

At the end of 2012, the FSB adopted a roadmap to accelerate the implementation of the principles. The aims of these
principles are twofold:

the removal or replacement of references to CRA ratings in laws and regulations, wherever possible, with suitable
alternative standards of creditworthiness assessment;

that banks, market participants and institutional investors make their own credit assessments, and not rely solely or
mechanically on CRA ratings.

The Basel Committee on Banking Supervision has also proposed to reduce overreliance on credit rating agencies' ratings
in the regulatory capital framework.

In the USA, the Dodd-Frank Wall Street Reform and Consumer Protection Act3 has strengthened rules on CRAs. Among
other things section 939A of the Dodd-Frank Act requires federal agencies to review how existing regulations rely on
ratings and remove such references from their rules as appropriate. As a consequence, the Securities and Exchange
Commission (SEC) is exploring ways to reduce regulatory reliance on external credit ratings and replace them with
alternative criteria. Some references have already been replaced in US legislation.
Why was a reform of the
CRA Regulation needed?
 non-transparent sovereign ratings: Downgrading
sovereign ratings has immediate consequences on the
stability of financial markets but CRAs are insufficiently
transparent about their reasons for attributing a particular
rating to sovereign debt. Given the importance of ratings on
sovereign debts, it is essential that ratings of this asset class
are both timely and transparent. While the EU regulatory
framework for credit ratings already contains measures on
disclosure and transparency that apply to sovereign debt
ratings, further measures are needed such as access to
more comprehensive information on the data and reasons
underlying a rating, in order to improve the process of
sovereign debt ratings in EU;
 investors' over-reliance on ratings: European and
national laws give a quasi-institutional role to ratings. For
example, the amount of capital that banks must hold is
determined in some cases by the external ratings given to it.
Furthermore, some investors rely excessively on the
opinions of CRAs, and don’t have access to enough
information on the debt instruments rated or the reasons
behind the credit rating which would enable them to conduct
their own credit risk assessments. Measures were needed
to reduce references to external ratings in legislation and to
ensure investors carry out their own additional due diligence
on a well-informed basis;
 conflicts of interest threaten independence of CRAs and
high market concentration: CRAs are not independent
enough from the rated entity that contracts (and pays) them:
e.g. as a rating agency has a financial interest in generating
business from the issuer that seeks the rating, this could
lead to assigning a higher rating than warranted in order to
encourage the issuer to contract them again in the future.
Furthermore, a small number of large CRAs dominate the
market. The rating of large corporates and complex
structured finance products is conducted by a few agencies
that also happen to have shareholders that sometimes
overlap;
 (absence of) liability of CRAs: CRAs issuing credit
ratings in violation of the CRA Regulation are not
always liable towards investors that suffered losses.
National differences in civil liability regimes could result
in credit rating agencies or issuers shopping around,
choosing jurisdictions under which civil liability is less
likely.
The main elements of the new
rules are:

1. Reduce overreliance on credit ratings

In line with G20 commitments, the new rules aim to reduce overreliance on external
ratings, requiring financial institutions to strengthen their own credit risk assessment and
not to rely solely and mechanistically on external credit ratings.

The package consists of a Regulation setting out the principles to reduce overreliance on
external credit ratings. Furthermore, the Regulation is complemented with amendments
in sectoral legislation.

Specifically, the package contains a Directive which amends current directives on the
activities and supervision of institutions for occupational retirement provision (IORP6)
undertakings of collective investment in transferable securities (UCITS)7 and on
alternative investment funds managers (AIFM)8 in order to reduce these funds' reliance
on external credit ratings when assessing the creditworthiness of their assets.

Also the European Supervisory Authorities9 should avoid references to external credit
ratings and will be required to review their rules and guidelines and where appropriate,
remove credit ratings where they have the potential to create mechanistic effects.
 2. Improve quality of ratings of sovereign debt of EU Member
States
 To avoid market disruption, rating agencies will set up a calendar
indicating when they will rate Member States. Such ratings will be
limited to three per year for unsolicited sovereign ratings. Derogations
remain possible in exceptional circumstances and subject to
appropriate explanations. The ratings will only be published on
Fridays after close of business and at least one hour before the
opening of trading venues in the EU. Furthermore, investors and
Member States will be informed of the underlying facts and
assumptions on each rating which will facilitate a better understanding
of credit ratings of Member States.
 Moreover, sovereign ratings would have to be reviewed at least every
six months (rather than every 12 months as currently applicable under
general rules).
 3. Make credit rating agencies more accountable
for their actions
 The new rules will make rating agencies more
accountable for their actions as ratings are not just
simple opinions. Therefore, the new rules ensure that a
rating agency can be held liable in case it infringes
intentionally or with gross negligence, the CRA
Regulation, thereby causing damage to an investor.

4. Reduce conflicts of interests due to the issuer pays remuneration model and
encourage the entrance of more players on to the credit rating market

The Regulation will also improve independence of credit rating agencies to eliminate
conflicts of interests by introducing new rules for complex structured finance instruments
and shareholders of rating agencies. Issuers of structured finance instruments will be
required to be more transparent on the underlying assets of these instruments.

Furthermore, all available ratings will be published on a European Rating Platform which
will improve comparability and visibility of all ratings for any financial instrument rated by
rating agencies registered and authorised in the EU. This should also help investors to
make their own credit risk assessment and contribute to more diversity in the rating
industry.

The Regulation will improve the independence of credit rating agencies and help
eliminate conflicts of interest by introducing mandatory rotation for certain complex
structured financial instruments (re-securitisations). There are also limitations as regards
the shareholding of rating agencies.

The principal ways by which the new Regulation will improve the independence of credit rating agencies are:

a) To mitigate the risk of conflicts of interest, the new rules will require CRAs to disclose publicly if a shareholder with 5% or more of
the capital or voting rights of the concerned CRA holds 5% or more of a rated entity, and would prohibit a CRA from rating when a
shareholder of a CRA with 10% or more of the capital or voting rights also holds 10% or more of a rated entity.

b) Furthermore, to ensure the diversity and independence of credit ratings and opinions, the proposal prohibits ownership of 5% or
more of the capital or the voting rights in more than one CRA, unless the agencies concerned belong to the same group (crossshareholding).

c) Due to the complexity of structured finance instruments and their role in contributing to the financial crisis, the Regulation also
requires the issuers, who pay credit rating agencies for their ratings, to engage at least two different CRAs for the rating of structured
finance instruments.

d) The Regulation introduces a mandatory rotation rule forcing issuers of structured finance products with underlying re-securitised
assets, who pay CRAs for their ratings ("issuer pays model"), to switch to a different agency every four years. An outgoing CRA would
not be allowed to rate re-securitised products of the same issuer for a period equal to the duration of the expired contract, though not
exceeding four years. But mandatory rotation will not apply to small CRAs, or to issuers employing at least four CRAs each rating
more than 10% of the total number of outstanding rated structured finance instruments A review clause provides the possibility for
mandatory rotation to be extended to other instruments in the future. Mandatory rotation would not be a requirement for the
endorsement and equivalence assessment of third country CRAs.

e) Measures are taken to encourage the use of smaller credit rating agencies. The issuer should consider the possibility to mandate at
least one credit rating agency which does not have more than 10 % of the total market share and which could be evaluated by the
issuer as capable for rating the relevant issuance or entity (Comply or Explain).
WHAT WILL CHANGE?
Who will be affected by the changes and
how?

Corporate, structured finance instruments’ and sovereign issuers:

They will benefit from more choice of rating providers which may lead to lower rating fees in the
medium term. Sovereign issuers (e.g. states and municipalities) will benefit from the improved
transparency and process of issuing sovereign ratings.

From now on, an issuer of structured finance products with underlying re-securitised assets who pays
credit rating agencies for their ratings ("issuer pays model") will be required to switch to a different
agency every four years. An outgoing credit rating agency would not be allowed to rate re-securitised
products of the same issuer for a period equal to the duration of the expired contract, though not
exceeding four years. But mandatory rotation would not apply to small credit rating agencies or to
issuers employing at least four credit rating agencies each rating more than 10% of the total number of
outstanding rated structured finance instruments. An issuer of structured finance instruments, who
pays credit rating agencies for their ratings, will need to engage at least two different credit rating
agencies. Moreover, an issuer, an originator and a sponsor of a structured finance instrument
established in the Union will jointly need to disclose to the public information on the credit quality and
performance of the underlying assets of the structured finance instrument, the structure of the
securitisation transaction, the cash flows and any collateral supporting a securitisation exposure as
well as any information that is necessary to conduct comprehensive and well informed stress tests on
the cash flows and collateral values supporting the underlying exposures.

All issuers, including sovereigns, will enjoy additional time to react to ratings before they are made
public. The current rules already provide for ratings to be announced to the rated entity 12 hours
before their publication. In order to avoid that this notification takes place outside working hours and to
leave the rated entity sufficient time to verify the correctness of data underlying the rating, the new
rules will require that the rated entity should be notified during working hours of the rated entity and at
least a full working day before publication of the credit rating or the rating outlook. A list of the persons
able to receive this notification a full working day before publication of a rating or of a rating outlook
should be limited and clearly identified by the rated entity. This information shall include the principal
grounds on which the rating or outlook is based in order to give the entity an opportunity to draw
attention of the credit rating agency to any factual errors.

The publication of sovereign ratings will be done in a manner that is least distortive on markets: at the
end of December, credit rating agencies should publish a calendar for the next 12 months setting the
dates for the publication of sovereign ratings and corresponding to these, the dates for the publication
of related outlooks where applicable. Such dates should be set on a Friday. Only for unsolicited
sovereign credit ratings should the number of publications in the calendar be limited between two and
three. Where this is necessary to comply with their legal obligations, credit rating agencies should be
allowed to deviate from their announced
calendar explaining in detail the reasons for such
deviation. However, this deviation may not happen routinely.

Investors:

They will be in a better position to evaluate the credit risk of financial instruments themselves,
including complex structured instruments. They will have free access to a European Rating Platform
where all ratings issued by rating agencies, registered and authorised in the EU, regarding a specific
company or financial instruments can be found and compared. In addition, investors will benefit from
an increase in the quality of ratings as conflicts of interest due to the "issuer-pays" model and the
shareholder structure will be reduced.

The investor will benefit from enhanced transparency on structured finance instrument established in
the European Union as the issuer, the originator and the sponsor of a structured finance instrument
established in the EU will jointly disclose to the public information on the credit quality and
performance of the underlying assets of the structured finance instrument, the structure of the
securitisation transaction, the cash flows and any collateral supporting a securitisation exposure as
well as any information that is necessary to conduct comprehensive and well informed stress tests on
the cash flows and collateral values supporting the underlying exposures. ESMA will set up a webpage
for the publication of the information on structured finance instruments. Furthermore, the investors'
right of redress against credit rating agencies having infringed the CRA Regulation are enhanced. The
new rules ensure that a rating agency can be held liable in case it infringes intentionally or with gross
negligence, the CRA Regulation, thereby causing damage to an investor or an issuer.
 Credit rating agencies that will need to:
 be more transparent notably regarding their pricing policy
and the fees they receive.
 be more transparent about how they conduct their process
of rating and reach their conclusions.
 be more independent from their shareholder base and from
other CRAs.
 be liable towards investors when breaching intentionally or
with gross negligence the CRA Regulation.
The European Securities and Markets
Authority (ESMA)
 Its role will be reinforced regarding supervision of sovereign
ratings. In addition, ESMA will be entrusted with new tasks
e.g. it will have to draft a number of new technical standards
for adoption by the Commission as well as to provide the
Commission with technical advice.
 For instance, ESMA should establish a European Rating
Platform so as to allow investors to easily compare all
ratings for EU-registered and authorised rating agencies that
exist with regard to a specific rated entity. ESMA will need to
develop draft regulatory technical standards to specify the
content to be used by CRAs when providing such
information.
 Regarding the new rating methodologies:
 A CRA that intends to change materially existing or use any
new rating methodologies, models or key rating
assumptions that could have an impact on a credit rating will
need to publish the proposed changes or proposed new
methodologies on its website inviting stakeholders to submit
comments during a period of one month together with a
detailed explanation of the reasons for and the implications
of the proposed material changes or proposed new
methodologies. A CRA will need to inform ESMA of errors
detected in methodologies and/or their application.
 Regarding existing ratings: European Rating
Platform
 EU registered and authorised CRAs will have to
communicate to ESMA all credit ratings they issue.
ESMA will make them available to the public on a
central website.
Why did the Commission propose
specific rules for sovereign ratings?
 Sovereign ratings include ratings of countries, regions and
municipalities. Sovereign ratings are very important for the
rated public entity. For instance, the conditions of access to
external funding very much depend on the rating received.
In addition, rating actions with regard to specific countries
can have impacts on companies located in that country, on
other countries and even on the stability of financial
markets. Due to this specific role, it is particularly important
that sovereign ratings are accurate and transparent so that
investors can fully understand rating actions regarding
sovereigns and their wider implications.
Should there be a prohibition of
sovereign debt ratings?

Sovereign debt ratings are important and the implications of such ratings can in some
circumstances be far-reaching. Not only do they affect the borrowing costs of Member
States but they can also have further implications for other Member States and the
financial stability of the Union as a whole. However, a prohibition of sovereign debt
ratings could give the impression that Member States had something to hide and
therefore it is not part of the new rules. A prohibition could have important effects for the
access to capital of some Member States and could increase the borrowing cost for
sovereign debt. The Commission considers that this Regulation improves considerably
the transparency of sovereign ratings and will avoid negative effects of sovereign ratings
which have been observed in recent years and stop risks of market disruption.

To avoid market disruption, rating agencies will set up a calendar indicating when they
will rate Member States. Such ratings will be limited to three per year for unsolicited
sovereign ratings. Derogations remain possible in exceptional circumstances and subject
to appropriate explanations. The ratings will only be published on Fridays after close of
business and at least one hour before the opening of trading venues in the EU.
Furthermore, investors and Member States will be informed of the underlying facts and
assumptions on each rating which will facilitate a better understanding of credit ratings of
Member States.
Will the Commission set up a European
Credit Rating Agency/Foundation?
 The Commission did not propose to set up a European credit
rating agency. This analysis showed that setting up a credit rating
agency with public money would be costly (approximately €300500 million over a period of 5 years), could raise concerns
regarding the CRA’s credibility especially if a publicly funded CRA
would rate the Member States which finance the CRA, and put
private CRAs at a comparative disadvantage. However, as part of
this new framework, the Commission will analyse the situation in
the rating market and report to the European Parliament with
regard to the feasibility of creditworthiness assessments of
sovereign debt of EU Member States, a European credit rating
agency dedicated to assessing the creditworthiness of Member
States' sovereign debt and/or a European Credit Rating
Foundation for all other ratings.
Will there be rules allowing civil claims
against credit rating agencies?
 Ratings are not mere opinions but have important
consequences. Therefore, CRAs should operate
responsibly. The regime does not aim to address
"wrong ratings". Investors will only be able to sue a
credit rating agency which, intentionally or with gross
negligence, infringes the obligations set out in the CRA
Regulation, thereby causing damage to investors. This
new regime will ensure that rating agencies will act
more responsibly as they can be held liable by
investors and issuers.
Will there be a reversal of burden of
proof for civil claims?
 No, the new rules do not include such a reversal.
However the Regulation ensures that the
judge/competent court will need to take into
consideration that the investor or issuer may not have
access to information, which is purely within the sphere
of the CRA. This new regime will ensure that rating
agencies will act more responsibly as they can be held
liable by investors and issuers.
rotation rule - limited to resecuritisations
 A long relationship between a CRA and an issuer could
undermine the independence of a CRA and in view of the
issuer pays model lead to an important conflict of interest
that could affect the quality of these ratings. To this end the
rotation rule limits the duration between a CRA an issuer.
While the Commission proposed a broader scope, the
Regulation limits the rotation rule to re-securitisations. This
can be seen as an important way to test the effectiveness of
the rotation rule. By end 2016, the Commission will report
back to the European Parliament on the effectiveness of the
rotation rule with a view to extending the scope if
appropriate.
new European Rating
Platform
 All ratings for EU registered and authorised rating
agencies will be published on the central European
Rating Platform, at the European Securities and
Markets Authority (ESMA), which will improve the
visibility and comparability of credit ratings from debt
instruments. The Platform will also contribute to the
visibility of small and medium-sized credit rating
agencies operating in the EU.
Is deleting all references to ratings from
EU legislation the best solution, i.e. the
Dodd-Frank Act in the US?
 The Commission supports the view that sole and mechanistic reliance
on the external credit ratings should be reduced. However, it is
important that reducing overreliance on credit ratings does not lead to
legal uncertainty. It would not be appropriate to remove all references
to external ratings without considering alternative credit risk
measures. The experience in the US has shown that it is difficult to
remove references to ratings without having viable alternatives in
place. The credit ratings should be considered as opinions amongst
others. Furthermore, it is important that all financial entities conduct
their own internal credit risk assessment, subject to supervision by the
competent authorities. To this end, the Commission favours a twostep approach. First, the Commission will propose to remove all
references which trigger mechanistic reliance on ratings, and in a
second step, the Commission will report to the European Parliament
on alternatives to external credit ratings with a view to removing all
remaining references by 2020.