The European Parliament recently approved new rules relating to rating by credit rating agencies (“CRAs”) of Member State debt and the financial health of private firms by way of a new Regulation known as CRA III. Although the original EU Regulation on Credit Rating Agencies (the “CRA Regulation”), which has been in place since December 2009, addresses requirements surrounding registration, conduct of business and supervision of rating agencies, it does not regulate the use and market impact of credit ratings.
The revised rules in CRA III, therefore, seek to:
- Reduce over-reliance on credit rating agencies
CRA III requires financial institutions (including UCITS and AIFMs) to strengthen their own credit risk assessment and not rely solely and mechanically on external credit ratings, in the context of their assessment of the creditworthiness of their assets
- Improve the quality of ratings of sovereign debt
Sovereign debt rating will now generally be limited to three ratings per year. Exceptions to this occur where a rating is requested or where a further rating is required for the CRA to comply with its obligations on methodologies, models, assumptions and disclosures. Explanation of the reason for the rating will also be required so as to facilitate a better understanding of the credit rating. Sovereign ratings will also have to be reviewed at least every six months
- Harmonise liability of CRAs across the EU
CRAs will now be more accountable for their actions as ratings are recognised as not being “simple opinions”. The new rules ensure that a CRA can be held liable where it intentionally, or with gross negligence infringes the CRA Regulation, thereby causing damage to an investor
- Reduce conflicts of interest for CRAs and encourage competition
- Requires CRAs to disclose if a shareholder with shareholdings in the CRA in excess of 5% holds 5% or more of a rated entity
- Prohibits a shareholder with shareholdings in the CRA in excess of 10% from holding 10% or more of a rated entity
- Prohibits ownership of 5% or more in more than one CRA (unless it is part of a group)
- Requires the issuers of structured finance instruments to engage at least two different CRAs for rating of instruments and introduces a mandatory rotation rule which will force issuers of structured finance products with underlying re-securitised assets, who pay CRAs for their ratings to switch to a different agency every four years
- Introduces measures to encourage the use of smaller CRAs (by obliging an issuer to consider the possibility of mandating at least one CRA with a 10% or less market share)
- Improve CRAs’ methodologies and processes
Additionally, all ratings will be published on a European Rating Platform thereby improving the ability to compare and have sight of all ratings for any financial instrument rated by CRAs registered and authorised in the EU.
CRA III also calls on the European Commission to prepare a report by 1 July 2016 which reviews the CRA market and, if required, to propose legislative amendments.