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Regulating credit rating agencies

In the wake of the financial crisis, the EU adopted rules on credit rating agencies to restore market confidence and increase investor protection.

Why regulate credit rating agencies?

Credit ratings help investors and lenders to understand the risks associated with a particular investment or financial instrument. However, over-reliance on credit ratings may reduce incentives for investors to develop their own capacity for credit risk assessment.

In the period leading up to the financial crisis in 2008, credit rating agencies (CRAs) failed to properly appreciate the risks in more complex financial instruments. For instance, structured finance products backed by risky sub-prime mortgages were issued with incorrect ratings that were far too high.

During the subsequent euro area debt crisis, certain countries were faced with abrupt bond sell-offs and higher borrowing costs following a downgrade of their credit rating.

Commission measures to strengthen regulatory and supervisory framework

In response, the Commission made proposals to strengthen the regulatory and supervisory framework for CRAs in the EU, to restore market confidence and increase investor protection. The new EU rules were introduced in three consecutive steps.

  • The first set of rules, which entered into force at the end of 2009, established a regulatory framework for CRAs and introduced a regulatory oversight regime, whereby CRAs had to be registered and were supervised by national competent authorities. In addition, CRAs were required to avoid conflicts of interest, and to have sound rating methodologies and transparent rating activities.
  • In 2011, these rules were amended to take into account the creation of the European Securities and Markets Authority (ESMA), which supervised CRAs registered in the EU
  • A further amendment was made in 2013 to reinforce the rules and address weaknesses related to sovereign debt credit ratings

Current regulatory framework

The latest legislative package on CRAs consists of a regulation (Regulation No 462/2013) and a directive (Directive 2013/14/EU). These laws seek to

  • reduce over-reliance on credit ratings
  • increase transparency regarding the issuing of sovereign debt ratings
  • improve the quality of the rating process and make credit rating agencies more accountable for their actions
  • reduce conflicts of interest and encourage a greater number of actors to operate in the credit rating market

International cooperation

Under the CRA regulation, it is possible for a rating agency established outside the EU to have its rating recognised and used for regulatory purposes in the EU. This can happen in one of two ways

  • certification through the equivalence regime
  • endorsement

Equivalence certification

CRAs established and supervised outside the EU that have no presence or affiliation in the EU can be certified under the equivalence regime. The regime applies to CRAs that are not systemically important for the stability or integrity of EU financial markets, and  allows financial entities and instruments established or issued in non-EU countries to be rated.

The European Commission has made a number of equivalence decisions attesting that the regulatory and supervisory regimes of several non-EU countries meet the requirements of the CRA regulation. CRAs established in these countries may apply to the European Securities and Markets Authority (ESMA) for certification. The certification requires a co-operation arrangement to be established between ESMA and the relevant countries' authority.

Endorsement

The endorsement regime applies to CRAs that are affiliated or work closely with EU-registered agencies. It requires agencies established outside the EU to comply with certain legal requirements. These requirements must be as stringent as the ones in the CRA regulation and be subject to effective supervision. This assessment is made by the ESMA, which establishes the list of non-EU countries whose regulatory regimes are as stringent as the EU standards.

You will find more details about this on the ESMA website.

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