Sunday, March 25, 2012

Credit Rating Agency Regulation

Credit Rating Agency (CRA) regulation is back in the news:

  • “According to European and UK regulators, forcing issuers to rotate the agencies that rate their bonds could do more harm than good by opening the door to lower quality ratings by inexperienced analysts.” (FT on 29 February 2012)
  • “The three big credit rating agencies must improve their transparency, IT and internal controls and strengthen the committees that oversee decisions on individual securities.” (FT on 22 March 2012)

Regarding the ongoing discussion on CRA regulation, I would like to share with you the major findings of an article that I read recently in the Journal of Finance. The authors Bolton, Freixas, and Shapiro develop an interesting model to analyze the effects of specific (CRA) regulation on the industry as such and the reliability of ratings in particular.

Their main findings are:

  • The competition among CRAs may reduce market efficiency since it facilitates ratings shopping by issuers and results in excessively high reported ratings. In particular, as a result of issuer shopping, efficiency may be higher under a monopoly CRA than under a duopoly despite the potential for the increased informativeness of two ratings.
  • CRAs are more prone to inflate ratings during booms when there is a larger clientele of investors in the market who take ratings at face value and when the risks of failure that could damage CRA reputation are lower. In other words, when times are good, the probability of defaults is lower, which may decrease due diligence on the part of investors as well as evidence of ratings bias.
  • When an issuer is more important to a CRA, either because it is a repeat issuer or because it has larger issues, the CRA is more prone to inflate that issuer's ratings.

In the authors' view, CRA regulation should address the following key issues:

  • Eliminate the CRA conflicts of interest by preventing issuers from influencing ratings
  • Prevent issuers from shopping for ratings and disclosing only those ratings they prefer
  • Monitor the quality of the ratings methodology

As a reminder, the current European CRA regulation may be summarized as follows:


The overall purpose of European CRA regulation is to enhance the integrity, transparency, responsibility, good governance, and reliability of credit rating activities.

Use of credit ratings for regulatory purposes

Where European legislation requires a credit rating to be obtained for a specific investment, such rating must comply with one of the following alternatives:

  • The CRA is registered with the European Securities and Markets Authority (ESMA) and the rating is issued in the EU.
  • The CRA is registered with ESMA and the rating, that has been issued outside the EU, is in line with specific endorsement conditions such as material compliance with European CRA regulation and the existence of an objective reason for the credit rating to be elaborated in a third country.
  • The CRA is not registered with ESMA, the rating, that has been issued outside the EU, opines on a non EU investment, and the foreign CRA regulation is comparable to European CRA regulation.

It should be noted that the registration process with ESMA is described in detail by the European regulation 2009-1060.

Independence and avoidance of conflicts of interest

The European regulation 2009-1060 contains very detailed provisions in this regard that apply to the rating agency as such as well as its rating analysts.

Credit Ratings

The credit ratings issued must ensure compliance with two major sets of conditions:

  • First, they must be developed on the basis of methodologies, models, and key assumptions that respect the framework set by European CRA regulation.
  • Second, credit rating must be disclosed to the general public.

Supervision by ESMA

The supervision by ESMA is a continuing process that includes the elaboration of an annual report, the right to request information, the right to lead general investigations, and the right to carry out on-site inspections.

Penalties and Fines

A detailed set of rules, including penalties and fines, ensure that European CRA regulation shall be effectively applied in practice.

On November 15, 2011, the European Commission has proposed to further refine the current CRA regulation as follows:

  • Necessary notification of stakeholders (including ESMA) prior to changing rating methodologies (Art. 5 a)
  • Ownership structure of CRA: The same investor cannot hold more that 5 % in two or more CRA simultaneously. (Art. 6 a)
  • Except for sovereign ratings, mandatory rotation of CRA after one year and 10 consecutive ratings or, at least, after 3 years. (Art. 6 b)
  • Transfer of relevant information in a handover file upon mandatory rotation (Art. 6 a)
  • Necessity to get a structured finance instrument rated by at least two independent CRA. (Art. 8 b)
  • Publication of all ratings in form of a centralized European Rating Index (EURIX) (Art. 11 a)
  • Development of common standards for rating scales (Art. 21 (4a))
  • Civil liability of CRA towards investors in case of intentional or gross negligent violation of European CRA regulation (Art. 35 a)


  • Bolton, Freixas, Shapiro: The Credit Ratings Game in Journal of Finance 2012, pages 85 et seq.
  • EC Regulation 2009-1060 of 16 September 2009, lastly amended on 1 July 2011
  • European Commission Proposal of a Regulation amending EC Regulation 2009-1060 (published on 15 November 2011)