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Gatekeepers: rating agencies

Gatekeepers: rating agencies. Paola Lucantoni. Outline. Features Background to gatekeeper regulation The EU regime – CRA Regulation I-III Scope/registration Examples of regulation Supervision by ESMA International reach Importance of institutional design

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Gatekeepers: rating agencies

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  1. Gatekeepers: rating agencies Paola Lucantoni

  2. Outline • Features • Background to gatekeeper regulation • The EU regime – CRA Regulation I-III • Scope/registration • Examples of regulation • Supervision by ESMA • International reach • Importance of institutional design • Regulatory governance + institutional governance • Main actor: ESMA • *NB: first example of centralized EU supervision • Compare prospectus regime • Regulatory governance • PD A6 on liability + some harmonization of powers of national competent authorities

  3. Outline • CRA regime is firm-focused (compare prospectus) • Authorization; conduct; organizational rules… • CRA regime contains distinct regime for international (third country) actors • Why? • Compare prospectus regime • Limited third country regime based on equivalence – but very under-developed • CRA regime is relatively new (compare prospectus) • Crisis-based

  4. What is a Gatekeeper? • What is a ‘gatekeeper’? • Verification, evaluation, certification services: vouching for issuers/disclosure/transactions • Repeat players • Link to seminar 3? • Types of gatekeeper? • Examples?

  5. What is a Gatekeeper? • Why are gatekeepers important for capital market efficiency? • Signalling credibility (equity markets - cost of capital) • Recall disclosure rationale • Risk management (credit markets – ‘risk weighted assets’) • The ‘enrolment’ of gatekeepers • What does this mean? • How does it fit with pre-crisis regulatory mood

  6. What is a Gatekeeper? • How does a gatekeeper establish credibility? • What asset does it ‘lend’? • ‘Reputational capital’? • Why is ‘reputational risk’ key to gatekeeper credibility? • Incentives for gatekeeper to monitor etc • What risks threaten the reputational incentive? • Weakening deterrents • Enforcement limitations • Declining value of reputation and poor investor monitoring/understanding • Bubbles…

  7. What is a Gatekeeper? • * Conflicts of interest • Enron-era (auditors and analysts) • Crisis-era (credit rating agencies) • Conflict of interest risk common to both • Note: our first major example of conflict-of-interest driven regulation in EU

  8. The EU Regime • CRA regime • 2009 (CRA I), 2011 (CRA II), 2013 (CRA III) • Regulation-based • Not a directive - implications • Detailed level 1 Regulations + technical/delegated level 2 rules • Central role for ESMA: • Rule production/technical advice + • Supervision + enforcement • Financial stability driven (compare prospectus) • Crisis-driven • Political economy? • Highly contested

  9. The EU Regime • Compare: Investment analyst regime • Originally: MiFID I (2004), and Market Abuse Directive I (2003) • Contained in related level 2 rules • Heavily disclosure based • Enron-era effect, including concern to protect EU’s competitive position v US • Minor reforms under MiFID II 2014/Market Abuse Regulation 2014 • Investor protection/market efficiency driven • Political economy • Relatively uncontroversial

  10. CRAs: Function • What do CRAs do? • Bonds (fixed income) • Issue ‘ratings’ on creditworthiness/likelihood of default • An opinion on credit risk – on ‘ability and willingness of an issuer…to meet its financial obligations in full and on time’; ‘not absolute measures of default probability’ (S & P) • Based on proprietary methodologies (S &P: AAA (extremely strong capacity to meet financial commitments) - D (default/bankruptcy petition) • Allow assessment of relative risk through standardized indicators

  11. CRAs: Function • A driver of capital market efficiency; and ‘hardwired’ into the regulatory system? • How? • Regulation (ex: capital rules) • Private ordering (contracts/loans – ratings as triggers for events) • ‘Quasi-regulatory’ power

  12. CRAs: the Risks • Long recognized as a source of risk (pre-crisis) • ‘Issuer pays’ model • Incentive difficulties • Competition/market structure problems • Three major CRAs • Moody’s; S & P; Fitch • High barriers to entry/acquisition of reputational capital • Liability not a strong deterrent (pre crisis) • Working model based on ‘opinion’ - not verification • Quality/competence and conflict of interest risks • Enron-era failures

  13. CRAs: the Risks • Increased given ‘hard-wiring’ within the regulatory system • Linked to capital requirements • Heavy dependence by market • Strong herding effects • Weaker internal risk management as a result

  14. CRAs: Initial Intervention • The emerging response prior to the financial crisis • The importance of self regulation (why?) • Historical antecedents – emerge as a market fix • The railways…. • The 2004 IOSCO Code • Quality and integrity of rating process; independence of CRAs and avoidance of conflicts of interest; responsibilities to investing public and issuers • EX: the CRA should separate, operationally and legally, its credit-rating business and analysts from any other business of the CRA, including consulting businesses, that may present a conflict of interest (Code, 2.5). • Based on ‘comply or explain’

  15. CRAs: the Financial Crisis • The Crisis (‘The Big Short’) • ‘Originate and Distribute’ model for loans (linked to ‘search for yield’; burgeoning financial innovation) • Debt (such as mortgage debt, personal loans, corporate debt) pooled and ‘repackaged’ and issued in the form of ‘structured finance’ products/bonds (based on the original debt and its income flows) issued by a structured finance vehicle • Asset-backed securities • Organized, arranged/structured/distributed by banks/investment banks • Ratings reflect relative risk (higher the rating, the lower the interest rate); and these ratings depended on the ratings of the assets (loans) in the repackaged pool, as well on priority of the product in case of default

  16. CRAs: the Financial Crisis • But problems in the process • The destabilizing of the gatekeeper function by structured finance (SF) • Rating dependence • The structured product; but also the ratings of the loans on which the product was based • Q to CRA: ‘what rating might this product get’? Rather than ‘what is the rating of this product’ • Value and size of SF business creates pressure on the CRA sector • Ex: 50% of EU CRA revenue from SF in 2008 • Concentration of incentive pressures given key role of small number of banks in SF business • → Conflict of interest risk heightened • Closer engagement with clients/investment banks and stronger pressure; SF products being ‘ratings-driven’; concentration of revenues among 5/6 investment banks and related influence of these clients

  17. CRAs: the Financial Crisis • In addition…. • Competence and reliability • Poor due diligence and model failures • Very limited investor monitoring • ‘overwhelming reliance’ by investors (IOSCO, 2008) • ‘self-reinforcing cycle of irrational exuberance’ (FSA, 2009) • Difficulties with the AAA rating label

  18. CRAs: the Financial Crisis • Failure of Ratings • Failure in US subprime mortgage market. Between 1 July 2007 and 24 June 2008: 145,899 downgrades of structured finance instruments (1,455 corporate downgrades) • Major systemic failure in the ratings process • Leads to knock-on effects given scale of holdings by major banks in of downgraded products, and consequent effects on capital • The initial reaction • Crisis linked to CRAs (the ‘early villains’) • Conflict of interest failures; competence failures; communication failures • But the risks of immediate intervention?

  19. CRAs: the Response • International momentum • Financial Stability Forum (now Board)(April 2008) • IOSCO revisions to the Code (May 2008) • Prohibition on ‘opinions and recommendations’ concerning S.F. • Methodologies to be assessed • Different ‘labels’ for SF ratings • Assist investors in understanding limitations of ratings G20 support for reform • Industry reaction (the threat of intervention dynamic)

  20. CRAs: the initial EU response • Significant change in EU position from ‘private sector’ /light-touch approach • Early moves reflect Enron-era and the 2003 Parmalat scandal • Post FSAP: ‘regulatory pause’ • 2006 Commission Communication on CRAs • Support for the IOSCO Code – industry agrees to monitoring by ‘CESR’ (the precursor to ESMA) (voluntary model) • ‘Threat of intervention’ approach • 2006 CESR reported on generally widespread compliance; self regulation working reasonably well • Initially, CESR not concerned about structured finance segment and was hostile to legislative action • Ex: little support for the registration model adopted by the US in 2006

  21. CRAs: the EU and the Financial Crisis • Political tensions emerge over crisis: • ECOFIN ‘roadmap’ October 2007 - France and Germany seek intervention • European Securities Markets Expert Group, advisory report (May 2008) • Hostile to regulation • But…‘chronic lack of private sector discipline and competence’ Commissioner McCreevy, September 2008 • ‘Some say it is intrusive, but it is a regulatory approach designed to restore confidence in the ratings process….No other jurisdiction in the world has demanded such changes…..we will be encouraging the other leading capital markets in the world to adopt a similar approach to us.’ Commissioner McCreevy, December 1 2008. • International incentives

  22. CRAs: A Three Step Reform • CRA I (2009) • Speedy adoption (November 2008-April 2009) • First major crisis-era measure • Rejection of IOSCO Code, and designed to respond to G20 (and shape international response) • Imposition of registration and ongoing regulation requirements (based on, but more demanding than, IOSCO Code) • Internal, procedural focus – not substantively radical • Member-State-based (negotiations on establishment of ESMA not yet complete) • CRA II (2011) • Supervision of CRA I moves to ESMA (exclusively) • Why: cross-border nature of CRAs; fiscal risks limited; political risks limited • A historically important precedent in terms of EUinstitutional organization and supervision - much more complex negotiations, linked to ESMA’s powers, and how it interacts with the Commission

  23. CRAs: A Three Step Reform • CRA III (2013) and the sovereign debt crisis • More radical substantive reforms • Market structures risksand over-reliance risks • Current market share analysis from ESMA • S &P: 40.42% • Moody’s: 34.6% • Fitch: 16% • Sovereign debt crisis influence (downgrades) (2010-2012); very tense political environment • Coverage: • Over-reliance; structured finance and sovereign debt ratings; market structure, including through rotation requirements; civil liability; enhanced disclosure through the ESMA-based European Ratings Platform

  24. CRAs: A Three Step Reform • → Very difficult negotiations

  25. CRA Regime: Scope • Article 1 • This Regulation (note – compare PD) introduces a common regulatory approach in order to enhance the integrity, transparency, responsibility, good governance and independence of credit rating activities, contributing to the quality of ratings issued in the EU and to the smooth functioning of the internal market while achieving a high level of consumer and investor protection • Lays down conditions for the issuing of ratings and rules on the organization and conduct of CRAs • Compare this objective/function with those of the PD • What does this tell us by the crisis-era reform period?

  26. CRA Regime: Scope • Scope • Applies to ‘credit ratings’ issued by CRAs registered in the EU, disclosed publicly or distributed by subscription (A2(1)) • What is a CRA (A3(1))? • Broadly, a legal person whose occupation includes the issuing of ratings on a professional basis • What is a ‘rating’ (A3(1))? • Broadly, an ‘opinion’ on creditworthiness (issuer or security), using an established and defined rating system

  27. CRA Regime: Scope • The scope ‘hook’: • Financial institutions in the EU (credit institutions, investment firms, insurance companies, mutual funds, CCPs etc.) may use ratings for ‘regulatory purposes’ only if they are issued by CRAs established in the EU and registered in accordance with the CRA regime (A4(1)) • ‘Regulatory purposes’? • Specific purpose of complying with EU law/EU law as implemented in the MS (A3(1)) • → Financial institutions become ‘quasi-enforcers’ of the new regime • Note the prospectus connection (seminar 3) • Where a prospectus contains a reference to a CRA or rating, an issuer must ensure prospectus contains clear and prominent information stating whether or not the ratings are issued by a CRA established in the EU and registered under the CRA regime

  28. CRA Regime: Scope • Registration process • 26 currently registered ( + four ‘certified’); • Three global CRA groups account for 17 separate entities, so 40 in total • Most recent ESMA Annual Report on CRAs • Arts. 14-20: an EU process - compare prospectus approval • Process operated by ESMA (A 15-20) • Once registered, effective for EU (passport) (A 14(2)) • Once registered, the CRA must comply with the CRA regime and is subject to ESMA supervision and enforcement (A 14(3))

  29. CRA Regime: Scope • Detailed articulation in Regulation of how ESMA registers CRAs • Ex: fees it may charge (A19); timescales for review (45 days - A16) • Reflecting constitutional requirements • Agencies may not exercise discretionary powers (Meroni) • + Detailed amplification at level 2

  30. CRA Regime: Main CRA Requirements • Ex (1): Conflict of Interest Management and Organizational Requirements • Wide-reaching, catch-all obligation to ensure issuing of rating not affected by CoI (A 6(1)) • Take all necessary steps to ensure rating not affected by existing/potential CoI; very widely cast to cover CoI relating to CRA/shareholders/managers/analysts/employees/persons directly/indirectly linked by control (group-based model) • Comply with Annex I, A and B (detailed) • + Effective internal control structure governing policies and procedures to prevent and mitigate possible CoI and ensure independence of analysts (A6(4)) • + Business structure rule: 5% shareholder in a CRA may not hold 5% of another CRA (A 6a) (not including groups)

  31. CRA Regime: Main CRA Requirements • Operative detail of CoI rules in Annex I (sects. A and B, heavily based on IOSCO Code – but amended and tightened across CRA I-III) • Ex: organizational requirements (including independent board members); independent review function for rating methodologies; independent compliance function; extensive CoI operational requirements (incld. prohibition on rating any entities which are shareholders in CRA) extensive CoI disclosure requirements (incld. disclosure of actors from which receives more than 5% of annual revenue); remuneration rules; prohibition on making recommendations on design of S.F. instruments where CRA to issue a rating • Note: • Proportionality rule – ESMA can exempt CRAs where requirements not proportionate in view of nature, scale, complexity of business (A6(3))

  32. CRA Regime: Main CRA Requirements • Conflict of Interest Management and Organizational Requirements • + A 7, cascades CoI to analysts and employees (eg: cannot participate in fee negotiations; pay/performance evaluation cannot be linked to revenue from rated entities) who must also have appropriate knowledge and experience • Sect. C, Annex which includes rules on dealing restrictions, remuneration, rotation (4 years limit for lead analysts), whistle-blowing, and recordkeeping)

  33. CRA Regime: Main CRA Requirements • Ex (2): Methodologies • Difficulties with industry (and ESMA concern not to be drawn into mechanics of methodologies) • ESMA prohibited from interfering in content of ratings and methodologies (A23), but CRA regime concerned to address quality of ratings through review of methodologies • A8(1): obligation to disclose methodologies and assumptions used (Annex) • A8(2): CRAs to ensure methodologies based on thorough analysis of relevant information and information of sufficient quality/reliable source; • A8(3): methodologies to be rigorous, systematic, continuous, and subject to back-testing. This process is reviewed by ESMA (Art. 22a) – this requires significant data to provided to ESMA on rating performance • A8(5): CRAs must monitor ratings and methodologies on an ongoing basis – and related consultation procedures where a CRA changes a methodology and ESMA notification obligations (A8(5a); (6))

  34. CRA Regime: Main CRA Requirements • Ex (3): Disclosure • CRA regime generally highly operational and driven by ESMA supervision, but disclosure still a key tool • A10: non-selective and timely disclosure of ratings; detailed presentations requirements in Annex I, Sect D (sources; methodologies; meaning; limitations of ratings, and any limitations of data on which based); ‘inside information’ until disclosed • A10: CoI disclosure; also Annex I, Sect D (annual Transparency Report, A 12: CRA ownership structure, internal controls, annual review, rotation policy, governance) • A11: range of reporting requirements to ESMA (non-public) and public • ESMA ‘CEREP’ platform for public disclosures • Single platform with CRA ratings • Allow assessment of performance and reliability • Shows different CRAs, different issuers, different instruments

  35. CRA Regime: Main CRA Requirements • Ex (4): Structured Finance Instruments • Differentiated symbol (A10) • Moody’s: (sf) • Specific disclosure requirements to ESMA (website) on the assets and structure (A8b) • Rotation reforms to reduce market concentration: re-securitizations move every 4 years (A6b) • Two ratings for all SF instruments (A8c)

  36. CRA Regime: Main CRA Requirements • Ex (5):Over-reliance • Attempt to reduce pro-cyclicality, herding, and volatility risks, and promote stronger internal credit risk assessment • Regulated entities (investment firms, funds, etc) must make their own credit risk assessment and not ‘solely or mechanically’ rely on ratings; supervisors must assess reliance on contractual references to ratings (A5a) • ESMA not to refer to ratings in its supervisory guidance/ rule-making, where risk of mechanistic reliance thereby created (A5b) • 2013 CRA Directive: UCITS (mutual fund) and alternative investment fund managers must not solely or mechanistically rely on ratings, and supervisors must monitor the adequacy of internal credit risk assessment by these fund managers

  37. CRA Regime: Main CRA Requirements • Ex (6): Competition and Market Structure • New tool/objectives for most supervisors (and ESMA) • Related reforms generally tentative • Attempt by Commission originally to introduce more widespread rotation (issuer moves every 3 years), but strong market opposition; now limited to re-securitizations, but Commission to re-examine • Issuers using two ratings to ‘consider the possibility’ of mandating at least 1 CRA which does not have more than 10% of total market share (A8d)) • ESMA produces list of CRAs and their market share • CRA fees must be based on ‘actual cost’ (Annex I, sect. B) • ESMA as a competition regulator • The EU CRA Agency proposal…..

  38. CRA Regime: Main CRA Requirements • Ex (7): Sovereign Debt • High political tensions over downgrades over 2011 • Portugal, Greece, Italy (and European Financial Stability Mechanism in 2012) • Impact on borrowing costs, contagion risks, bank instability • Accusations as to objectivity, competence, failure to reflect euro area support measures, effectiveness of methodologies (July 2011 downgrade of Portugal (Moody’s) led to sharp Commission reaction) • Led to targeted rules in CRA III (A8a) • ‘Individual specificity’ of sovereigns to be assessed; sovereign debt ratings to be reviewed every 6 months; release to follow a pre-set calendar (Fridays only); research report explaining related assumptions • More radical ideas proposed included ESMA power to ban temporarily sovereign ratings; rating of sovereign debt to be located in ECB or Commission; complete prohibition on such ratings • Indicative of tensions

  39. CRA Regime: Supervision and Enforcement • ESMA Powers (compare PD network model – strikingly different) • Charged with ensuring regime applied (A21) • Split model in some respects • NCAs can be used by ESMA to achieve supervision – its ‘operational arms’ (A30); but in practice ESMA has built its own, extensive supervisory capacity • NCAs responsible for supervision of use by regulated entities of ratings (ie, overseeing the A5a over-reliance requirement) • But ESMA pre-eminent re CRA supervision – exclusive supervisor (A 21) • NCAs must co-operate; notify ESMA where breaches arise; ESMA can act in response, but not required to (A31) • ESMA conferred with distinct supervisory and investigatory powers, including onsite inspections (A23b, 23c, d) and distinct enforcement powers, including re fines and suspension of ratings(A23e and 24, and 36a) • Specified in detail – constitutional risks where ESMA powers are ‘discretionary’ (Meroni)

  40. CRA Regime: Supervision and Enforcement • ‘Risk-based’ operating model for supervision constructed • Thematic reviews important • General Commission review of ESMA over 2013/2014 of initial experience • Strong support for ESMA’s CRA oversight role • IMF support

  41. CRA Regime: Supervision and Enforcement • Current Evidence on ESMA’s developing approach • Most recent annual report on supervision (2015) • ‘Risk based approach’: analysis of data; day-to-day supervision, engagement meetings, on-site inspections, and dedicated investigations • Highest area of risk relates to governance and strategy • ESMA focus on: governance; risk management; internal decision-making; business development processes • Boards; validation/review of methodologies; IT systems • Robust enforcement capacity • July 2016 fine of euro 1.38 million for Fitch - Why? • Negligent breaches of CRA Regulation relating to sovereign ratings • Disclosure within Fitch group regarding sovereign ratings before public • Insufficient internal process relating to sovereign debt (Slovenia not given 12 hours to respond, as required, to downgrade)

  42. CRA Regime: Supervision and Enforcement • Civil Liability - new harmonized civil liability regime under CRA III • Designed to provide strong compliance incentives • A35a: • Where CRA commits ‘intentionally’ or ‘with gross negligence’ specified infringements, an investor or issuer may claim damages in respect of damage ‘due to that infringement’; • The investor must show that it has ‘reasonably relied’ on the rating (i.e., not over-reliance); • Lower threshold for issuer, who must show that its instruments are covered by the rating in question, and the relevant infringement not caused by misleading/inaccurate information provided by the issuer • Liability can be limited by the CRA – but only where reasonable and proportionate • New departure for EU financial regulation: compare A 6 of PD • Significant gap-filling required of national law (‘damage’, ‘intention’, ‘reliance’ etc)

  43. Third Countries • Extensive global reach of CRA regime • Compare PD • Limited coverage of third country prospectuses • In essence (a) • (1) Ratings from third country CRAs (not established in the EU), but which form part of a group with an EU CRA, can be used in EU, but • Subject to a rating endorsement regime, under which the requirements of the third country must be ‘as stringent as’ the EU regime • And there is an objective reason for the rating to be elaborated in a third country • And supervisory co-operation arrangements are met (A4(2)-(6))

  44. Third Countries • In essence (b) • (2) Where the rating originates from a CRA without a connection to an EU group, it can be used only where • the legal and supervisory framework of the third country is ‘equivalent’ to the EU, • co-operation arrangements are in place, • the CRA does not have systemic importance for the stability/integrity of financial markets in 1 or more MS • And: the CRA in question has been ‘certified’

  45. Third Countries • Model 1: A 4 endorsement • Lighter • Designed to reflect heavy reliance on ratings issued in third countries by the 3 large CRA groups, and potential for severe market disruption were these to be prohibited for regulatory purposes • Endorsement (of the rating) is via the EU-registered and established CRA within the group, but depends on ESMA analysis of the third country regime (major assessments required of ESMA completed by April 2012) • ESMA’s related assessment process designed to ensure that the third country regime is broadly equivalent to the EU regime (rules are ‘as stringent as’) • Once endorsed, the rating is considered to be issued by the EU established and registered CRA

  46. Third Countries • Model 2: A 5 Certification • Based on a higher ‘equivalence’ assessment by the Commission • Applies in relation to ratings of issuers established in third countries, or instruments issued in third countries, issued by CRA which does not form part of an EU group • Equivalence assessment by the Commission of the regulatory and supervisory regime of the third country • CRA must also be ‘certified’ by ESMA • Similar to CRA registration

  47. Third Countries • → Combination of endorsement and certification significantly increases EU’s reach over CRA regulation • In practice: • Convergence to EU model occurring • Japan, Australia, US, Canada, Hong Kong, Singapore, Mexico, Argentina, and Brazil all ‘as stringent as’ according to ESMA A 4 (endorsement) assessments – the majority of non-EU issued ratings have been found by ESMA to be subject to a broadly EU-equivalent regime • Formal equivalence under A5 granted to similar range of jurisdictions • But has been a robust process – initially, the US did not meet the equivalence test, but US reforms followed

  48. A New Model for Regulation? • Legislative regulations (CRA I-III), and detailed administrative rules, and ESMA guidance • + Template for a new EU ‘supervisory approach’ • International reach

  49. Investment Analyst Regime: a note • Based on conflict of interest + disclosure requirements • Embedded across different measures – not a stand-alone regime • Sits within MiFID (investment services) + Market Abuse Regulation • Located in level 2 rules • Based on national supervision/enforcement • More limited ESMA role • Development of level 2 rules • Roots in pre-crisis period • Concerned with market efficiency/integrity and consumer protection– not financial stability

  50. Investment Analyst Regime: a note • (1) 2006 MiFID I – 2006 MiFID I Commission Directive (conflicts of interest) • (ii) A 24: investment research is research or other information recommending or suggesting an investment strategy, explicitly or implicitly, concerning one or several financial instruments, intended for distribution channels or the public and • It is labelled as investment research – or otherwise presented as an objective or independent explanation of the matters contained in the recommendation; and not regulated investment advice

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