Credit Rating and Credit Rating Agencies

1. Credit Rating and Credit Rating Agencies Maddalena Marchesi

2. Credit rating Different definitions IOSCO – Statement of Principles “an opinion regarding creditworthiness of an entity, a credit commitment a debt or debt-like securitiy or an issuer of such obligations, expressed using an established and defined ranking system”; “credit ratings are not recommendations to purchase, sell or hold any security”. International Monetary Fund “A credit rating measures the relative risk that an entity or transaction will fail to meet its financial commitments, such as interest payments and repayment of principal on a timely basis”

3. Credit rating Different definition Credit Rating Reform Act 2006 “an assessment of the creditworthiness of an obligor as an entity or with respect to specific securities or money markets instruments” REGULATION (EC) No 1060/2009 “an opinion regarding the creditworthiness of an entity, a debt or financial obligation, debt security, preferred share or other financial instrument, or of an issuer of such a debt or financial obligation, debt security, preferred share or other financial instrument, issued using an established and defined ranking system of rating categories” “credit ratings are not mere opinions about a value or a price for a financial instrument or a financial obligation”

4. Credit rating Different definitions Credit rating is an opinion measure of the risk of an obligor with respect to a specific financial obligation • S&P and Fitch define risk as the probability of default (PD), whereas Moody’s define it as ‘loss‘, which is the product of PD and the loss rate given default. Categories of rating: 1. issuer rating; 2. issue rating (corporate finance product; structured finance product) 3. sovereign debt rating

5. Cradit rating agencies Credit Rating Reform Act 2006 CRA is “any person: (A) engaged in the business of issuing credit ratings on internet or through another readily accessibile means, for free or for a reasonable fee, but not include a commercial credit reporting company; (B) employing either a quantitative or qualitative model or both to determinate credit ratings; and (C) receiving fees from either issuers, investors or other market participants or a combination thereof” Nationally Recognized Statistical Rating Organization NRSRO is “a credit rating agency that: (A) has been in business as a credit rating agency for at least the 3 consecutive years; (B) issues credit ratings certified by qualified institutional buyers, in accordance with section 15E(a)(1)(B)(ix), with respect to ‘‘(i) financial institutions, brokers, or dealers; ‘‘(ii) insurance companies; ‘‘(iii) corporate issuers; ‘‘(iv) issuers of asset-backed securities (as that term is defined in section 1101(c) of part 229 of title 17, Code of Federal Regulations, as in effect on the date of enactment of this paragraph); ‘‘(v) issuers of government securities, municipal securities, or securities issued by a foreign government; or ‘‘(vi) a combination of one or more categories of obligors described in any of clauses (i) through (v); and ‘‘(C) is registered under section 15E.

6. Cradit rating agencies REGULATION (EC) No 1060/2009 CRA is “a legal person whose occupation includes the issuing of credit ratings on a professional basis”; Credit rating agencies are not mere financial analysts or investment advisors. CRA are defined also GATEKEEPERS: “reputational intermediaries who provide verification and certification services to investors” (Coffee). Ratings are used by many sujects for a variety of reasons. Investors use ratings to determine their investment appetite; Governments require ratings in their financial markets and banking supervision regulation (ie credit ratings have regulatory value for regulated investors, such as credit institutions, insurance companies and other institutional investors); isuuers require rating to acquire reputation (credit rating have reputation value). INFORMATION INTERMEDIARIES “intermediaries who provide information to the markets” Their opinions help overcome the information asymmetry between those issuing debt instruments and those investing in these instruments (credit rating have information value)

7. Cradit rating agencies The most important CRAs are Standard & Poor’s, Moody’s Investors Service and Fitch Ratings They effectively dominate the market, but there are also a number of local and well established agencies in China, Japan and Canada as well as niche rating agencies such as AM Best in insurance in the US. An important and influent non-US based CRA is the Chinese Dagong.

8. Business models The three CRAs operate under the “issuer pays” model:issuers solicit and pay for the ratings of their own debt instruments. Other possible models: • “investor pays” model: credit rating agencies earn fees from users of the rating information, which are consequently released only to those parties who have subscribed to that rating service • "public utility/government" model: it involves transforming the credit rating agency into a public utility and funding it with government revenues

9. Business modelsofCRAs • “payment-upon-resultsmodel”: the performance of credit rating over time could be used to determine the level of fees the credit rating agencies may charge. An important part of the fees could be put into a fund, against which the credit rating agencies could borrow to finance their operations • “trading venues pay” model: trading venues pay for the ratings of their listed companies/instruments. In case of non-listed companies/instruments the "Subscriber/Investor Pays" model could apply

10. The EU regulatoryframework • CRA I:Regulation (EC) No 1060/2009 of 16 September 2009 on credit rating agencies • CRA II: Regulation (EU) No 513/2011 of 11 May 2011 amending Regulation (EC) No 1060/2009 on credit rating agencies (mainly introducing ESMA (CESR before) and penalties for infringements) • CRA III package: Regulation (EU) 462/2013 of 21 May 2013 amending Regulation (EC) No 1060/2009 on credit rating agencies

11. The EU regulatoryframework on CRAs (2/2) • Commission Delegated Regulations (EU): • No 446/2012 of 21 March 2012, with regard to regulatory technical standards (RTS) on the content and format of ratings data periodic reporting to be submitted to ESMA by CRAs • No 447/2012 of 21 March 2012, by laying down RTS for the assessment of compliance of the rating methodologies • No 448/2012 of 21 March 2012, with regard to RTS for the presentation of the information that CRAs shall make available in a central repository (CEREP) established by ESMA • No 449/2012 of 21 March 2012, with regard to RTS on information for registration and certification of CRAs

12. MainContentsof CRA I CRA Iintroducesan effective surveillance regime whereby authorietieswill supervise credit rating agencies as well as rigorous rules to make sure that (i) rating are not affected by conflicts of interest, (ii) credit rating agencies supervise the quality of the rating methodology and the ratings, (iii) rating are tranparent. Regulation (EC) No 1060/2009 of the European Parliament and of the Council requires credit rating agencies to comply with rules of conduct in order to mitigate possible conflicts of interest, and to ensure high quality and sufficient transparency of credit rating and the rating process.

13. MainContentsof CRA I Main obligations of CRAs: • CRAs may not provide advisory services • They will not be allowed to rate financial instruments if they do not have sufficient quality information to base their ratings on • They must disclose the models, methodologies and key assumptions on which they base their ratings • They must differentiate the ratings of more complex products by adding a specific symbol • They will be obliged to publish an annual transparency report • They will have to create an internal control mechanism to review the quality of their ratings • They should have at least two independent directors on their boards whose remuneration cannot depend on the business performance of the rating agency. They will be appointed for a single term of office which can be no longer than five years. They can only be dismissed in case of professional misconduct. At least one of them should be an expert in securitisation and structured finance

14. MainContentsof CRA II CRA IImodifies the complexsurveillance regime, giving responsibilities to the neo insituited ESMA ESMA began exclusively responsible for the registration and supervision of credit rating agencies in the Union. ESMA is responsible for the registration and ongoing supervision of credit rating agencies, but not for the oversight of the users of credit ratings. ESMA acquires regulation powers (ESMA should submit to the Commission draft regulatory technical standards) , information powers (ESMA is able to require, by all necessary information from credit rating agencies) and investigation powers (ESMA is able to conduct investigations and on- site inspections) ESMA isable to impose fines on credit rating agencies, where they have committed, intentionally or negligently, an infringement of Regulation.

15. Open issues • Overreliance: • Large-scale and often automatic use of external ratings amplifieprocyclical effects and has mechanical effects that are all the more negative in times of crisis; selective elimination is required to reduce this overreliance on rating. Issuers of financial instruments should disclose the necessary information for investors in order to make them able to fulfil their own analysis and due diligence based on the essential data and in a well informed manner • Sovereigndebt rating: • The specificities of sovereign debt rating justify enhanced requirements for sovereign debt rating compared to other rating classes. The volatility of rating in periods of market instability raise questions as to these rating and, ultimately, as to the methods underlying them • Confidence in the agencies and in their changes to the rating of Sovereign States generates all the more mistrust among investors towards sovereign issuers, and has negative repercussions in the medium term by limiting the financing capacities of these sovereign issuers and increasing the cost of borrowing for them

16. Open issues • Competition in the CRA industry: • Ratings of large multinational corporations and structured finance products rely only on a small number of agencies, as the rating agency sector is composed of a very limited number of large companies, and the barriers to entry are high. New players might be encouraged to enter the sector via external competition. • Conflictof interest: • The “issuer-pays” model inherently contains conflicts of interest. CRAs have a financial interest in generating business from the issuers that seek the rating, which could lead to assigning higher ratings than warranted in order to increase its revenues from the issuer. A low rating might affect future business. If reputational concerns or regulation are not strong enough to discipline credit rating agencies, the "issuer-pays" model can result in inflated ratings.

17. Open issues • CivilliabilityofCRAs: • The CRA Regulation does not regulate civil liability itself but states in Recital 69 that any claim against credit rating agencies in relation to any infringement of the provisions of this Regulation should be made in accordance with the applicable national law on civil liability. • A specific liability regime for credit rating agencies at EU level would improve legal certainty for investors, prevent forum shopping and have a preventive disciplining effect on credit rating agencies. It should also be noted in this context that the civil liability of credit rating agencies has been recently introduced in the US legal system by the Dodd-Frank Act.

18. Maincontentsof CRA III Two main objectives: • Reducing over - reliance on credit rating; • Enhance transparency and monitoring of sovereign debt ratings • Over reliance: various provisions for simple and institutional investors, for supervisory authorities (national and european), and for regulators to reduce over time over reliance. For example better information underlying the rating would need to be disclosed by CRAs and by the rated entities themselves, so that professional investors will be better informed in order to make their own judgments. “The Union is working towards reviewing, at a first stage, whether any references to credit ratings in Union law trigger or have the potential to trigger sole or mechanistic reliance on such credit ratings and, at a second stage, all references to credit ratings for regulatory purposes with a view to deleting them by 2020, provided that appropriate alternatives to credit risk assessment are identified and implemented”.

19. Maincontentsof CRA III Sovereignratings: Member States would be rated more on a regular basis and investors and Member States would be informed of the underlying facts and assumptions on each rating. To avoid market disruption, sovereign ratings should only be published after the close of financial market, and as scheduled. Othercontents • Civilliability: A CRA should be liable in case it infringes, intentionally or with gross negligence, the CRA Regulation, thereby causing damage to an investor, ora an issuer having relied on the rating that followed such infringement. • Disclosure of information on methodologies: CRAs will have to consult issuers and investors on any intended changes to their rating methodologies. Such changes would have to be communicated to ESMA which would check that applicable rules on form and due process have been respected.

20. Maincontentsof CRA III • Enhancecompetition in rating market: measures to encourage the use of smaller credit rating agencies, seeking credit ratings from two or more credit rating agencies for complex structured finance instruments . Plus regular rotation of credit rating agencies issuing credit ratings on re-securitisations • Independenceof CRAs: the credit rating agency should abstain from issuing credit ratings, or should disclose that the credit rating may be affected, where a shareholder or member holding 10 % of the voting rights of that agency is also a member of the administrative or supervisory board of the rated entity or has invested in the rated entity when the investment reaches a certain size. Furthermore, the fact that a shareholder or member holding at least 5 % of the voting rights of that credit rating agency has invested in the rated entity or is a member of the administrative or supervisory board of the rated entity should be disclosed to the public, at least if the investment reaches a certain size.