New statutory basis

In reaction to the financial crisis, the EU Credit Rating Agencies Regulation laid the foundations in 2010 for government supervision of credit rating agencies. The EU thus followed the lead of the United States, which had been the first key financial centre to establish a substantial regulatory framework governing the activities of rating agencies, as early as in 2006.

All entities which issue credit ratings throughout the EU are now subject to registration. Prior to registration, the rating agencies must submit to a comprehensive review and approval process. Once they have successfully completed this process, they may commence their activities, which are subject to ongoing supervision by ESMA.

Usable ratings

Pursuant to the EU Credit Rating Agencies Regulation, key market players may only use ratings for regulatory purposes from rating agencies which are registered with ESMA or which, in lieu of registration, are certified third-country agencies. Moreover, ratings issued by rating agencies in third countries may also be used if they have been endorsed by a registered rating agency pursuant to the endorsement mechanism set forth in the EU Credit Rating Agencies Regulation.

A credit rating within the meaning of the Regulation is an opinion regarding the creditworthiness of an entity, a debt or financial obligation, debt security, preferred share or other financial instrument, or of an issuer of such a debt or financial obligation, debt security, preferred share or other financial instrument, issued using an established and defined ranking system of rating categories (such as the widely used rating scales from AAA to D). The EU Credit Rating Agencies Regulation does not govern, inter alia, private ratings (which are provided only to the client), recommendations within the meaning of the Market Abuse Directive (MAD) and investment research within the meaning of the Markets in Financial Instruments Directive (MiFID) or credit scores.

Provisions regarding organisation, presentation and transparency

The EU Credit Rating Agencies Regulation contains comprehensive provisions relating to the internal organisation of rating agencies intended to avoid or mitigate potential conflicts of interest and to ensure the highest possible quality of the ratings. In addition, it contains a large number of presentation and transparency provisions intended to make it possible for rating users to better understand the bases for and significance of a rating. Pursuant to the Regulation, “the rating agencies should use rating methodologies that are rigorous, systematic, continuous and subject to validation including by appropriate historical experience and back-testing”.

At the same time, the legislation states that ESMA as the competent supervisory authority may not interfere with the content of credit ratings or methodologies. While there is a certain contradiction in the provisions named above, it is clear that ESMA only has the authority to control rating methodologies within extremely narrow bounds.

ESMA: the competent supervisory authority for the EU

Under the original draft of the EU Credit Rating Agencies Regulation, rating agencies were subject to supervision by the national regulatory and supervisory authorities, which cooperated with each other in supervisory colleges. ESMA and its predecessor, the Committee of European Securities Regulators (CESR), only performed a supporting function.

In the first amending Regulation (Credit Rating Agency Regulation II – CRA II), the European legislators bundled the competence for EU-wide supervision with ESMA and granted it comprehensive executive authority accordingly. In practice, this means that upon the completion of the final registration procedures in October 2011, which had been begun by the supervisory colleges, all supervisory authority over rating agencies was transferred to ESMA, and since then it has been solely responsible for the application of the EU Credit Rating Agencies Regulation. The cooperation of the national regulators and supervisors such as BaFin is now focused on collaboration in the relevant ESMA Technical Committee which develops guidelines and recommendations, as well as regulatory and implementing technical standards, which are adopted by either ESMA itself or by the European Commission with the involvement of the European Parliament and the Council. It is also focused on cooperation with resolutions and decision-making by the Board of Supervisors, ESMA's main decision-making body. It is the Board of Supervisors which passes final resolutions relating to the activities of ESMA and the measures it implements, such as whether sanctions are imposed on entities subject to its supervision.

The Rating Agencies unit at ESMA's secretariat in Paris, which currently employs a staff of just under 20, is responsible for performing the entirety of the practical supervisory work, including on-site inspections of rating agencies. However, the EU Credit Rating Agencies Regulation grants ESMA the option to delegate, under certain circumstances, individual supervisory activities back to national supervisory authorities, although ESMA bears ultimate responsibility for all measures initiated.

ESMA's activities since transfer of authority

To date, 33 registrations have been issued to 19 firms and one certification process has been completed throughout the EU. In addition to the “Big Three” (Fitch, Moody’s, Standard & Poor's), there have also been many smaller and medium-sized agencies which have received registration or a certification. The list of these rating agencies can be viewed at ESMA's website. There is also a detailed Activity Report of ESMA's Rating Agencies unit for the 2011/12 year as well as the 2013 Work Plan.

Before and shortly after assuming its supervisory authority, ESMA made a large number of fundamental decisions regarding the interpretation of the EU Credit Rating Agencies Regulation. It also reviewed a host of third-country rating agencies legislation for comparability with the Regulation for the certification procedure, and signed several memoranda of understanding with third-country supervisory authorities.

Difficulty differentiating between ratings and scores

At present, ESMA is faced with the task of searching the market for providers of credit assessments which have thus far not submitted registrations but are obliged to do so pursuant to the Regulation. This is because it has proven difficult in practice in particular to differentiate between credit ratings and credit scores, which is essential to the existence of the registration requirement, due to the lack of clear statutory provisions. Certain market participants have thus far failed to recognise that their activities fall under the scope of the EU Credit Rating Agencies Regulation.

The transfer of supervisory authority to the new agency ESMA took place under circumstances which were all but ordinary: it was right at the time when the ratings of a large number of European sovereigns were downgraded. While the secretariat still had to be set up at ESMA – from the executive level down to the lowest ranks – there were already a large number of measures which had to be implemented and which often stood at the focus of public interest.

Outlook

The flurry of activity on the part of legislators in Brussels also has not left ESMA or the rating agencies much time to catch their breath. Though the new EU Credit Rating Agencies Regulation only entered into force in 2010, a second amended version (CRA III) is already in the pipeline. It, too, will bring a host of new provisions for the rating agencies, and thus also new supervisory responsibilities for ESMA.

CRA III is aimed at blunting to the greatest extent possible references to external ratings – particularly in supervisory frameworks. In addition, the opportunities of holding a financial interest in rating agencies will be subject to limitations in order to
avoid conflicts of interest. Moreover, the planned amendments will stipulate that certain engagements of the rating agencies must rotate within given periods, will set out special provisions for sovereign ratings and will introduce a European rating platform and civil-law liability rules.

The negotiations between the European Commission, European Council and European Parliament (trialogue) were concluded in early December 2012. If the European Parliament passes CRA III, the new Regulation is likely to enter into force in the summer of 2013.