CRA3 Regulations: Twin ratings to be mandatory for structured finance instruments

August 10, 2013:

Recently the European Regulations on Credit Rating Agencies ("CRA3")[1] came into force in June, 2013. Ideally as the name suggests at the first go, it appears that the regulation will be applicable only to Credit Rating Agencies ("CRAs"). However it not only amends the European regulatory framework for CRAs, but also has a dual effect on the issuers, originators and sponsors.

Prior to CRA3 the framework that governed the CRA was the CRA Regulation (EU) No 462/2013[2].

Highlights of CRA Regulations:

Credit rating agencies should, on a voluntary basis, apply the Code of Conduct Fundamentals for credit rating agencies issued by the International Organisation of Securities Commissions (IOSCO Code)

Appropriate rotation mechanism which should provide for a gradual change in analytical teams and credit rating committees.

Requirements in relation to the conduct of business of CRAs, including measures intended to avoid conflicts of interest, to ensure the quality of credit ratings and rating methodologies and to ensure transparency

Requirements for CRAs established in the European Community to be registered

A credit rating agency should indicate any appropriate risk warning, including a sensitivity analysis of the relevant assumptions.

Supervision of CRAs in the EU by the European Securities and Markets Authority ("ESMA")

Moving from CRA Regulations to CRA3 Framework

The CRA Regulations did have solutions for problems such as, the same CRA providing continuous rating to the same issuers; wherein the concept of rotational mechanism came into picture. Along with this, proper disclosures and information transmission to the investor were also taken into consideration. However to incorporate a sound credit rating processes and methodologies also to reduce the risk involved; CRA Regulations were amended.

The amended CRA Regulations is now known as CRA3 the reason being; lack of transparency, over-reliance on credit ratings, conflicts of interest, limited liability of CRAs in relation to the credit ratings they have issued, disclosure for structured finance instruments etc.

 

Highlights of CRA3:

To start off with, the CRA3 has inserted few additional definitions for the better understanding along with its proper implementations. This includes definitions of

"Credit Institution" means a credit institution as defined in point (1) of Article 4 of Directive 2006/48/EC[1]; means an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account; or  an electronic money institution within the meaning of Directive 2000/46/EC[2];

"Credit Score" means a measure of creditworthiness derived from summarizing and expressing data based only on a pre-established statistical system or model, without any additional substantial rating-specific analytical input from a rating analyst;

"Issuer" means an issuer as defined in Article 2(1)(h) of Directive 2003/71/EC[3]; means a legal entity which issues or proposes to issue securities;

"Originator" means an originator as defined in point (41) of Article 4 of Directive 2006/48/EC[4]; means either of the following:

• an entity which, either itself or through related entities, directly or indirectly, was involved in the original agreement which created the obligations or potential obligations of the debtor or potential debtor giving rise to the exposure being securitized; or

• an entity which purchases a third party's exposures onto its balance sheet and then securitises them;

"Sponsor" means a sponsor as defined in point (42) of Article 4 of Directive 2006/48/EC[1]; means a credit institution other than an originator credit institution that establishes and manages an asset backed commercial paper programme or other securitisation scheme that purchases exposures from third party entities. 

Over-reliance on credit ratings by financial institutions

In order to reduce the sole reliability on the CRA, the CRA3 has initiated that the Financial Institutes such Credit institutions, investment firms, insurance undertakings, reinsurance undertakings, institutions for occupational retirement provision, management companies, investment companies, alternative investment fund managers and central counterparties should have their own credit risk assessment and shall not solely rely on other CRA. This shall be a dual risk assessment for the creditworthiness of any entity or financial instrument. The probability of any error shall be reduced. 

Conflicts of interest concerning investments in credit rating agencies

A shareholder or a member of a credit rating agency holding at least 5% of either the capital or the voting rights in that credit rating agency or in a company which has the power to exercise control or a dominant influence over that credit rating agency, shall be prohibited from:

1. a.       holding 5% or more of the capital of any other credit rating agency;

   b.      having the right or the power to exercise 5% or more of the voting rights in any other credit rating agency;

   c.       having the right or the power to appoint or remove members of the administrative or supervisory board of any other credit rating agency;

   d.      being a member of the administrative or supervisory board of any other credit rating agency;

   e.       exercising or having the power to exercise control or a dominant influence over any other credit rating agency.

This shall help to curb down the conflicts of interest between 2 CRAs and shall lead to a reliable ratings for other companies. 

Maximum duration of the contractual relationship with a single CRA

As said earlier, the CRA Regulations did have the rotational mechanism for the CRA; however the CRA3 has laid down provision for credit rating of re-securitisations. Under this credit ratings on re-securitisations with underlying assets from the same originator shall not exceed a period of four years. 

Upon the expiry of the contract, a CRA shall not enter into a new contract for the issuing of credit ratings on re-securitisations with underlying assets from the same originator for a period equal to the duration of the expired contract but not exceeding four years. 

Twin ratings to be mandatory for structured finance instruments

Due to increasing complexity of the structured finance instruments, CRA have not always succeeded in providing accurate ratings. This has resulted into loss of confidence along with monetary loss to the investors. Hence to overcome this problem the CRA3 has directed that where an issuer or a related third party intends to solicit a credit rating of a structured finance instrument, it shall appoint at least two credit rating agencies to provide credit ratings independently of each other. Conditions for the same shall be as below.

1. a.       they do not belong to the same group of credit rating agencies;

   b.      they are not a shareholder or a member of any of the other credit rating agencies;

   c.       they do not have the right or the power to exercise voting rights in any of the other credit rating agencies;

   d.      they do not have the right or the power to appoint or remove members of the administrative or supervisory board of any of the other credit rating agencies;

   e.       none of the members of their administrative or supervisory boards are a member of the administrative or supervisory boards of any of the other credit rating agencies;

   f.        they do not exercise, or have the power to exercise, control or a dominant influence over any of the other credit rating agencies.

Use of multiple credit rating agencies

Where an issuer or a related third party intends to appoint at least two credit rating agencies for the credit rating of the same issuance or entity, the issuer or a related third party shall consider appointing at least one credit rating agency with no more than 10% of the total market share, which can be evaluated by the issuer or a related third party as capable of rating the relevant issuance or entity, provided that, based on ESMA's list referred to in paragraph 2, there is a credit rating agency available for rating the specific issuance or entity. Where the issuer or a related third party does not appoint at least one credit rating agency with no more than 10% of the total market share, this shall be documented.

Joint Disclosures

CRA3 emphasis on the fact that, the CRA, the issuer, the originator and the sponsor shall provide information of the happening on their website set up by European Securities and Markets Authority (ESMA). However to publish information shall not extend to where such publication would breach national or Union law governing the protection of confidentiality of information sources or the processing of personal data.

As the whole concept of the ratings is to give a true picture to the investor, this initiative of Joint Disclosure would help the general public to enhance their investing options.

• credit/risk ratings department in order to avoid reliance on other CRA.
• As the competition in the market seems to be increasing day by day encouragement to the small CRAs should be the hour of the need.
• Though the concept of frequent rotation of the CRA is a positive move, however this shouldn't result into any complications or increase in the cost to the issuer.
• For a better transparency the CRAs should maintain proper records of the projects undertaken.
• Investors, issuers and other interested parties should have access to up-to-date rating information on a central website.
• It is to be noted that from now onwards any manipulative rating from the CRA intentionally done, shall be liable to civil liability.
• The current rules provide for credit ratings to be announced to the rated entity 12 hours before their publication. In order to avoid such notification taking place outside working hours and to leave the rated entity sufficient time to verify the correctness of data underlying the credit rating, the rated entity should be notified a full working day before publication of the credit rating or of a rating outlook. A list of the persons entitled to receive such notification should be limited and should be clearly identified by the rated entity.

Scope

Now that we have gone through the highlights of the CRA3 and as per the fact that European Regulation on Credit Rating Agencies (CRA3) has a binding effect on the Issuers, Originators and Sponsors, it gives us a clear picture that the scope of CRA3 is not limited only to the CRAs but also has a simultaneous effects on the additional requirements that the Issuers, Originators and Sponsors has to comply with.

Date of Applicability

As per the European Union, this Regulation shall enter into force on the twentieth day following that of its publication in the Official Journal of the European Union. Since this Regulation was published on 21 May 2013, it has already been considered as a Regulation with effect from 10^th June, 2013.

Conclusion

With the lawmakers trying to tighten regulations day by day, Issuers, sponsors and originators along with the CRAs will have to be cautious when it comes to credit ratings. Right from the joint disclosure to the fact that the even the small CRAs needs to be promoted along with the additional requirements, the regulators have put Issuers, sponsors, originators and the CRAs at par. Any leniency from either of the sides shall attract heavy penalties. From an investor’s point of view 'they believe what they see', so any deviation/wrong rating shall cost all the four parties mentioned above their reputation.

 

 

 

 

[Reported by: Pooja Rawal]