The CRA III Regulation and accompanying Directive were published in the Official Journal of the EU on 31 May 2013. The legislative package supplements and reinforces the regulatory framework for credit rating agencies (CRAs) within the European Union. The general objective of the proposal is to contribute to reducing the risks to financial stability and restoring the confidence of investors and other market participants in financial markets and ratings quality.
The main aims of these rules are:
-reducing over-reliance on credit ratings;
-in the context of the sovereign debt crisis, improving the quality of ratings of sovereign debt of EU Member States;
-reinforcing independence of credit rating agencies and reducing conflicts of interest (in particular due to the “issuer pays” remuneration model);
-reducing concentration of the CRAs market;
-improving transparency of ratings and ratings methodologies; and
-providing for civil liability of CRAs when acting in breach of European regulations.
The Directive - Directive 2013/14/EU
The Directive introduces amendments to the UCITS IV Directive (2009/65/EC) and the Alternative Investment Fund Managers Directive (2011/61/EU) preventing managers of UCITS assets or AIFs from solely or mechanistically relying on external credit ratings for risk management purposes. An effect of the financial crisis has been that there is over-reliance by investors, including IORPs, UCITS, and alternative investment funds (AIFs), on credit ratings to carry out their investments in debt instruments, without necessarily conducting their own assessments of the credit worthiness of issuers of such debt instruments.
The Directive also empowers the Commission to further specify this principle in delegated acts.
Similar measures have been included in the Capital requirements Directive IV (CRD IV) requiring banks with material credit risk exposures to develop and use their own internal risk models rather than relying solely on ratings from CRAs.
The Regulation - Regulation (EU) 462/2013
The new Regulation amends existing rules as regards credit rating agencies and contains the principal proposals set out by the Commission. The principal ways by which the new Regulation will improve the independence of credit rating agencies are:
-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.
-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 (cross-shareholding).
-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.
-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.
-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).
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.
ESMA is required to 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.
Regulation (EU) 462/2013 came into force 20 June 2013.