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New rules regarding credit rating agencies also have impact on financial institutio

In 2013 new rules came into effect with regard to credit rating agencies. Although this so-called CRA 3 Regulation is primarily aimed at credit rating agencies, a number of rules also apply to users of ratings (such as banks, insurers and money market funds) and to issuers of structured products and securitisation products.

It is important for these ratings users and issuers to take timely measures to comply with these stricter rules.

 

Background CRA regulation

Credit rating agencies have been under fire since the start of the financial crisis. This is partially due to the fact that they gave ratings to collateralised sets of mortgage credits that were retrospectively far too high. Credit rating agencies have been accused of having listened too much to large issuers, more often than not banks, who bought high and retrospectively incorrect ratings from the rating agencies.

In reaction to the role of credit rating agencies before and during the financial crisis regulators have decided worldwide to bring these parties under supervision from now on. The European Union made the choice to, as from 2010, impose a pan European registration duty to rating agencies working in the EU. Besides, the word registration is somewhat misleading, because there is a de facto very heavy registration duty. At this moment approximately 24 rating agencies have such a registration, including major players such as S&P, Moody’s and Fitch, alongside some local parties form Bulgaria and Cyprus, for instance. Within the EU the rating agencies are supervised by the European supervisor ESMA.

The European Regulation 1060/2009 is the basis for the supervision on credit rating agencies within the EU. Two of the stipulations of this Regulation were aimed at other parties rather than the rating agencies themselves. In Article 4 of the Regulations it was determined that users of ratings who used these ratings for regulatory purposes, for instance the calculation of the capital tie-up by banks, could only use ratings for this purpose that were issued by rating agencies registered within the EU. In addition, in the same article it was determined that issuing institutions were obliged, when referring to a rating in their prospectus, to indicate whether this was issued by a rating agency within the EU.

In 2011 the regulations with regard to credit rating agencies were adapted partially by means of a new Regulation, without further implications for users of ratings and issuing institutions.

As of 20 June 2013 the European Regulation applicable to credit rating agencies that operate within the EU has been tightened up. Under this so-called CRA 3 Regulation rating agencies can be held responsible if due to gross negligence damage is suffered by ratings users. Furthermore, the rules for controlling conflicts of interest have been expanded and rating agencies must keep to more stringent rules when issuing country ratings. In addition, the rules for users of ratings and issuing institutions have been extended.

 

New rules for ratings users

Many financial enterprises use ratings. Banks that use the so-called standard model when calculating the capital requirements that apply to them use for instance, ratings to determine the risk weight of unpaid credits. However, insurers and asset managers for instance also use ratings, for regulation purposes or otherwise.

The CRA 2 Regulation now stipulates explicitly that financial enterprises cannot exclusively or mechanically rely on ratings with regard to the credit worthiness of an entity or financial instrument. On account of the CRA 3 Regulation banks and other users of ratings are explicitly liable to make their own risk evaluation, complementary to the used ratings, of the enterprise, authority or product in question. This stipulation will be incorporated further, for instance in CRD IV.

Due to this reinforcement under CRA3 banks and other financial enterprises that are reliant on ratings, for instance when determining the capital demands on unpaid credits or when making investment decisions, are considered to extend their own risk evaluation. How they do this is up to them, as long as they can prove not to have used ratings indiscriminately and as long as the use of external rating has become less important. Users of rating have to decide for themselves how to fill in this own responsibility. In the Netherlands DNB and AFM will monitor this.

 

New rules for issuing institutions

Under CRA 3 the responsibilities for issuing institutions with regard to ratings have also been extended. This applies especially to institutions that issue structured products and for institutions that issue securitised products. Both types of products are issued by banks in particular, but also often by other financial enterprises.

 

Reinforced rules structured products

Under CRA 3 issuing institutions of structured products that choose to have their issued product rated are henceforth obliged to request and use ratings from at least two rating agencies. In addition the two rating agencies must work independently from each other and not be part of the same group.

In addition, at least one of the two rating agencies to be used, must have a market share of no more than 10%, based on an annual list of market shares drawn up by ESMA. This stipulation has large impact in practice, because the market for ratings of structured products was until recently, almost entirely divided among S&P, Moody’s and Fitch. As all three rating agencies have a market share of more than 10%, from June 2013 issuing institutions of structured products may only select one of those three parties and, moreover, have to take on another, much smaller and lesser known rating agency.

Parties that issue structured products must draw up a procedure which describes how they select the two compulsory rating agencies and which guarantees that one of these agencies has a market share of less than 10% in the issuing of such ratings. It is advisable to start looking for these small rating agencies well in advance, since the number of these parties is very limited. On ESMA’s website you can find an overview of credit rating agencies registered in the EU.

Furthermore, parties that issue structured products must put information of these products on a website set up by ESMA, probably sometime in 2014. The purpose of this is to diminish the investors’ dependency on ratings. The information to be published concerns amongst other things data regarding the credit quality and performance of the underlying assets of the structured financing instrument. Currently ESMA is still working on the development of a template to provide ESMA with the information needed. Besides, it is not known yet if the information duty will only apply to new issues or also to structured products that have already been issued.

As soon as the aforementioned website and obligation to provide information to ESMA comes into force issuing institutions of structured products must have procedures at their disposal to guarantee that the information that has to be given to ESMA concerning the structured products is accurate and complete and is submitted to ESMA on time.

 

Securitisations

With regard to securitised products, CRA 3 has a stipulation that the three large rating agencies (S&P, Moody’s and Fitch) are only permitted to issue ratings of securitisations to one and the same party for a maximum period of four years. Consequently, an issuing institution has to start searching for other rating agencies in order to be able to have assets rated that need to be securitised longer than that. Moreover, the further application of this rotational principle to cover other instruments yet to be issued is currently under consideration.

Since the term of four years only started on 20 June 2013 market parties that have securitised products regularly do not have to take any measures in the short term. Assuming that the majority of securitised products are currently rated by one of the three large raging agencies this does mean that the rotation of the rating agencies used must take place in 2017 at the latest. This already needs to be set down in future agreements.

Charco & Dique
If you want to know more about this subject or about drawing up, adapting and implementing policy in the compliance field regarding the stipulations of CRA 3, Charco & Dique can help you.

For more information on this subject please contact Charco & Dique on: 020-4165403 or e-mail to: info@charcoendique.nl