Commission staff working document accompanying the proposal for a regulation of the European Parliament and of the Council on Credit Rating Agencies - Impact assessment {COM(2008) 704 final} {SEC(2008) 2746}
Date: 2008-11-12
Institutions: European Commission
Subjects: credit guarantee, credit institution, credit policy, exchange of information, financial solvency, official market, securities

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COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 12.11.2008 
SEC(2008) 2745 

COMMISSION STAFF WORKING DOCUMENT 

accompanying the 

Proposal for a 

REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL 

on Credit Rating Agencies 

IMPACT ASSESSMENT 

{COM(2008) 704 final} 
{SEC(2008) 2746} 

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1. 

INTRODUCTION 

Credit rating agencies (CRAs) play a vital role in global securities and banking markets: they 
issue creditworthiness opinions that help to overcome the information asymmetry that exists 
between  those  issuing  debt  instruments  and  those  investing  in  these  instruments.  It  is 
essential,  therefore,  that  they  consistently  provide  ratings  which  are  independent,  objective 
and of the highest possible quality. The Commission will present in autumn 2008 its policy 
response  in  relation  to  the  role  that  CRAs  have  played  in  the  recent  financial  turmoil.  This 
document reflects the impact assessment carried out by the Commission services to determine 
this policy response. 

1.1. 

Role of CRAs and importance of ratings.  

CRAs  are  companies  recognised  in  the  markets  as  independent  providers  of  credit  opinions 
(ratings). For the most part of the last century the main business of these companies was to 
perform analyses and issue opinions on the probability of default or expected losses of other 
companies ("corporate") and governments ("sovereign"). However, over the last few decades 
these  companies  have  engaged  in  providing  ratings  for  a  wide  range  of  more  complex 
financial instruments, known as structured finance products.  

CRAs  have  a  major  impact  on  the  financial  markets,  with  their  ratings  actions  closely 
followed by investors, borrowers, issuers and governments. Investors refer to ratings as a key 
piece of information to determine their investment decisions, depending on the risk they are 
willing  to  assume.  The  rating  given  to  issuers  and  securities  will  affect  the  cost  of  raising 
capital.  Very  often  deterioration  of  a  debtor's  creditworthiness  concluded  in  a  rating  may 
trigger  particular  contractual  obligations  (e.g.  immediate  debt  repayment).  Finally,  there  are 
references to credit ratings in financial regulation: the most prominent example is the Capital 
Requirements Directive1, under which credit institutions are entitled to use the ratings as one 
of the references for the calculation of their capital requirements for solvency purposes.  

Over  the  last  decade  CRAs  have  attracted  the  attention  of  policymakers  on  a  number  of 
occasions,  coinciding  with  the  times  of  tension  in  financial  markets.  Regulators  worldwide 
turned their attention to the role of CRAs following their failure to weather the difficulties of 
Asian  economies  in  July  1997  and  the  corporate  collapses  at  the  beginning  of  this  century 
notably in the EU and the US (Enron, Worldcom, Parmalat). 

Against  this  background  and  following  the  resolution  on  CRAs  adopted  by  the  European 
Parliament in February 20042, the Commission considered very carefully whether legislative 
measures  would  be  necessary  to  regulate  the  activities  of  CRAs.  In  line  with  the  advice 
received from the Committee of European Securities Regulators (CESR) in March 20053, the 

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Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the 
taking up and pursuit of the business of credit institutions (recast). OJ L 177, 30.6.2006, p. 1–200. An 
explanation on the Directive could be found in annex 9.1. 
European Parliament resolution on Role and Methods of Rating Agencies (2003/2081(INI)). 
CESR's  technical  advice  to  the  European  Commission  on  possible  measures  concerning  credit  rating 
agencies,  CESR/05/139b,  March  2005.  CESR  is  an  independent  advisory  group  to  the  European 
Commission composed by the national supervisors of the EU securities  markets. The Committee was 
established by the European Commission's Decision of 6 June 2001 (Commission Decision of 6 June 
2001,  establishing  the  Committee  of  European  Securities  Regulators,  2001/527/EC,  OJ  L191, 
13.7.2001, p.43). The role of CESR is to improve co-ordination among securities regulators, act as an 

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Commission decided not to present new legislative proposals in the area of CRAs considering 
that the existing financial services directives applicable to CRAs would provide an answer to 
all the major issues of concern raised by the European Parliament (for an overview of the EU 
regulatory framework for CRAs see annex 9.1).  

In  this  context,  the  Commission  adopted  in  2006  a  Communication  on  Credit  Rating 
Agencies4; in this Communication the Commission concluded that various financial services 
directives, combined with self regulation by the CRAs themselves on the basis of the Code of 
Conduct Fundamentals for CRAs of the International Organisation of Securities Commissions 
(IOSCO)5,  could  provide  a  satisfactory  answer  to  the  major  issues  of  concern  in  relation  to 
CRAs. It was stated that this approach would require continuous monitoring of developments 
in  this  area  by  the  Commission.  In  addition,  the  Commission  asked  CESR  to  monitor 
compliance with the IOSCO Code and report back on an annual basis.  

The  Commission  indicated  in  the  Communication  that  it  might  consider  putting  forward 
legislative  action  if  it  became  clear  that  compliance  with  EU  rules  or  IOSCO's  code  was 
unsatisfactory or if new circumstances were to arise – including serious problems of market 
failure or significant changes in the way CRAs are regulated in other parts of the world. 

1.2. 

The financial crisis, the role of CRAs and the ECOFIN Roadmap 

Since August 2007 financial markets worldwide are suffering from a major confidence crisis. 
The  crisis  originated  in  the  US  residential  subprime  mortgage  market  and  subsequently 
developed into other sectors of the financial markets.  

This  financial  crisis  is  a  complex  phenomenon  that  involved  multiple  actors.  Subprime 
mortgages were offered to homebuyers with suboptimal credit situation (and thus higher risk 
of  payment  defaults)  and  made  subject  to  less  demanding  underwriting  standards.  A  large 
number of these mortgages were then normally grouped in pools of assets and transformed in 
a securitisation process into new financial instruments (structured products)6 that were sold in 
the  financial  markets  worldwide.  Often  these  instruments  were  rearranged  in  new  complex 
innovative  financial  structures  and  sold  to  investors  like  banks,  investment  funds,  pension 
funds,  insurance  companies  and  other  professional  investors.  Over  80%  of  these  subprime 
structured  products  were  rated  with  the  highest  ratings  by  the  CRAs.  (For  an  extended 
explanation on the financial crisis see Annex 9.2.).  

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advisory  group  to  assist  the  EU  Commission  and  to  ensure  more  consistent  and  timely  day-to-day 
implementation of community legislation in the Member States. 
Communication  by  the  Commission  on  Credit  Rating  Agencies,  11.3.2006  (2006/C  59/02),  OJ  C59, 
11.3.2006, p.2. 
The International Organisation of Securities Commissions (IOSCO) is an international non mandatory 
standard  setting  organisation  composed  of  securities  markets  supervisors.  Securities  markets 
supervisors  cooperate  within  IOSCO  in  order  to  promote  high  standards  of  regulation  aiming  at 
maintaining just, efficient and sound securities markets. 
The original lenders of sub-prime loans bundled the mortgage loans together and sold them to investors 
as mortgage backed securities – in essence these investors bought securities that would entitle them to a 
return from these mortgages in return for taking on all or part of the risk. These securities were rated by 
credit  rating  agencies  and  then  sold  to  other  financial  institutions  and  investors.  The  process  of 
packaging and pooling assets like mortgage loans, and selling them to investors as securities is referred 
to as 'securitisation'. Banks transferred most of these mortgage assets to off-balance sheet entities (so-
called  structured  investment  vehicles  or  SIVs),  which  financed  themselves  via  short-term  loans.  This 
made  them  vulnerable  to  a  sudden  financing  disruption  if  those  providing  the  loans  were  to  lose 
confidence, which is exactly what happened in August 2007. 

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This  turmoil  has  hit  Europe  through  three  different  channels.  Firstly,  some  EU  financial 
institutions faced losses because they were exposed to the US sub-prime market, e.g. through 
credit  lines  on  special  purpose  vehicles  that  had  bought  US  sub-prime  securities  (In 
accordance with data from Bloomberg in mid May, since the beginning of 2007 the biggest 
banks  and  securities  firms  have  faced  $379  billion  in  asset  write  downs  and  credit  losses. 
More  information  can  be  found  in  the  annex  9.10).  Secondly,  the  US  sub-prime  problems 
have considerably slowed down US growth prospects. Given global trade inter-linkages this 
affects the EU economic growth as well. Thirdly, the general market uncertainty has eroded 
equity  market  prices  also  in  Europe  as  well  as  reduced  consumer  and  business  confidence. 
Illustrative  data  on  the  trend  of  issuance  of  structured  finance  products  could  be  found  in 
annex 9.11. 

CRAs were close to the origin of the problems that have arisen with subprime markets: they 
were giving favourable opinions on instruments that were financially engineered to give high 
confidence to investors. The investors – relying on CRAs' expertise – very often took little or 
no interest in the risks characteristics of these instruments, performance of underlying assets 
and general market outlook.  

The  amount  of  securitised  products7  outstanding  (before  maturity)  in  Q1  2008  surpassed 
6,000  billion  EUR  in  the  US,  while  the  amount  outstanding  in  Europe  was  around  1,200 
billion EUR.  Instruments  awarded with the highest rating grade8 amounted to 75% of those 
rated  by  the  rating  agencies.  Most  investors,  who  were  less  familiar  with  the  structured 
products and merely sought to take advantage of superior returns in these markets, normally 
did not look at instruments rated below that grade.  

In response to worsening market outlook, faltering confidence in the financial viability of the 
subprime  structured  products  and  internal  reassessments,  over  the  past  months  CRAs  have 
decided  on  downgrading  of  these  instruments  on  a  massive  scale.  Recent  figures  show  (see 
Chart  1  below)  that  CRAs  have  seriously  and  systematically  failed  to  assess  correctly  the 
creditworthiness of structured finance instruments, as opposed to traditional ones (corporate, 
sovereign). In the period between 1 July 2007 and 24 June 2008, CRAs downgraded 145,899 
structured  ratings  compared  whereas  only  1,445  corporate  ratings  were  downgraded  in  the 
same period9. Hence, the problem has affected most severely the structured finance segment. 

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9 

These  figures  cover  asset  backed  securities  (ABS),  commercial  mortgage  backed  securities  (CMBS), 
residential mortgaged-backed securities (RMBS) and collateralized debt obligations (CDO). In the case 
of CDOs tailor-made (typically non-public) issues and issues with a significant element of derivatives 
in the underlying assets are not included due to data limitations (see also Annex 9.3).  
So called AAA, or triple A, i.e. top of the rating scale which is used by the CRAs to present in relative 
terms creditworthiness of issuers.  
Source: Bloomberg. 

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Chart 1. Downgrades and upgrades comparison for largest CRAs - start date: July 2007 

Downgradings since July 1st 2007
  (---) corporte) ; (---) structured

Upgradings since July 1st 2007
  (---) corporte) ; (---) structured

S&P

Mooody's

Mooody's

S&P

Fitch

Fitch

6000

4000

2000

0

S&P

Fitch

S&P Mooody's

Mooody's

Fitch

70000

60000

50000

40000

30000

20000

10000

0

(Source: Bloomberg) 

As  the  financial  crisis  evolved,  a  considerable  increase  in  the  ratings'  changes  could  be 
observed.  Table  1  below  shows  upgrades  and  downgrades  for  European  and  US  structured 
products respectively. In the first half of 2007 the three major credit rating agencies active in 
this field (Fitch, Standard & Poor's and Moody's – see point 1.3) generally upgraded slightly 
more times than they downgraded. In the second half of 2007 as well as the first half of 2008 
this  changes  dramatically.  The  overall  number  of  rating  changes  increases  as  well  as  the 
relationship between the number of upgrades and downgrades, although the change in Europe 
is not as strong as in the US. In the second quarter of 2008 the total number of upgrades for 
European and US securitised products was 659, while the number of downgrades amounted to 
28700.  

Table 1. Upgrades/Downgrades in structured products in the 3 largest agencies 

2007:Q1 

2007:Q2 

2007:Q3 

2007:Q4 

2008:Q1 

2008:Q2 

EU 

Fitch  

116 /19  

78 / 12 

124 / 44 

163 / 139 

36 / 61 

33 / 159 

Moody's  101 / 38 

62 / 42 

38 / 76 

81 / 94 

22 / 257 

67 / 655 

S&P 

Total  

126 / 65 

81 / 72 

92 / 77 

83 / 145 

50 / 512 

65 / 657 

343 / 122 

221 / 126 

254 / 197 

327 / 378 

108 / 830 

165 / 1471 

US 

Fitch  

654 / 221 

637 / 643 

335 / 2053 

132 / 3099 

335 / 4901 

165 / 5763 

Moody's  447 / 158 

279 / 380 

562 / 1619 

315 / 7498 

111 / 4751 

223 / 16563 

S&P 

Total 

418 / 194 

414 / 372 

407 / 1230 

292 / 4741 

216 / 8895 

106 / 4903 

1519 / 573 

1330 / 1395 

1304 / 4902 

739 / 15338 

662 / 18547 

494 / 27229 

Source: European Securitisation Forum. Securitisation Data Report Q2:2008, p. 10  

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The massive downgrading of securitised products further undermined the market's confidence 
in the ratings produced by CRAs. This massive downgrading would also suggest that the rated 
products  have  been  construed  in  such  a  way  that  they  have  narrowly  met  the  criteria  for  a 
certain  rating  at  the  time  of  issuance  and/or  the  assessment  of  the  probability  of  default  or 
expected loss was unrealistic. 

CRAs failed to reflect early enough in their ratings the worsening of market conditions. The 
explanation for this poor performance by CRAs could be found in the unsatisfactory way the 
agencies manage their conflicts of interest, the lack of quality of the ratings they issued, the 
need  for  improved  transparency  of  the  agencies  and  the  inappropriate  internal  governance. 
The  subprime  debacle  demonstrated  that  the  existing  framework  for  the  operation  of  CRAs 
needs to be significantly reinforced. 

As  indicated  above,  CRAs  cannot  be  blamed  alone  for  the  current  financial  turmoil;  other 
actors and special circumstances concurred in the events that led the financial markets to the 
crisis.  As  a  consequence,  in  close  cooperation  with  the  European  Commission,  the  EU 
Finance  Ministers  in  October  2007  unanimously  agreed  to  a  set  of  conclusions  to  respond 
comprehensively to the main weaknesses identified in the financial system. These initiatives, 
which  are  consistent  with  the  agenda  set  at  global  level,  are  grouped  into  the  so-called 
"ECOFIN  roadmap".  The  Spring  Council  of  March  2008  endorsed  the  policy  areas  of  the 
roadmap  and  stated  that  authorities  in  the  EU  should  "stand  ready  to  take  regulatory  and 
supervisory action were necessary"10. The roadmap combines different actions of a regulatory 
and non-regulatory nature which are structured around four main objectives:  

•  Improve  transparency  in  the  market,  notably  with  respect  to  banks'  exposures  relating  to 

securitisation and off-balance sheet items;  

•  upgrade  valuation  standards  to  respond  in  particular  to  the  problems  arising  from  the 

valuation of illiquid assets;  

•  strengthen  the  prudential  framework  for  the  banking  sector,  including  the  treatment  of 
large  exposures,  banks'  capital  requirements  for  securitisation,  and  liquidity  risk 
management; 

•  investigate  structural  market  issues,  such  as  the  role  played  by  CRAs  and  the  "originate 

and distribute" model.  

Therefore, this Impact Assessment focuses only on the last of the Council requests where the 
Commission has to examine the role of CRAs and the uses of credit ratings, in particular as 
regards  structured  finance  instruments,  conflicts  of  interest,  transparency  of  rating  methods, 
time-lags in rating reassessments and regulatory approval processes.  

1.3. 

Overview of CRAs market 

The  credit  rating  market  is  oligopolistic  and  is  effectively  dominated  by  three  big  entities 
operating  globally:  Standard  &  Poor's,  Moody’s  Investors  Service  and  Fitch  Ratings. 
Moody’s  and  Standard  &  Poor's  have  a  combined  market  share  in  excess  of  80%,  while 
Fitch’s  market  share  is  approximately  14%.  These  entities  have  their  head  office  and  main 

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Presidency Conclusions of the Brussels European Council (13/14 March 2008). 

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management,  administrative  and  supervisory  bodies  in  the  US.  They  operate  in  the  EU 
through  subsidiaries  established  in  several  countries11.  Their  activity  does  not  have  a 
territorial character.  

Moody's  Investor  Services  is  owned  by  Moody's  Corporation  (listed  in  New  York  Stock 
Exchange  -  NYSE).  Standard  &  Poor's  is  owned  by  the  American  publisher  Mc  Graw-Hill 
(which is a listed entity at NYSE). Fitch is dual-headquartered in New York and London and 
is  a  subsidiary  of  the  French  financial  company  Fimalac  (listed  in  Euronext  Paris)12.  (For 
more precise information about the three big CRAs please see the first part of Annex 9.4.) 

Beyond these three big organisations, the CRA landscape is occupied by a number of smaller 
players,  often  catering  to  very  specific  market  needs.  Among  them,  Dominion  Bond  Rating 
Service (DBRS) 13, Japan Credit Rating Agency, Ltd. and Rating and Investment Information, 
Inc.  are  well  established  regional  players  (in  Canada/US  and  Japan  respectively)  with 
ambitions to develop their international market presence. Finally, there are a number of local 
rating agencies active in different countries, issuing rating opinions both for general purposes 
and for specialized uses; their impact on the global financial markets is nonetheless marginal 
(for a comprehensive list of CRAs, see the second part of Annex 9.4).  

Over the past years, there has been a major shift in the revenue structure of the leading CRAs. 
Until the mid-nineties CRAs specialised in and derived most of their revenues from the rating 
of  corporate  or  sovereign  debt.  However,  with  the  growth  of  structured  markets  they 
increasingly  engaged  in  the  highly  lucrative  rating  activity  of  new  structured  finance 
transactions.  As  a  consequence  CRAs  currently  earn  approximately  50%  of  their  revenue 
from structured finance ratings.14  

1.4. 

The legal framework for CRAs 

At  present,  Community  law  addresses  only  specific  aspects  relevant  to  the  activity  of  the 
rating  businesses  (basically  measures  included  in  the  Market  Abuse  Directive15  and  the 
Capital Requirements Directive16). CRAs are not required to seek authorisation or to register 

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Standard  &Poor's  has  subsidiaries  in  France,  Germany,  Italy,  Spain,  Sweden  and  UK;  Moody's  has 
subsidiaries  in  Bulgaria,  Cyprus,  Czech  Republic,  France,  Germany,  Italy,  Spain  and  UK.  Fitch  has 
subsidiaries in UK ("Fitch Europe"), France, Germany, Italy, Poland and Spain. 

Fitch  merged  in  1997  with  the  British  IBCA  rating  company,  which  is  specialised  in  rating  banks. 
Fitch-IBCA then bought the fourth-largest American rating agency, Duff & Phelps, in June 2000 and, in 
December 2000, Thomson BankWatch, another agency specialised in rating banks. 

DBRS has its headquarters and main offices in Toronto. DBRS opened offices in Paris (in early 2006), 
in London (September 2005) and Frankfurt (December 2005) and sought to compete for market share in 
Europe  on  offering  research  and  ratings  on  banks  and  securitisation.  Due  to  adverse  economic 
conditions, in January 2008 DBRS announced that they were closing all their EU offices.  

In  accordance  with  a  Report  on  rating  agencies  published  by  the  French  Autorité  des  Marchés 
Financiers for 2006 the ratings income of the agencies in Europe represented in 2006 between 16% and 
30%  of  worldwide  income,  with  transactions  in  the  United  States  representing  more  than  half  of  the 
income  of  the  agencies.  Structured  finance  business  represented  between  35%  and  45%  of  European 
earnings. 

Directive  2003/6/EC  of  the  European  Parliament  and  of  the  Council  of  28  January  2003  on  insider 
dealing and market manipulation OJ L 96, 12.4.2003, p. 16 

Article  80  et  seq of Directive  2006/48/EC of  the  European  Parliament  and  of  the  Council  of  14  June 
2006 relating to the taking up and pursuit of the business of credit institutions OJ L 177, 30.6.2006, p. 
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and  they  are  not  subject  to  any  form  of  official  (public  or  self-regulatory)  oversight  at  EU 
level. For more details on the legal approach on CRAs, see Annex 9.1.  

As mentioned in section 1.1, the European Commission issued a Communication on CRAs in 
2006  where  it  concluded  that  various  financial  services  directives,  combined  with  self 
regulation by the CRAs themselves on the basis of the IOSCO Code, could provide an answer 
to  the  major  issues  of  concern  in  relation  to  CRAs.  The  Communication  stated  that  this 
approach would require continuous monitoring of developments in this area by the European 
Commission and additionally asked CESR to monitor compliance with the IOSCO Code and 
report back on an annual basis.  

The Commission Communication concluded that CRAs had to incorporate all the provisions 
of the IOSCO Code into their own internal Codes of Conduct on a voluntary basis; CRAs are 
free not to respect certain obligations stemming from the Code, as long as they disclose them 
("comply or explain" principle). The annual monitoring report produced by CESR is the only 
mechanism available in order to control the CRAs' compliance with the Code. 

Conversely, CRAs operating in the US are regulated entities. They have to be registered and 
supervised  by  the  US  securities  markets  supervisor  (the  Securities  and  Exchange 
Commission, SEC). A description of the main elements of the US legal framework for CRAs 
can  be  found  in  the  second  part  of  annex  9.1.  The  US  Act  on  CRAs  of  200617  is  relatively 
recent  and  its  effectiveness  has  not  been  tested  yet;  it  entered  into  force  in  June  2007,  just 
weeks before the beginning of the subprime turmoil. The SEC announced last September its 
intention  to  reinforce  this  framework.  On  11  June  and  1  July  2008  the  SEC  proposed 
important changes in the legal framework for CRAs18. These proposals are presented in more 
detail in the Annex 9.5 of this Impact Assessment. 

2. 

PROCEDURE 

2.1. 

Consultation 

The European Commission decided to mandate CESR in September 2007, and the European 
Securities  Markets  Expert  Group  (ESME)19,  in  November  2007,  to  provide  advice  on  the 
various aspects of CRAs' activity and role in the financial markets and especially in structured 
finance.  The  Commission  services  followed  the  work  of  both  groups  throughout  the  entire 
process. Both groups have carried out an extensive consultation with stakeholders notably on 
the role of structured finance in the context of the subprime turmoil. CESR delivered its report 
on 13 May 2008 and ESME delivered its report on 4 June 2008. 

In  addition,  the  Commission  services  have  held  discussions  with  major  rating  agencies  and 
other  stakeholders  (industry  associations  from  the  insurance,  securities  and  banking  sectors, 
information providers, etc). The Commission services have also received written inputs from 

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US Credit Rating Agency Reform Act of 2006. 

More information can be found at www.sec.gov/rules/proposed.shtml. 

The  European  Securities  Markets  Experts  Group  (ESME)  is  an  advisory  body  to  the  Commission, 
composed of securities markets practitioners and experts. It was established by the Commission in April 
2006 and operates on the basis of the Commission Decision 2006/288/EC of 30 March 2006 setting up 
a European Securities Markets Expert Group to provide legal and economic advice on the application of 
the EU securities Directives (OJ L 106, 19.4.2006, p. 14–17). 

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a wide range of associations, market practitioners and stakeholders. On the international side, 
the Commission services have followed closely the developments like the revision of the code 
of conduct for CRAs approved by IOSCO on May 26 and the report of the Financial Stability 
Forum  (FSF)20  published  on  April  7,  2008.  The  Commission  services  have  been  also 
following the consultations carried out by both IOSCO and the FSF. Finally, the Commission 
took  into  consideration  the  various  initiatives  proposed  and  /  or  implemented  by  the  CRAs 
either individually or on an industry-wide basis (among them the industry White Paper, they 
prepared  in  response  to  the  work  on  the  IOSCO  Code  revision21)  and  benefited  from  an 
intensive  informal  dialogue  with  the  interested  rating  agencies.  An  overview  of  the  main 
elements of these initiatives can be found in Annex 9.5. 

Taking  into  account  the  global  dimension  of  the  rating  business,  the  Commission  services 
have  thoroughly  scrutinised  the  current  legal  framework  for  CRAs  in  the  US,  and  have 
followed  closely  the  evolution  of  the  proposals  for  changes  in  the  US  Act  on  CRAs 
implementing measures presented by the US Securities and Exchange Commission (SEC) on 
11 June and 1 July 2008. This issue has also been part of the ongoing regulatory dialogue with 
the US. A comparative table of the US regime, IOSCO code standards and the proposal of the 
Commission can be found in annex 9.12.  

Additionally,  the  Commission  has  encouraged  comments  from  interested  stakeholders  in  a 
public consultation starting on 31 July and lasting till the beginning of September 2008.  

The Commission services received 82 contributions: 13 from credit rating agencies, 52 from 
organizations of stakeholders (banks, associations, investment funds, savings banks etc) and 
17 from securities regulators and ministries of finance of Member States. 

The  non-confidential  contributions  can  be  consulted 
(http://ec.europa.eu/internal_market/securities/agencies/index_en.htm). 

in 

the  Commission  website 

2.2. 

Steering Group 

The Steering Group for this Impact Assessment was formed by representatives of Directorate 
General Internal Market and Services, Directorate General Competition, Directorate General 
Economic  and  Financial  Affairs,  Directorate  General  Enterprise  and  the  Secretariat  General 
and met four times, on 27 June and 8, 11 and 16 July 2008. The contributions of the members 
of the Steering Group have been taken into account in the content and shape of this impact 
assessment.  

20 

21 

The Financial Stability Forum was convened in April 1999 to promote international financial stability 
through information exchange and international co-operation in financial supervision and surveillance. 
The Forum brings together on a regular basis national authorities responsible for financial stability in 
institutions,  sector-specific 
significant 
international groupings of regulators and supervisors, and committees of central bank experts. The FSF 
seeks  to  co-ordinate  the  efforts  of  these  various  bodies  in  order  to  promote  international  financial 
stability, improve the functioning of markets, and reduce systemic risk. 

financial  centres, 

international 

international 

financial 

Discussion  Paper  about  Measures  to  Enhance  the  Independence,  Quality  and  Transparency  of  Credit 
Ratings,  endorsed  by  5  rating  agencies  (A.M.  Best,  Moody's,  Standard  &  Poor's,  Fitch,  DBRS). 
December 2007.  

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2.3. 

Impact Assessment Board 

DG  MARKT  services  met  the  Impact  Assessment  Board  the  3  September.  The  Board 
analysed this Impact Assessment and delivered its opinion on 9 September 2008. During this 
meeting the members of the Board provided DG  Markt services with comments to improve 
the content of the Impact Assessment that led to some modifications of this final draft. These 
are the most relevant ones: 

–  Clarifications  in  sections  1.2  and  3  about  the  financial  crisis  and  the  role  of  CRAs, 
explaining  that  the  financial  crisis  is  a  phenomenon  caused  by  multiple  factors,  and 
presenting the Commission proposal on CRAs as a part of a wider exercise (the ECOFIN 
roadmap). 

–  In  order  to  highlight  the  synergies  and  differences  of  the  proposal  with  US  regulatory 
framework the section 2.1 was amended and a comparative table was incorporated to this 
Impact Assessment (annex 9.12). 

–  A  summary  of  the  main  elements  of  the  consultation  was  added  in  section  2.1,  and  the 

Impact Assessment has been consistently revised. 

–  More evidence for some of the elements of the problem definition was added in chapter 3. 

–  In  order  to  highlight  the  added  value  of  the  proposal  of  the  Commission  tacking  into 
account the revised IOSCO code of conduct and the voluntary initiatives implemented by 
CRAs, the structure and content of sections 5.2, 6.2.1 and 6.3 were revised. 

–  The substance and the two options for the supervisory architecture of the legislative option 

were further elaborated in section 5.2. 

–  Further  clarifications  about  the  assumptions  used  in  the  analysis  of  impacts  in  chapter  6 
were added, in  particular in relation to the convergence of the substantive policy options 
with the rules in the US and the standards of the IOSCO code of conduct for CRAs.  

–  The analysis of the legislative proposal was further elaborated in section 6.2.4. 

–  Some  clarifications  concerning  the  costs  of  the  proposal  were  added  in  chapter  7,  in 
particular in relation to the cost of the prohibition of the provision of consulting activities. 

–  Finally, the monitoring and evaluation strategy was further elaborated in chapter 8. 

3. 

PROBLEM DEFINITION 

The measure proposed by the Commission on CRAs does not intend to tackle all issues linked 
to  the  financial  turmoil  but  only  focuses  on  CRAs.  Evidence  shows  that  CRAs  have  had  a 
markedly worse performance when assigning ratings to  innovative, structured products than 
when issuing traditional ones. The analysis of the Commission therefore focuses on the issues 
that  have  arisen  in  the  contexts  of  rating  structured  finance  products.  However,  it  has  to  be 
borne  in  mind  that  as  financial  innovation  progresses,  similar  problems  may  occur  in  the 
future  in  other  areas  where  CRAs  have  limited  or  no  experience.  Moreover,  certain 
deficiencies  that  became  evident  with  respect  to  structured  finance  ratings  relate  to  the 
structure, business model and internal processes of the entities. Bearing this in mind, they may 

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also  have  a  harmful  effect  on  the  more  traditional  areas  of  CRAs'  activity.  The  major 
problems  that  the  Commission  services  have  identified  with  respect  to  rating  agencies  are 
grouped in three broad areas:  

–  Failures in the integrity of the CRAs (mainly in relation to conflicts of interest); 

–  unsatisfactory quality of methodologies and ratings; 

–  lack of transparency of the CRAs. 

Moreover, the lack of effective supervision and enforcement can accentuate these problems. 
Contrary to the US, in the EU CRAs are not subject to direct supervision. Public authorities in 
the  Member  States  are  not  entitled  to  sanction  a  rating  agency  when  it  breaches  the  current 
IOSCO standards of integrity, quality and transparency.  

Further  issues  have  been  highlighted  by  stakeholders,  notably  the  limited  scope  of 
competition  among  CRAs  and  the  unfair  practices,  like  the  so  called  "notching  practice"22. 
While  the  Commission  services  acknowledge  the  relevance  of  these  problems,  competition 
rules developed under the articles 81 and 82 of the EC Treaty are best placed to address these 
concerns.  Therefore,  any  measure  proposed  will  fully  take  into  account  its  impact  on  the 
competition among CRAs. 

Another issue out of the scope of this Impact Assessment is the question of the over-reliance 
on ratings by investors. A number of stakeholders have noted that many investors relied solely 
on  the  rating  of  a  product  to  make  up  their  investment  decisions  and  did  not  carry  out  any 
further  analysis  about  the  risks  of  their  investment.  The  Commission  launched  a  parallel 
consultation about this issue on 31 July 2008. Further action may be envisaged at a later stage. 

3.1. 

Failures in the integrity of CRAs; conflicts of interest in the rating business  

All contributors, institutions and stakeholders consulted have unanimously expressed the view 
that  the  conflicts  of  interest  that  could  arise  when  CRAs  rate  structured  products  have  not 
been avoided or managed in a satisfactory way. The lack of independence of the agency, the 
influence of the remuneration aspects over the independence of the analysts, the conflicts of 
interest  that  arise  from  the  performance  of  services  other  than  rating,  the  influence  of  the 
analyst's relations with potential future employer and the possible "shopping" for ratings are 
the most relevant topics which need to be addressed.  

3.1.1.  Conflicts of interest originated by the "issuer-pays" model  

The task of evaluating the creditworthiness of an issuer undertaken by an agency is – as a rule 
-  paid  by  the  same  issuer  who  is  being  rated  or  the  originator  of  the  issue.  This  situation 

22 

"Notching  refers  to  the  practice  whereby  one  rating  agency  reduces  the  ratings  from  another  rating 
agency on structured finance collateral it has not rated itself. Notching can arise when structured finance 
collateral  such  as  commercial  mortgage  backed  securities  (CMBS),  residential  mortgaged-backed 
securities (RMBS) and asset backed securities (ABS) are included in rated investment vehicles such as 
collateralized debt obligations (CDO), structured investment vehicles (SIV) or asset-backed commercial 
paper 
– 
programs 
www.greenbergresearch.com) 

(From  Greenberg  Quinlan  Rosner  Research 

(ABCP)." 

Inc 

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creates  conflicts  of  interest  for  the  agency23.  As  ratings  effectively  translate  into  borrowing 
costs, issuers and originators would always strive to have their instruments rated at the highest 
possible grade. On the other side, the accuracy of the rating is under pressure as the agency 
makes efforts to attract business and maximise profits. Another source of conflicts of interest 
is  the  lack  of  independence  of  the  CRA  in  relation  to  the  issuer/originator  whose  financial 
instruments are to be rated. In a survey carried out in June 2008 the CFA Institute24 asked its 
members  (investment  professionals  worldwide)  whether  they  had  ever  witnessed  a  CRA 
changing  a  rating  as  consequence  of  pressure  or  influence  from  an  investor,  issuer  or 
underwriter. 211 of the 1.956 respondents said they have indeed witnessed a CRA changing 
ratings  in  response  to  external  pressures.  When  asked  to  specify  how  this  pressure  was 
accomplished,  51%  mentioned  the  threat  to  take  future  rating  business  to  other  CRAs  and 
17%  mentioned  the  offer  to  deliver  more  business  to  the  agency.  When  an  agency  is  not 
independent  its  rating  opinions  may  not  be  accurate.  Corporate  or  economic  links,  business 
interests  or  other  kind  of  links  between  the  issuer/originator  and  the  agency  jeopardise  the 
agency's independence. 

There  are  two  alternatives  to  the  "issuer-pays"  model:  a  "subscriber-pays"  model  and  a 
"public utility" model. The "subscriber-pays" model was used by the agencies until the 1970s. 
There  were  two  main  reasons  why  the  agencies  abandoned  such  a  model:  firstly,  the 
dissemination  of  ratings  created  an  unlevel  playing  field  as  they  did  not  reach  all  market 
participants (such a piece of information would only be limited to the subscribers); secondly, 
the model did not provide enough funding for the analysis of increasingly complex products 
(which required the agencies to devote more resources). On the other hand, the "public utility" 
model requires transforming the CRAs into a public utility and funding them with government 
revenues. This model has its own disadvantages: it is not free from own conflicts of interest 
(governments  are  rated  entities  too);  it  is  also  considered  that  it  could  severely  hamper  the 
innovation  within  the  financial  markets  and  it  is  a  costly  proposition  involving  taxpayers' 
money. 

3.1.2.  Conflicts of interest that emerge from the agency's activities: advisory and ancillary 

services; the dialogue of the analysts with the rated entity  

3.1.2.1.  Conflicts  of  interest  arising  from  the  provision  of  advisory  services  and  ancillary 

services 

One  source  of  conflicts  of  interest  for  CRAs  is  the  provision  of  services  different  from  the 
rating  to  the  issuer/originator,  like  advisory  services.  Should  these  non-rating  services  give 
rise to significant, high-margin revenues from a rated client, a CRA has a clear incentive to 
continue this lucrative relationship and look more favourably at the client's creditworthiness 
for rating purposes. The provision of advisory services also creates a clear conflict of interest 
for  the  CRAs,  where  their  analysts  formulate  proposals  or  recommendations  regarding  the 

23 

24 

"Many  observers  cite  the  conflicts  of  interest  inherent  in  the  credit  rating  industry  as  a  source  of 
concern. The most common conflict noted is that many of the CRAs receive most of their revenue from 
the issuers that they rate. The fear is that where a CRA receives revenue from an issuer, the CRA may 
be  inclined  to  downplay  the  credit  risk  the  issuer  poses  in  order  to  retain  the  issuer’s  business". 
IOSCO, The Role of Credit Rating Agencies in Structured Finance Markets – Final Report. 

CFA  Institute  (Chartered  Financial  Analysts  Institute)  is  a  global,  not-for-profit  association  of 
investment professionals that manages educational programs for investment professionals and analysts 
and  promotes  ethical  standards  and  professional  excellence  within  the  global  investment  community 
(more information in www.cfainstitute.org). 

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design  of  a  structured  finance  instrument.  In  this  case,  impartiality  of  the  agency  and  its 
independence become questionable: it both advises the issuer/arranger on how to structure a 
product and rates the probability of default of such a product.  

Ancillary  services  are  activities  other  than  the  rating  process,  like  pricing  analysis  for 
structured  finance  securities  that  do  not  have  a  liquid  market  or  rating  assessment  services, 
where  CRAs  provide  issuers  with  the  likely  impact  on  a  rating  of  hypothetical  events  (for 
instance a merger between two corporations), or several hypothetical structures in relation to a 
structured product (for instance when it comes to how different tranches of debt are set up, or 
when it comes to levels of credit enhancement). Provision of ancillary services may give rise 
to similar situations as in the case of advisory services (i.e. when ancillary service relationship 
prevails over the rigour and independence of the rating process).  

On  the  one  hand  CRAs  have  not  properly  separated  operationally  and  legally  their  analysts 
and credit rating business from any other business of the CRA that may represent a conflict of 
interest to their rating services. On the other hand, there is a lack of clarity in this regard as 
CRAs do not have a precise and common definition of the concepts of ancillary and advisory 
services25.  

3.1.2.2.  Conflict of interest and the dialogue of the analysts with the rated entity 

CRAs have been criticised for being too involved in the structuring process of securitisation 
products. Both CESR and ESME express concerns in this respect in their reports26. They point 
out that the dialogue between the CRAs and the issuers in the structuring process is often very 
close and happen on a continuous basis. This may raise concerns that the relationship between 
CRAs and the  issuers of structured financial products is sometimes becoming too close and 
advisory in nature which could create conflicts of interests particularly given the fact that the 
profitability of a CRA is heavily dependent on the flow of its new structured finance ratings. 

Moreover,  CESR  points  out  that  there  are  cases  were  the  analysts  take  part  in  the  fee 
negotiation with the originator of the rated product. This is particularly the case in complex 
structured finance deals where rating staff may be involved in discussing the amount of work 
that has to be done as it also has an impact on fees.27 

3.1.3. 

"Shopping for ratings" practice  

The practice of shopping for ratings takes place when issuers/arrangers of a structured product 
inquire several CRAs for their preliminary rating assessment of the potential structures before 
they  finally  decide  on  an  issue.  On  the  basis  of  the  "best  rating  offer"  received,  the 
issuer/arranger  will  determine  the  choice  of  the  rating  agency  that  will  prepare  the  official 

25 

26 

27 

Paragraph 190 and 195 of CESR’s Second Report to the European Commission on the compliance of 
credit rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. 
May 2008. (CESR/08-277). 

Paragraph  180  of  CESR’s  Second  Report  to  the  European  Commission  on  the  compliance  of  credit 
rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. May 
2008.  (CESR/08-277);  First  paragraph  of  the  answer  to  Question  12.  ESME  Report  to  the  European 
Commission on the Role of Credit Rating Agencies. 4 June 2008. 

Paragraph  100  of  CESR’s  Second  Report  to  the  European  Commission  on  the  compliance  of  credit 
rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. May 
2008. (CESR/08-277). 

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rating.  This  is  likely  to  lead  to  ratings  inflation  and  lack  of  applied  methodological  rigour. 
This  practice  is  mentioned  in  IOSCO  report  and  CESR  has  received  evidence  on  this  issue 
from stakeholders28.  

3.1.4.  Analyst's independence when joining a rated entity  

Rating  analysts  are  an  attractive  recruitment  target  for  investment  banks  and  other 
originators/issuers. More recently, concerns have been raised that prior to their departure from 
the  CRA  they  may  be  prone  to  look  more  favourably  at  issues  originated  by  their  future 
employer, and therefore such ratings would lack accuracy.  

3.2. 

Lack of quality in methodology and ratings  

As explained in Section 1.2 there was a significant number of downgrades in the second half 
of 2007 and first quarter of this year as compared to figures of the first half of 2007. These 
ratings  failed  to  reflect  market  conditions  in  the  underlying  assets.  One  cause  of  this  bad 
performance is most probably the lack of quality in the methodologies used by the CRAs to 
issue a rating29. The main criticisms identified in this respect are the following: 

–  lack of a regular review of the methodologies and rating criteria; 

–  insufficient macroeconomic analysis in the ratings; 

–  inadequacy of the information on which the agencies base their rating opinion; 

–  lack of statistical checking; 

–  inadequacy of the staff involved in the rating of complex products.  

3.2.1.  Lack of adequacy of methodologies and rating criteria 

The methodologies and models employed by the rating agencies appeared unable to properly 
reflect the worsening conditions in the underlying asset markets. Agencies were not keen to 
review their methodologies because they preferred as much stability of the ratings as possible. 
Among  other  sources,  the  FSF  report  indicated  that  the  ratings  performance  may  also  have 
been damaged by flaws in the rating methodologies. These flaws in methodology include the 
impact of having only limited historical data in the area of subprime lending which led to the 
inability to assess how a pool of assets would respond to given economic scenarios. The FSF 
report  points  out  that,  in  particular,  the  agencies  underestimated  the  correlations  in  the 
defaults  that  could  occur  in  the  event  of  a  wide  market  downturn.  CESR  considers  that  the 
delay  in  the  downgrading  process  of  structured  finance  securities  backed  by  subprime 
mortgage assets raises questions on the efficiency of CRAs’ methodologies, the robustness of 
their  historical  default  models  in  a  relatively  new  market  and  their  rating  surveillance 

28 

29 

Paragraphs 203 and 204 of CESR’s Second Report to the European Commission on the compliance of 
credit rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. 
May 2008. (CESR/08-277).  
Paragraph  106  of  CESR’s  Second  Report  to  the  European  Commission  on  the  compliance  of  credit 
rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. May 
2008. (CESR/08-277). See annex 9.5. 

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procedures30. It was recently published that technical errors in CRAs models could have also 
had a major distorting effect on the conclusions produced in the course of the rating process31. 

3.2.2.  Lack  of  diligent  monitoring  of  ratings;  inconsistent  application  of  changes  to 

methodology; inadequate staffing. 

A critical part of the rating process is the surveillance or monitoring of the rating through the 
life  of  the  product  to  which  it  refers.  Surveillance  should  determine  whether  the  agency 
should upgrade, downgrade or keep the rating unchanged. CRAs not only have issued a great 
number of ratings that assured investors of top credit quality of subprime products, but also 
they were not vigilant enough and did not downgrade such ratings in a timely way when the 
first signs of deterioration of the situation started to become apparent.  

The  difficulties  experienced  with  structured  finance  ratings  have  demonstrated  that  CRA's 
were not attaching sufficient importance to monitoring the performance of the ratings issued 
in  the  past.  Understaffing  and  low  qualifications  of  the  surveillance  teams  on  the  one  hand 
and  questionable  frequency  of  the  actual  monitoring  reviews  of  the  ratings,  and  superficial 
character of such reviews on the other, have significantly affected the quality of ratings.  

The lack of sufficient, high quality and skilled resources to deal with the rating of complex 
structured products has – in general – been considered as one of the possible explanations for 
the  failures  of  the  agencies.  As  mentioned  above,  this  failure  might  have  been  even  more 
severe in relation to the surveillance function.32 CESR has gathered evidence supporting this 
assumption during the consultation with stakeholders33. 

CRAs have also been found to be inconsistent in how they deal with ratings issued in the past, 
if the methodology or key assumptions  they  were based on have been altered. In particular, 
anecdotal evidence suggests that when an agency upgraded or downgraded rating of a specific 
issue as a result of a change in its methodology, the agency would not concurrently review or 
adjust  the  ratings  given  to  similar  products  on  the  basis  of  such  a  methodology.  Therefore, 
users often find it difficult to establish whether unchanged ratings have been maintained in the 
light  of  methodology  change  or  whether  they  simply  have  not  been  reviewed.34  Finally, 
recently  concluded  examinations  by  the  US  Securities  and  Exchange  Commission  revealed 
that  some  rating  agencies  were  effectively  using  different  methodologies  and  models  for 
producing initial ratings and for ensuing surveillance activity.  

30 

31 

32 

33 

34 

Paragraph  106  of  CESR’s  Second  Report  to  the  European  Commission  on  the  compliance  of  credit 
rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. May 
2008. (CESR/08-277). 
The  Financial  Times  revealed  in  May  that  a  computer  bug  distorted  Moody's  ratings  for  a  complex 
instrument known as constant proportion debt obligation (CPDOs). However, Moody’s maintained the 
top-notch  ratings  on  these  products  until  2008,  when  they  were  downgraded  amid  general  market 
declines. The agency never denied this event. 
ESME  echoes  this  concern:  "For  structured  finance,  the  resources  of  the  CRAs  have  been  stretched 
following  the  rapid  growth  in  new  ratings  and  the  exponential  growth  in  deteriorating  structured 
finance securities. This has contributed to a delay in the re-rating decisions." 
Paragraphs 159 and 160 of CESR’s Second Report to the European Commission on the compliance of 
credit rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. 
May 2008. (CESR/08-277). 
Paragraphs 136 and 137 of CESR's Second Report to the European Commission on the compliance of 
credit rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. 
May 2008. (CESR/08-277) See annex 9.6. 

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3.2.3.  Lack of quality in the information used by the CRAs  

It is widely accepted that there is insufficient information available for market participants on 
the  evolution  of  the  underlying  assets  for  specific  structured  products35.  In  more  mature 
market  segments,  the  Prospectus36  and  Transparency37  Directives  require  issuers  to  provide 
periodical  and  ongoing  information  to  the  public  on  the  performance  of  the  issuer  and  the 
financial instruments traded in a regulated market or offered to the public. Investors could not 
easily find similar information on the performance and evolution of the underlying assets of 
the  structured  products  allowing  them  to  perform  their  own  risk  assessment  (e.g.  the 
originator of RMBS is not obliged to disclose on a monthly or quarterly basis the performance 
of the underlying mortgages: number of foreclosures, failures, defaults, etc).  

Another significant issue of concern is the information that the agencies use in order to make 
their  decision  on  the  ratings,  for  example,  whether  a  significant  level  of  fraud  or 
irresponsibility  has  been  identified  with  respect  to  the  underlying  assets  of  some  structured 
products. This is mainly in relation to RMBS (loans given to creditors with very poor or false 
creditworthiness;  exaggerated  valuations  of  the  underlying  assets).  Despite  the  fact  that 
originators  are  obliged  to  carry  out  their  own  due  diligence  processes  concerning  the 
information  that  they  are  conveying  to  the  agency,  CRAs  have  not  adequately  checked  the 
quality of the information they received from the originators38.  

The  lack  of  disciplined  underwriting  allows  for  an  increase  in  defaults  through  the  use  of 
inaccurate data or fraud. An analysis of a sample of loans which underperformed significantly 
compared  with  expectations  based  on  each  loan's  disclosed  risk  attributes,  showed  a 
significant number of irregularities. Among other issues, 66 % of the mortgage files contained 
occupancy  fraud,  51  %  contained  irregularities  related  to  property  value  or  other  loan 
conditions, 44 % stated a questionable income or employment, 16 % indicated identity theft 
and  10  %  indicated  signature  fraud.  Less  than  5000  cases  of  mortgage  loan  fraud  were 
reported  before  2002,  while  2004  and  2005  showed  18,391  and  25,989  cases  of  fraud, 

35 

36 

37 

38 

The  first  of  the  four  areas  of  action  of  the  ECOFIN  Roadmap  of  October  2007  relates  to  the 
transparency in the markets. The absence of accurate and timely information on exposures to credit risk 
has been a key factor in the generalised loss of investor confidence in financial markets since August 
2007. Questions about the adequacy of transparency have been raised in several respects, including: (i) 
information  provided  to  individual  investors  and  the  broader  market  by  special  purpose  vehicles 
(SPVs), i.e. conduits and Structured Investment Vehicles (SIVs) involved in the securitisation process; 
(ii)  bank  disclosure  of  securitisation  operations  and  exposures  to  SIVs,  (iii)  complexity  in  the 
structuring  and  measurement  of risk  in  structured  finance products  as  well  as  difficulties  in valuating 
these  products;  and  (iv)  opacity  in  the  functioning  of  markets  for  complex  financial  instruments. 
Supervisors, regulators and industry associations are examining how and where progress can be made in 
improving transparency, including in arrangements for information exchange among themselves. 

Directive  2003/71/EC  of  the  European  Parliament  and  of  the  Council  of  4  November  2003  on  the 
prospectus  to  be  published  when  securities  are  offered  to  the  public  or  admitted  to  trading  and 
amending Directive 2001/34/EC (OJ L 345, 31.12.2003, p. 64–89) 

Directive  2004/109/EC  of  the  European  Parliament  and  of  the  Council  of  15  December  2004  on  the 
harmonisation of transparency requirements in relation to information about issuers whose securities are 
admitted to trading on a regulated market and amending Directive 2001/34/EC (OJ L 390, 31.12.2004, 
p. 38–57) 

Fitch Ratings has analysed this issue and concluded that poor underwriting practices and fraud may be 
widespread  and  account  for  as  much  as  one-quarter  of  the  underperformance  of  recently  issued 
subprime  RMBS.  See:  The  Impact  of  Poor  Underwriting  Practices  and  Fraud  in  Subprime  RMBS 
Performance, Fitch Ratings, 28 November 2007 (research report available on website of Fitch).  

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respectively39. Considering the real impact and the extent of poor underwriting standards and 
fraud  in  the  class  of  subprime  RMBS  a  thorough  analysis  of  the  actual  quality  of  the  loans 
seems warranted.  

3.2.4.  Lack of analytical information in the ratings on the impact of market developments 

and macro economic expectations and price volatility 

It  appears  that  the  monitoring  of  the  structured  products  ratings  was  very  much  limited  to 
mere  data  monitoring,  whereas  the  analysis  of  the  impact  on  ratings  of  possible  future 
macroeconomic  expectations  was  left  aside40.  Investors  maintain  that  they  were  not  able  to 
ensure due diligence in their investment decisions based on ratings, as it was not clear how 
various market developments that move the parameters built-in the model may influence the 
rating  change.  Besides,  currently  the  agencies  do  not  include  in  their  rating  opinion  any 
indication about the volatility of the ratings. 

3.3. 

Lack of transparency of CRAs 

CRAs do not communicate with sufficient precision the characteristics and limitation of the 
ratings of structured finance products and they do not provide either sufficient information on 
critical  model  assumptions.  The  lack  of  this  information  hinders  the  understanding  of  the 
ratings  significance  by  market  participants.  CRAs  do  deliver  information  on  rating 
performance, but such information does not facilitate comparison among CRAs' performance. 

3.3.1. 

Structured and traditional ratings are not differentiated 

CRAs  use  the  same  rating  scale  for  structured  and  traditional  ratings.  Many  investors, 
typically less familiar with securitisation products, were confused as to the risk profile of the 
instruments involved: as they drew simple comparisons with traditional debt, rated according 
to the same scales, they were convinced that AAA-rated securitisation products (e.g. CDOs) 
were as safe as sovereign debt. As for the rating agencies, most of them have been reluctant to 
consider  separate  rating  scales  for  different  asset  classes.  They  argued  that  in  quantitative 
terms the probabilities of defaults can be compared across diverse asset classes, although the 
instruments  themselves  have  very  different  market  characteristics.  Nevertheless,  more 
recently  some  agencies  started  seeking  comments  from  market  participants  on  the  use  of 
distinctive grades for different asset classes (see initiatives by Moody's and S&P's described 
in  Annex  9.7).  A  survey  from  the  CFA  Institute41  dated  on  June  2008  posed  the  following 
question  to  its  members  (investment  professionals):  "do  you  believe  that  CRAs  ought  to  be 
compelled  to  use  different  rating  symbols  for  structured  products?"  There  were  1.956 
respondents, 47% answered yes, 42% answered no and 11% had no opinion.  

3.3.2.  No comparable information on CRAs performance available 

CRAs  occasionally  furnish  users  of  ratings  with  rating  transition  and  default  studies  – 
analyses  that  track  rating  activity  for  debt  instruments  over  a  certain  period.  Such  reports  – 
done  separately  for  structured  finance  and  traditional  debt  –  usually  include  a  review  of 

39 

40 
41 

EN 

Fitch  Rating  also  notes  that  such  reports  are  only  filed  by  federally  chartered  or  federally  insured 
institutions and the true number of cases could easily be two or three times higher. See: The Impact of 
Poor Underwriting Practices… 

ESME report, page 14 (see annex 9.6).  

www.cfainstitute.org 

17 

   EN 

                                                 
upgrades/downgrades and defaults by rating category for each of the main sub sectors – e.g. 
for structured finance it could be ABS, RMBS, CMBS and CDOs42. As a result, these reports 
are potentially a good basis for assessing CRAs' sound judgment in attributing ratings over the 
years.  There  are  two  major  caveats:  firstly,  market  practitioners  indicate  that  the  data 
presented in these reports have not always been complete; secondly, rating agencies differ in 
their approaches to collecting relevant data and presenting them to the public.  

4. 

OBJECTIVES 

Accurate  and  independent  ratings  are  essential  for  the  proper  functioning  of  the  financial 
markets. Therefore the main objective of the Commission proposal is to ensure that ratings are 
reliable  and  accurate  pieces  of  information.  Consequently,  it  is  of  the  utmost  importance  to 
mitigate  any  negative  influence  in  the  ratings  that  might  result  from  conflicts  of  interest  in 
CRAs, low standards of quality in the ratings and lack of transparency of the agencies. The 
objective of the European Commission is to achieve a solution for each of the elements of the 
three problematic areas that have been mentioned above under the problem definition section. 
Thus, the objectives of the proposal from the European Commission are the following:  

1) 

2) 

Ensure that CRAs avoid and manage appropriately any conflict of interest.  

Ensure that CRAs remain vigilant on the quality of the rating methodology and the 
ratings.  

3) 

Increase the transparency of CRAs.  

In addition there is an overall objective which is to enhance the compliance of CRAs with the 
measures  responding to the  three specific objectives listed  above throughout the territory of 
the European Union.  

4.1. 

Objectives in relation to CRAs' insufficiencies in their internal organisation and 
controls in relation to conflicts of interest 

Conflicts  of  interest  are  inherent  in  any  business.  They  relate  not  only  to  business 
relationships  but  also  to  other  type  of  relationships,  such  as  personal  or  economic 
relationships  the  staff  and  senior  managers  may  have.  Therefore,  CRAs  should  be  in  a 
position  to  avoid  conflicts  of  interest  or,  when  they  are  unavoidable43,  manage  them  and 
mitigate  their  effects.  This  general  objective  can  be  specified  in  the  following  concrete 
objectives: 

42 
43 

Please see Annex 9.3, where these acronyms are being explained.  

Following the example of other pieces of legislation there are situations where it is not possible to avoid 
all of the conflicts of interest. One example is Directive 2004/39/EC on markets in financial instruments 
(Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in 
financial  instruments  amending  Council  Directives  85/611/EEC  and  93/6/EEC  and  Directive 
2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC 
(OJ L 145, 30.4.2004, p. 1–44). Article 18 of this Directive provides investment firms are to maintain 
and  operate  effective  organisational  and  administrative  arrangements  with  a  view  to  taking  all 
reasonable  steps  designed  to  prevent  conflicts  of  interest  from  adversely  affecting  the  interests  of  its 
clients; in case those arrangements are not sufficient to ensure that risks of damage to client interests 
will be prevented, the investment firm shall clearly disclose to the client the general nature and sources 
of conflicts. 

EN 

18 

   EN 

                                                 
–  Ensure that the provision of advisory or ancillary services do not pose a conflict of interest 

to CRAs; 

–  ensure  that  the  dialogue  of  the  analysts  with  the  rated  entity  remains  unbiased  and 

objective; 

–  arrange remuneration policies and structures in a way to eliminate or manage conflicts of 

interest; 

–  mitigate "shopping for ratings" practice; 

–  ensure the independence of the analysts when joining a rated entity. 

4.2. 

Objectives in relation to the lack of quality of the methodology and the ratings 

CRAs should improve the quality of the rating methodology and the ratings. The intention of 
the  proposal  from  the  European  Commission  in  this  regard  should  not  be  to  prescribe  a 
specific rating methodology, but to ensure the quality and due diligence of the CRAs in their 
activities. In particular, the following specific objectives should be fulfilled:  

–  Ensure that the methodologies, models and key rating assumptions are appropriate for the 

rated instruments; 

–  ensure that existing ratings are diligently monitored; 

–  ensure that changes in methodology are consistently applied to all ratings concerned;  

–  ensure  that  the  information  used  by  the  CRAs  to  issue  a  specific  rating  is  statistically 

sound; 

–  ensure  that  CRAs  devote  adequate  staff  (in  terms  of  quantity  and  quality)  to  the  rating 

process (initial rating and monitoring); 

–  ensure that the analysis of an issuer or a product takes into account the impact of market 

developments and macro economic expectations.  

4.3. 

Objectives in relation to transparency of the CRAs 

CRAs should improve transparency in relation to their internal policies and the presentation of 
the  ratings.  The  purpose  of  enhanced  transparency  with  regard  to  disclosures  and  record-
keeping is two-fold: on the one hand, it will facilitate investor's awareness of the purpose and 
limitation of the ratings and it will allow comparison among CRAs performance. On the other 
hand, it will help to restore the confidence of the public on the rating business. 

In particular, the following specific objectives should be fulfilled:  

–  Ensure  sufficient  transparency  with  respect  to  the  functioning  of  internal  processes  and 

procedures; 

–  ensure  that  the  information  included  in  the  ratings  is  relevant  and  sufficient  in  order  to 

efficiently assess the probability of default of an instrument; 

EN 

19 

   EN 

–  avoid investors' confusion originated by the fact that the ratings for structured products and 

the ratings for traditional products (corporate, sovereign) are not distinguished; 

–  ensure that relevant data on CRAs performance in a standardised manner is available for 

market participants to allow for industry-wide comparisons. 

4.4. 

Horizontal  objective:  Enhancing  the  CRAs'  compliance  with  the  measures 
responding to the three specific objectives 

There should be a mechanism in place to ensure the effective compliance of the substantive 
requirements  to  be  respected  by  CRAs.  This  mechanism  should  create  the  least  possible 
burdens for CRAs while ensuring optimum observance of all substantive requirements. 

5. 

IDENTIFICATION OF POLICY OPTIONS 

The policy options that are going to be presented under this section have been developed in 
due consideration of the following sources: CESR Report, ESME Report, IOSCO Report on 
the Role of CRAs in Structured Finance Markets, the Report of the Financial Stability Forum 
on Enhancing Market and Institutional Resilience, the US Act on CRAs of 2006, the recent 
SEC  regulatory  proposals  on  CRAs  and  collective  and  individual  initiatives  presented  by 
CRAs. 

In  the  first  section  (5.1)  we  name  the  main  policy  options  that  have  been  discussed  and 
proposed  in  relation  to  the  substantive  requirements  that  could  be  fulfilled  by  the  CRAs  in 
order to meet each of the objectives set out in section 4. The options presented under each of 
the objectives are not necessarily exclusive or substitutive among themselves. A more detailed 
description of each policy option that also indicates its source is found in annex 9.8.  

In the next section (5.2) we shortly present the instruments that could be used to implement 
such  requirements.  The  assessment  of  each  of  the  different  policy  options  –  on  material 
requirements  and  on  instruments  for  implementation  –  is  presented  in  sections  6.1  and  6.2 
respectively. 

5.1. 

Policy options on the substantive requirements  

5.1.1.  Policy  options  to  remedy  CRAs'  insufficiencies  in  their  internal  organisation  and 

controls in relation to conflicts of interest 

The  general  policy  in  this  regard  is  that  CRAs  have  to  ensure  that  existing  and  potential 
conflicts of interest will not affect ratings.  

1. 

There should be some limitations for CRAs in order to avoid conflicts of interest.  

Options: 

a) 

b) 

CRAs shall identify conflicts of interest and either eliminate or properly manage and 
disclose them. 

Impose concrete limitations on CRAs activities: CRAs shall not be entitled to issue a 
rating in certain situations that can impair their independence. 

EN 

20 

   EN 

c) 

Impose  high  internal  governance  standards  including  an  independent  review 
function and fit and proper requirements for non-executive directors.  

To  eliminate  conflicts  of  interest  in  the  provision  of  advisory  services  CRAs 

2. 
should avoid human or technical link between the rating and advisory activities. 

Options: 

a) 

b) 

c) 

Obligation to separate business: A CRA shall separate, operationally and legally, its 
credit  rating  business  and  CRA  analysts  from  any  other  businesses  including 
consulting businesses.  

Separation  with  additional  caveats:  CRAs  are  required  to  publish  a  transparency 
report which discloses potential conflicts of interest.  

Limited  prohibition:  CRAs  shall  not  provide  consulting  or  advisory  services  to 
issuers that they are rating.  

d) 

Complete prohibition: CRAs shall not provide any consulting or advisory services. 

CRAs  should  ensure  that  the  dialogue  of  the  analysts  with  the  rated  entity 

3. 
remains unbiased and objective. 

Options: 

a) 

b) 

c) 

d) 

Clearly  defined  role  of  the  analysts:  Analysts  shall  be  prohibited  from  making 
proposals or recommendations regarding the creation or design of structured finance 
products.  

Transparency: CRAs shall ensure that they are fully transparent in terms of the exact 
nature of their interaction with issuers/arrangers of structured finance products.  

Record keeping: CRAs shall record the event and substance of the dialogue between 
the analyst and the issuer.  

Additional safeguards: the analysts and any other employees directly involved in the 
credit rating process shall not be allowed to participate in discussions regarding fees 
or payments with any rated entity. The rating agencies should envisage compulsory 
periodic rotation of analysts. 

4. 
CRAs should avoid the negative impact of conflicts of interest  in relation to  the 
remuneration prospects and other economic incentives of persons involved in the rating 
process. 

Options: 

a) 

b) 

Reporting  lines  for  the  rating  staff  and  their  compensation  arrangements  shall  be 
structured in a way to eliminate or effectively manage actual and potential conflicts 
of interest.  

Additional organisational requirements: the agency shall ensure the independence of 
the  analysts  and  persons  approving  the  ratings  in  the  design  of  the  reporting  and 

EN 

21 

   EN 

communication channels between them and the part of the agency responsible for the 
commercial interests of the entity;  

c) 

5. 

Increase the fixed element of the salary for the top managers.  

The "shopping for ratings" practice should be mitigated. 

Options: 

a) 

b) 

c) 

Disclosure  to  the  market:  an  agency  shall  disclose  on  a  periodic  basis  a  list  of  all 
cases where it comes across a "shopping for rating" practice.  

CRAs clients should refrain from shopping for ratings. 

Require issuers to disclose all necessary information to allow all interested CRAs to 
provide unsolicited ratings. 

The  independence  of  the  analysts  should  be  granted  even  when  he/she  joins  a 

6. 
rated entity.  

Options: 

a) 

b) 

Cooling off period: During a certain period after leaving the agency the analyst shall 
not be able to accept key management positions from the previously rated entity.  

Look back reviews: The agency shall review the past work of an analyst in the event 
that he or she leaves the agency to work for a client that he or she has rated. 

5.1.2.  Policy options for improving the quality of rating methodologies and the ratings 

Methodologies, models and key rating assumptions should be appropriate and up 

1. 
to date for the rated instruments. 

Options: 

a) 

b) 

c) 

2. 

CRAs  shall  put  in  place  an  independent  rigorous  and  formal  review  function 
responsible for periodically reviewing the methodologies and models it uses.  

CRAs shall review its methodologies in case of significant changes and on a regular 
basis, e.g. once a year. 

Methodologies and models should be validated by a public authority. 

CRAs should diligently monitor the existing ratings. 

Options: 

a) 

b) 

c) 

Require  CRAs  to  have  separate  teams  for  the  initial  rating  and  the  ongoing 
surveillance, both with adequate resources and expertise. 

Require CRAs to regularly monitor and update ratings  

Envisage expiry of ratings after a certain time period 

EN 

22 

   EN 

3. 

CRAs should apply changes in methodology consistently to all ratings concerned.  

Options: 

a) 

b) 

c) 

Impose disclosure obligation: CRAs shall disclose whether they apply retroactively 
model changes to existing ratings.  

Re-rate regularly: Require CRAs to apply the changes to past ratings due to the new 
methodology in the course of the regular review cycle of ratings  

Require  CRAs  to  promptly  re-rate  existing  ratings  according  to  the  new 
methodology. 

4. 

CRAs should use sound information for the issuance of ratings. 

Options: 

a) 

b) 

c) 

d) 

e) 

5. 

Ensure good quality of information in order to support a credible rating  

CRAs or a suitable third party (e.g. accounting firm) shall undertake due diligence of 
the underlying information:  

Quality warranties: CRAs shall require underwriters to provide representations about 
the level and scope of due diligence that they have performed and disclose the limits 
of their own due diligence.  

CRAs  shall  abstain  from  issuing  ratings  if  no  sound  data  is  available  or  if  the 
structure of the rated instrument is too complex to understand  

CRAs shall warn the users of ratings if the underlying data is not sufficiently sound.  

CRAs shall allocate adequate staff to the rating process. 

Options: 

a) 

b) 

c) 

CRAs  shall  ensure  that  employees  directly  involved  in  the  rating  process  have 
appropriate knowledge and experience.  

Additional  transparency  requirement  with  respect  to  the  employees:  CRAs  shall 
disclose staff numbers and qualifications as allocated to the different functions of the 
rating agency and keep record of the identity of credit analysts. 

Require  a  formal  qualification  for  rating  analysts  defining  a  minimum  level  of 
knowledge and experience.  

The analysis of an issuer or a product by the CRA should take into account the 

6. 
impact of market developments and macro economic expectations.  

Options: 

a) 

CRAs shall provide sufficient information about loss and cash-flow analysis related 
to the structured finance instrument. 

EN 

23 

   EN 

b) 

CRAs shall expand the initial and ongoing information that they provide on the risks 
characteristics of structured products and model assumptions by including additional 
information  on  e.g.  the  rating  stability,  the  assumptions  underlying  a  structured 
product  rating,  the  sensitivity  of  the  rating  to  changes  in  these  assumptions, 
weightings of key parameters and correlations.  

c) 

Public authorities shall validate the models and assumptions applied by CRAs 

5.1.3.  Policy options in relation to transparency of the CRAs 

A  number  of  options  may  be  considered  in  order  to  trigger  improvements  in  the  CRAs' 
transparency as regards their internal policies, their performance and the presentation of the 
ratings. In particular, the following specific objectives should be fulfilled:  

The  agency  has  to  be  transparent  with  respect  to  the  functioning  of  internal 

1. 
processes and procedures. 

Options: 

a) 

b) 

CRAs  shall  publish  sufficient  information  about  their  procedures,  methodologies, 
models and assumptions.  

Require  CRAs  to  disclose  a  periodic  report  containing  information  such  as  legal 
structure  and  ownership  of  the  CRA,  description  of  the  internal  quality  control 
system and indicators of staff allocation.  

The information included in the ratings has to be relevant and sufficient in order 

2. 
to efficiently assess the probability of default of an instrument.  

Options: 

a) 

b) 

c) 

Require  CRAs  to  inform  investors  on  loss  and  cash-flow  analysis  and  about 
sensitiveness to changes in rating assumptions  

Require  CRAs  to  be  committed  to  investors'  education  by  clearly  explaining 
attributes and limitations of credit rating opinions  

Require additional technical information in the ratings: including, e.g. ‘expected loss‘ 
‘worst  case/best  case  scenarios  ratings‘  and  ‘break-even‘  credit  loss  for  different 
tranches as well as 'what if' scenarios.  

3. 
Avoid  investors'  confusion  triggered  by  the  use  of  the  same  symbols  for  the 
ratings  for  structured  products  and  the  ratings  for  traditional  debt  (corporate, 
sovereign).  

Options: 

a) 

b) 

EN 

Use  different  symbols  or  a  different  rating  scale  for  traditional  ratings  and 
structured finance ratings.  

Use the same scale but aggregate additional information to the ratings (highlighted 
by  a  label/rating  suffix):  CRAs  shall  also  inform  users  of  the  greater  potential 
volatility associated with structured finance instruments.  

24 

   EN 

c) 

Educate  investors  in  the  particularities  of  the  ratings  for  structured  products  and 
traditional debt respectively 

CRAs should make available to market participants the relevant data about their 

4. 
performance in a standardised manner to allow for industry-wide comparisons.  

Options: 

a) 

b) 

c) 

CRA industry shall establish a centralized repository for ratings performance studies 
to  allow  easier  market  comparisons  among  the  CRAs  and  make  available  ratings 
performance data to regulatory authorities.  

Obligation to publish historical default rates of CRA rating categories and whether 
the default rates of these categories have changed over time.  

Obligation to disclose standardised performance information and create a repository 
of ratings at EU level preferably by CESR.  

5.2. 

Instruments to put in place the policy option 

In response to Objective 4.4 identified in Section 4 of this report (ensure that CRAs indeed 
comply  with  a  given  set  of  rules),  several  options  may  be  considered,  ranging  from  simple 
reliance  on  the  CRAs’  internal  efforts  to  the  establishment  of  a  comprehensive  surveillance 
framework  administered  by  public  authorities.  It  should  be  borne  in  mind  that  specific 
supervisory arrangements may imply prior use of a particular instrument introducing them as 
well as accompanying substantive requirements. For example, if a public authority were to be 
vested  with  the  task  of  supervising  CRAs,  its  competence  would  need  to  be  anchored  in 
binding  legislation  that  would  envisage  clear  obligations  for  the  CRAs.  Similarly,  self-
regulatory oversight mechanisms cannot be mandated by legislators or proclaimed by a single 
market  player,  but  will  normally  require  an  industry  wide  commitment  to  succeed  (e.g. 
expressed in a code of conduct).  

EN 

25 

   EN 

Supervision by 
public body 

Oversight Body 
(private sector) 

Policy options chart 

OPTION 2 
European Code of Conduct 

OPTION 4 
Legislation at EU 
level 

No supervision 

OPTION 1A 
IOSCO Code of 
Conduct 

OPTION 1B 
Industry-wide 
efforts White Paper 

OPTION 1C 
Additional 
initiatives by 
individual CRAs 

OPTION 3 
Commission 
Recommendation 

Self regulation 

Rules at EU level 

The  above  scheme  identifies  a  number  of  policy  approaches  that  could  be  considered  to 
address the CRA issues. Each of them is effectively determined by two parameters: (i) how 
the  CRAs  are  regulated  [horizontal  axis]  (ii)  how  the  CRAs  are  supervised  [Vertical  axis]. 
Those  two  parameters  are  closely  interrelated.  We  may  broadly  distinguish  the  following 
approaches: 

1. 

2. 

3. 

4. 

Proposing no action – existing solution remains satisfactory (self regulation based on 
IOSCO code and CRAs initiatives); 

proposing a European code of conduct; 

proposing a recommendation by the Commission;  

proposing legislative measures;  

As an  essential  element of  these different policy alternatives, supervisory arrangements will 
be presented in the next subparagraphs. Each of these modalities for a supervisory framework 
is evaluated in section 6.  

5.2.1. 

Self regulation (No policy change) 

5.2.1.1.  IOSCO code 

This option implies that the European Commission would consider that the current situation in 
relation to CRAs is satisfactory and appropriate in order to fulfil the objectives described in 
section  4.  In  this  case,  the  framework  described  in  the  Commission  Communication  in 
relation to CRAs in 200644 would be considered still adequate: CRAs should just adapt their 
internal codes of conduct to the revised IOSCO code45. CESR would keep its monitoring role 

44 
45 

EN 

See section 1.4. 

In  May  2008  the  Members  of  IOSCO  approved  a  revision  of  the  code  of  conduct  for  CRAs.  The 
relevant changes introduced in the code are mentioned in point 2.3.1 of this Impact Assessment. 

26 

   EN 

 
 
 
                                                 
and publish once a year an annual report to the European Commission on the compliance of 
CRAs with the IOSCO Code (for a more comprehensive explanation of the current framework 
in  the  EU,  see  annex  9.1).  Additionally,  this  option  would  consider  that  the  agencies 
themselves  have  come  forward  with  appropriate  solutions  to  the  problems  and  concerns 
mentioned above. It should be noticed that CRAs have recently presented several initiatives, 
in the form of self-regulatory proposals (see 5.2.1.1 and 5.2.1.2). Initially the big CRAs put 
forward  collectively  a  joint  initiative.  At  a  later  stage,  some  of  them  presented  additional 
initiatives on an individual basis. 

5.2.1.2.  Industry-wide efforts – White Paper 

In January 2008 the five main CRAs46 jointly addressed a White Paper to regulators with 12 
proposals to improve the IOSCO code of conduct in relation to the independence, quality and 
transparency of the credit ratings:47  

•  The  independence  of  the  credit  rating  process  (prohibit  analysts  to  make  proposals  or 
recommendations on the securitization products; advisory services should not be provided 
by  CRA;  "look  back"  reviews  when  analysts  leave  the  agency  should  be  imposed; 
periodical review of remuneration policies and practices for analysts should be in place). 

•  The  quality  of  the  ratings  (introduce  reviews  of  criteria  and  methodology  of  ratings; 
introduce  improvements  in  the  monitoring  process;  enhance  staff  training;  encourage 
issuers for a full disclosure to the market of information on structured products). 

•  The  transparency  of  credit  ratings  (set  up  of  a  centralised  depository  of  ratings;  give 
regulators access to data on rating performance to allow them to conduct their own controls 
on  rating  performance;  investor  education  on  the  meaning  of  a  rating,  the  rating  process 
and CRAs' role in the market). 

Almost all of the above mentioned proposals coincided with the reform plans of the IOSCO 
code48. 

5.2.1.3.  Additional initiatives by individual CRAs 

Apart from the joint proposal, each of the big CRAs put in place several improvements: 

•  On February 2008 Standards and Poor's presented an ambitious reform plan that included 
measures like the appointment of an Ombudsman for stakeholders, a public annual review 
of governance processes by an independent firm or the client rotation for analysts.  

•  In  September  2007  Moody's  proposed  a  set  of  practical  requirements  to  enhance  the 
control  of  the  quality  of  the  information  about  the  underlying  assets  of  a  structured 
product.  Later  in  March  2008  the  agency  presented  other  initiatives  to  better  address  the 
issue  of  the  quality  of  the  data  used  in  the  rating  process.  In  February  2008  Moody's 

46 

47 
48 

EN 

Standard & Poor's rating Services, Moody's Investors Services, Fitch, Inc., DBRS Limited and AM Best 
Company, Inc. 

A detailed summary of the proposals can be found in Annex 9.9. 

See point 2.3.1 

27 

   EN 

                                                 
carried  out  a  public  consultation  on  whether  the  rating  scales  for  structured  finance 
products should be differentiated from traditional ratings.  

•  Fitch has separated its non-rating businesses into a separate division (Fitch Solutions) and 
has implemented internal changes in its structured finance operations to support objectivity 
and  consistency  in  the  rating  review  process.  Fitch  presented  further  improvements,  like 
increased  analyst  and  manager  rotation,  enhancements  to  the  formal  internal  training 
programs  for  analysts,  greater  external  investor  education  efforts  and  is  considering  a 
broad range of feedback on other aspects of the current agency business model. The CRA 
also  worked  on  the  development  of  additional  rating  scales  and  indicators  that  would 
complement its opinions on structured finance transactions.  

For a more detailed summary of these initiatives of the CRAs, see Annex 9.7. 

5.2.2.  European Code of conduct for CRAs 

Another  form  of  self-regulation  but  with  some  sort  of  external  monitoring  would  be  one 
inspired  by  CESR  and  ESME  report:  a  code  of  conduct  that  encompasses  IOSCO 
requirements  (plus  the  recommendations  made  by  CESR  and  ESME)  and  monitored  by  an 
external oversight body composed of e.g. representatives of investors, issuers and investment 
firms. 

This  self-regulatory  solution  could  follow  another  precedent  in  the  EU  financial  sector,  the 
European  Code  of  Conduct  for  Clearing  and  Settlement  of  November  2006.  This  is  a 
voluntary  solution  and  needs  the  previous  common  agreement  of  the  CRA  industry.  The 
members of the industry would commit themselves in writing to respect a range of standards – 
listed in the code – and to accept and respect the recommendations of a monitoring body that 
would check the level of compliance of the code by the signatories. Nevertheless, this body 
would not be invested with enforcement powers. 

This option is inspired by the CESR and ESME advice49. Both bodies welcomed the revision 
of IOSCO code and made additional recommendations. Both bodies – explicitly or implicitly 
– recommended the Commission to promote a new voluntary European code of conduct (the 
revised  IOSCO  code  supplemented  by  CESR/ESME  recommendations).  The  role  of  the 
Commission in this case would be to invite those CRAs having relevant presence in the EU to 
adhere to such a code. ESME and CESR differed in relation to the oversight body that should 
monitor the compliance of CRAs with the standards of the code. 

a) 

49 
50 

CESR encouraged the Commission to form an international "CRAs standard setting 
and  monitoring  body"50  that  would  develop  international  standards  for  the  rating 
industry and would monitor the compliance of CRAs with those standards, using full 
transparency as the method for enforcement and having "name and shame" capacity. 
CESR also provided for a fall-back option in case this international oversight scheme 

See point 2.2. 

Paragraph  269  of  CESR’s  Second  Report  to  the  European  Commission  on  the  compliance  of  credit 
rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. May 
2008. (CESR/08-277). 

EN 

28 

   EN 

                                                 
can not be achieved: In that case CESR recommends the formation of such a body at 
EU level.51 

b) 

ESME  recommended  that  CESR  should  keep  its  monitoring  role  concerning  the 
CRAs' adherence to the IOSCO code as set out in the Commission Communication 
on  CRAs  of  2006,  but  such  a  task  should  be  bolstered  by  commissioning,  in 
conjunction with the CRAs, an external annual review and report on the adequacy of 
corporate governance in each CRA and forming an advisory group to advise CESR 
of:  (a)  significant  developments,  trends  and  issues  in  the  credit  markets  which  are 
relevant  to  the  activities  of  the  CRAs;  and  (b)  any  rating  trends/issues  which  are 
prompting concerns.52 

In  this  context,  the  Commission  would  have  to  invite  CRAs  to  accept  that  such  an 
international/European body is entitled to monitor their compliance with the code of conduct. 
To  make  it  operative,  CRAs  should  commit  themselves  to  fully  collaborate  with  the 
monitoring body. 

5.2.3.  Recommendation 

Under  this  option  the  Commission  would  outline  the  standards  that  CRAs  would  have  to 
comply  with  when  they  operate  in  the  EU.  These  standards  would  be  aligned  with  those 
mentioned in the fourth option (below). The standards would be built upon the revised IOSCO 
code and CESR and ESME recommendations, and would include those additional standards 
considered by the Commission relevant in order to achieve the objectives set out in section 4 
of this Impact Assessment. 

In  accordance  with  Article  249  of  the  Treaty  establishing  the  European  Community, 
recommendations do not have binding force. It would therefore be up to the CRAs whether 
they  comply  with  the  standards  set  out  in  the  Recommendation.  This  option  of  a  voluntary 
nature would have similar effects to a code of conduct. 

5.2.4.  Legislation 

A  fourth  policy  option  would  consist  in  a  legislative  proposal  to  be  presented  by  the 
Commission providing for a comprehensive regulatory framework for CRAs. The addressees 
of the rules would be all existing and prospective CRAs (with business operations in Europe) 
whose  ratings  are  intended  for  use  for  regulatory  purposes  like  the  Capital  Requirements 
Directive53, by financial institutions in the EU.  

The  main  objective  of  the  legislative  proposal  would  be  to  ensure  that  ratings  are  more 
reliable and accurate. Therefore it is of utmost importance to mitigate any negative influence 
on the ratings resulting from conflicts of interest within CRAs, low standards of quality in the 
ratings and lack of transparency of the agencies. The objective is to address systematically the 

51 

52 
53 

EN 

Paragraph  271  of  CESR’s  Second  Report  to  the  European  Commission  on  the  compliance  of  credit 
rating agencies with the IOSCO Code and the role of credit rating agencies in structured finance. May 
2008. (CESR/08-277). 

ESME's Report to the European Commission. Role of Credit Rating Agencies. June 2008. 

See section 1.4 and annex 9.1. 

29 

   EN 

                                                 
risks arising from these three areas. Thus, the objectives of the legislative proposal would be 
the following: 

–  Ensure that CRAs avoid and manage appropriately any conflict of interest. 

–  Ensure that CRAs apply a high standard for the quality of the rating methodology and the 

ratings. 

–  Increase the transparency of the CRAs. 

On the one hand, the legislative proposal would contain a set of rules introducing a number of 
substantive  requirements  that  CRAs  will  need  to  respect  in  the  issuance  of  ratings.  These 
substantive  requirements  would  cover  issues  related  to  the  organisational  structure  and 
internal governance of credit rating agencies, the avoidance and management of conflicts of 
interest,  the  quality  of  ratings  and  transparency  obligations.  These  requirements  would  not 
interfere with the result of the rating process, (the content of the ratings) for which the CRAs 
retain full responsibility. 

On  the  other  hand,  the  legislative  proposal  will  need  to  provide  for  a  registration  and 
surveillance system which is adapted to the specificities of the rating activity. There are two 
possible options regarding the supervisory architecture: 

–  In  a  first  option  public  authorities  in  the  Member  States  would  be  entrusted  with  the 
registration and surveillance of the rating activity. CESR would play a strong coordination 
role. Competent authorities would have legal powers to assess the compliance of the CRAs 
with  the  new  legal  requirements  and  would  be  entitled  to  impose  sanctions  on  CRAs  in 
case of non-compliance. In this framework the competent authority of the home Member 
State  could  decide  on  the  registration  request  of  an  applicant  CRA  and  would  have  the 
main responsibility in supervising this CRA and apply sanctions, where necessary. Other 
competent  authorities  would  be  strongly  involved  in  the  surveillance  process  and  would 
retain  competence  notably  in  case  of  lack  of  or  ineffective  action  by  the  competent 
authority  of  the  home  Member  State.  The  convergence  of  supervisory  and  enforcement 
practices could be ensured by CESR 

–  A second option would be to set up a Community Agency (this could be either CESR or a 
new Agency) that would carry out the registration at central level. The daily surveillance of 
CRAs  would  remain  with  national  regulators.  The  Agency  would  designate  the  home 
Member State competent authority for the surveillance and would coordinate the action of 
the  competent  authorities.  It  would  also  give  advice  to  competent  national  authorities  in 
supervisory issues. Further, the Agency would have the power to intervene in the event that 
national  competent  authorities  fail  to  cooperate  effectively.  The  mandate  of  the  new 
Agency would be restricted to CRA issues. It would have its own staff and could also have 
technical committees. The Agency would be financed from the EU budget. 

6. 

ANALYSIS OF IMPACTS 

6.1. 

Analysis of the policy options on the substantive requirements 

This section  discusses the main  issues  to be addressed by each particular instrument among 
those  described  in  section  5.2.  Summary  tables  measure  the  comparative  advantages  and 
disadvantages of the different possible solutions against the following criteria: 

EN 

30 

   EN 

a) 

b) 

c) 

d) 

Effectiveness:  The  extent  to  which  the  option  fulfils  the  objectives  formulated  in 
section 4. 

Certainty: There should be highest possible confidence of the  relevant stakeholders 
as to the content of the rules to be respected and that the rules followed in practice 
are closely aligned with the objectives of the framework.  

Convergence:  The  framework  for  operation  of  CRAs  should  be  governed  by  the 
same  requirements  in  all  Member  States.  A  level  playing  field  should  be  created. 
Furthermore, given the global dimension of this industry, it is necessary to take into 
account  the  global  context,  international  standards  and  legal  requirements  in  third 
countries (particularly US rules).  

Flexibility  and  efficiency:  An  environment  should  be  established  to  facilitate  the 
operation of CRAs across the Member States. CRAs should have a level of flexibility 
to  shape  their  internal  organisation,  but  without  hampering  the  achievement  of  the 
objectives of the EU policy in this area. Flexibility, which captures simplicity, also is 
a  cost  indicator  and  therefore  indicates  efficiency:  the  greater  the  flexibility  left  to 
CRAs,  the  more  CRAs  can  make  choices  adapted  to  their  needs  and  control  their 
costs. 

In the tables, the options are measured against the above-mentioned pre-defined criteria. Each 
scenario is rated between “---” (very negative impact) and “+++” (very positive impact). 

At the end of each assessment of the different policy options, it is highlighted which policy 
option(s)  is/are  best  placed  to  reach  the  objectives  outlined  in  section  4  with  regard  to  the 
assessment criteria and are therefore the preferred policy options. The policy options do not 
necessarily  exclude  each  other.  Thus,  the  preferred  policy  response  will  often  be  a 
combination of the different policy options.  

6.1.1.  Analysis of the options to remedy CRAs' insufficiencies in their internal organisation 

and controls in relation to conflicts of interest 

1. 

Limitations for CRAs in order to avoid conflicts of interest. 

The  existing  general  approach  in  the  IOSCO  Code  has  not  been  sufficiently  effective  to 
manage  the  CRAs'  conflicts  of  interest.  It  does  not  guarantee  certainty  for  stakeholders  and 
CRAs.  It  essentially  leaves  to  the  CRAs  to  decide  what  is  effectively  prohibited  and  what 
safeguards are necessary in their internal structures and procedures.  

The use of specific limitations, situations in which CRAs would not be allowed to issue credit 
ratings, would not be effective enough to manage all possible conflicts of interest in a CRA. 
Whilst  for  CRAs  this  solution  would  be  easier  than  the  introduction  of  changes  in  their 
internal structure, only the latter would offer strong structural underpinning to overcome the 
weaknesses  of  the  current  conflicts  of  interest  management  in  the  agencies  and  would 
ultimately help restore their credibility in the markets.  

To impose certain limitations for CRAs in this field would be consistent with the US Act on 
CRAs,  where  CRAs  have  strict  limitations  for  situations  where  there  are  links  between  the 
analysts  or  person  approving  ratings  and  the  rated  entity  (a  rating  agency  is  not  allowed  to 
issue  ratings  when  he  or  she  has  direct  ownership  or  is  a  member  of  supervisory  or 

EN 

31 

   EN 

management  board  of  the  rated  entity,  or  the  CRA  is  associated  with  the  rated  entity)  and 
where CRAs cannot receive more than the 10% of their annual revenue from the same client.  

However,  to  impose  a  concrete  limitation  in  the  annual  revenue  that  a  CRA  could  receive 
from the same client could be disproportionate for small or newcomer CRAs. Therefore, an 
alternative solution could be not to impose such a limit but to require the agency to disclose to 
the public the cases where it has received more than the 5% of its annual revenue from the 
same client. The solution of disclosure when reaching certain limits would be consistent with 
the IOSCO code of conduct for CRAs. 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Identification of 
conflicts  

Concrete 
limitations 

High internal 
governance 
standards 

- 

+ 

++ 

- 

+ 

++ 

Efficiency 

+ 

- 

- 

+ 

++ 

+ 

The  preferred  solution  would  thus  be  a  combination  of  the  three  policy  options  proposed. 
Although a general principle may be offering too much flexibility on a standalone basis, it is 
important to keep it in order to cover any kind of conflict of interest which may emerge and 
which  is  not  covered  by  express  limitations.  In  addition  appropriate  internal  governance 
requirements should also be part of the policy response. 

2. 

Elimination of conflicts of interest in the provision of advisory services. 

In order to ensure that CRAs are sufficiently insulated from the resulting conflicts of interest 
it is necessary to have an express prohibition of combining rating and advisory activity in the 
same  rating  agency.  In  few  cases  only  would  the  disclosure  be  enough  to  manage  these 
conflicts. On the whole, however, the range and magnitude of negative incentives to which a 
CRA would be exposed justifies that it is necessary to introduce a clear obligation to avoid all 
these conflicts, a prohibition of providing consulting or advisory services should be ensured. 
CRAs  would  need  to  revisit  their  business  structure  to  ensure  the  complete  elimination  of 
consulting  and  advisory  services  from  the  product  portfolio  and  strict  focus  on  their  core 
activity.  The  prohibition  to  provide  advisory  services  is  consistent  with  the  US  rules  and 
IOSCO  code  provisions.  In  any  event,  most  of  the  parent  undertakings  of  the  CRAs  have 
already  separated  legally  and  operationally  the  consultancy  part  of  the  business  form  the 
rating activity. Therefore such requirement would not create any costs to the CRAs. 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Obligation to 
separate business 

Separation with 
additional caveats 

Limited 
prohibition 

+ 

+ 

+ 

EN 

Efficiency 

+ 

+ 

- 

+ 

+ 

++ 

- 

+ 

+ 

32 

   EN 

 
Complete 
prohibition 

++ 

++ 

++ 

- 

The  preferred  solution  is  a  combination  of  the  obligation  to  separate  business  and  the 
complete prohibition of providing consulting or advisory services. 

CRAs  should  ensure  that  the  dialogue  of  the  analysts  with  the  rated  entity 

3. 
remains unbiased and objective. 

In line with IOSCO we consider that it is essential to increase the transparency of the rating 
process  within  CRAs.  Thus,  there  is  merit  in  monitoring  analysts'  activities  and  keeping 
records of any communication related to the credit rating activity. For some CRAs this may 
imply additional costs; however it will assist these CRAs which are already introducing some 
closer  internal  controls  on  the  activity  of  analysts.  Such  measures  would  help  to  restore  the 
credibility  of  CRAs'  rating  activity.  Such  an  option  would  be  consistent  with  the  US 
requirements, where CRAs have extensive record keeping obligations. 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Clearly defined role 

Transparency 

Record-keeping 

Additional 
safeguards 

- 

++ 

++ 

++ 

- 

++ 

++ 

++ 

Efficiency 

+ 

+ 

+ 

+ 

- 

++ 

++ 

++ 

As  all  these  measures  are  complementary  and  safeguard  the  integrity  and  independence  of 
analysts vis-à-vis the issuers, the preferred policy response would be a combination of all the 
options outlined above. 

4. 
CRAs  should  avoid  negative  impact  of  conflict  of  interest  in  relation  to  the 
remuneration  prospects  and  other  economic  incentives  of  persons  involved  in  rating 
process. 

Compensation  policies  are  extremely  important  to  ensure  the  objectivity  of  the  credit  rating 
process. It should be avoided that the analysts are compensated by reference to the amount of 
revenue that their work generates to the agency. It is necessary to ensure that the analysts are 
entirely independent from the commercial interests of the CRA (e.g. they are not involved in 
discussing impacts of methodology changes on CRAs' revenue prospects).  

EN 

33 

   EN 

 
Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Structure reporting 
lines  

Additional 
organisational 
requirements 

Increased fixed 
element of 
managers' salary 

+ 

++ 

++ 

Efficiency 

+ 

+ 

+ 

-- 

+ 

++ 

+ 

++ 

++ 

The preferred policy response would be inspired by the second and third policy option, i.e. in 
addition  to  structured  reporting  lines  (status  quo)  compensation  of  rating  analysts  and 
managers should be de-linked form the amount of revenue generated by the analyst and other 
additional safeguards ensuring the independence of analysts from commercial interests of the 
CRA should be undertaken. 

5. 

Elimination of the "shopping for ratings" practice. 

The  solution  could  consist  in  making  the  CRAs  disclose  information  about  cases  of  non-
publication  of  credit  ratings  prepared  and  about  cases  where  after  a  preliminary  rating  an 
originator of a structured finance instrument did not contract for a final rating. This measure 
would  allow  for  closer  market  scrutiny  of  those  engaging  in  the  shopping  for  ratings  and 
would take off some pressure from the CRAs to compete by way of offering more favourable 
ratings.  By  encouraging  issuers  to  disclose  all  relevant  information  concerning  structured 
finance  products,  CRAs  would  have  the  possibility  to  issue  unsolicited  ratings  that  might 
counter the rating opinion issued by another agency on the issuer's request; however, none of 
these measures would in itself eliminate the shopping for ratings. CRAs should not be entirely 
responsible for the elimination of such a practice; rather the clients of the CRAs should refrain 
from engaging in the "shopping for ratings". 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Disclosure  to  the 
market 

Issuers  to  disclose 
information  

Issuers 
should 
avoid the practice 

+ 

+ 

++ 

Efficiency 

- 

+ 

++ 

++ 

- 

+ 

+ 

- 

- 

The  preferred  policy  option  would  be  the  third  option  mentioned  above,  i.e.  to  encourage 
issuers  to  avoid  such  a  practice.  This  solution  would  be  more  effective  and  flexible,  as  it 
would not impose CRAs an obligation that is not up to them to meet. 

EN 

34 

   EN 

 
The  independence  of  the  analysts  should  be  granted  even  when  he/she  joins  a 

6. 
rated entity. 

A  "cooling  off"  period54  would  effectively  fulfil  the  objective  of  managing  conflicts  of 
interest. The "look back" review would reinforce the fulfilment of that objective.  

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Cooling off period 

Look back reviews  

++ 

++ 

++ 

++ 

+ 

++ 

Efficiency 

+ 

++ 

The preferred policy response is a combination of a proportionate cooling off period together 
with look-back reviews. 

6.1.2.  Policy options for improving the quality of the methodology and the ratings 

Methodologies, models and key rating assumptions should be appropriate and up 

1. 
to date for the rated instruments. 

The  need  for  an  internal  review  function  for  the  methodologies,  models  and  key  rating 
assumptions  is  now  broadly  accepted  by  CRAs.  Moreover,  it  is  largely  accepted  that  CRAs 
should review their methodologies in case of significant developments to ensure the validity 
of their ratings; in addition, these reviews should also be undertaken on a periodic basis. The 
validation of the methodologies by the public authorities would not be effective enough given 
that public authorities may not always have the expertise and knowledge required to validate 
models for complex financial products. Such a solution would not be consistent with US rules 
or  IOSCO  code.  Moreover,  it  would  reduce  the  necessary  flexibility  that  CRAs  need  to 
perform their activity and adapt to financial innovative products.  

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Review function  

Review when 
significant 
changes 

Validation of 
models by public 
authorities 

+ 

++ 

- 

+ 

++ 

+ 

Efficiency 

+ 

+ 

- 

+ 

++ 

- 

Options 1 and 2 should be applied whereas option 3 (validation of methodologies by public 
authorities) does not appear to be proportionate. 

2. 

CRAs should diligently monitor the existing ratings. 

On-going monitoring of ratings by CRAs would be an effective measure to ensure the quality 
of the ratings. This would encourage timely adjustments of the ratings to the developments in 

54 

See point 6 in section 5.1.1 

EN 

35 

   EN 

                                                 
the  markets  (as  opposed  to  more  cyclical  reviews).  This  on-going  monitoring  of  ratings  is 
largely  practised  by  the  CRAs,  and  it  may  be  further  reinforced  by  some  transparency 
obligations (e.g. disclosures on the scope and frequency of monitoring activity). While there 
may be some merit in introducing a periodic review to ensure more in-depth analysis of the 
validity of existing ratings, enough flexibility should be given to CRAs to perform this work. 
In  the  same  vein,  while  it  may  be  desirable  to  have  separate  teams  in  the  CRAs  for  initial 
ratings  and  their  subsequent  reviews,  it  should  not  be  translated  –  especially  beyond  the 
structured ratings field – into a firm requirement on CRAs.  

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Separate teams 

Ongoing update of 
ratings  

Expiry date for 
ratings 

++ 

++ 

- 

++ 

++ 

++ 

Efficiency 

- 

+ 

-- 

+ 

+ 

-- 

The preferred policy option is to require the ongoing update of ratings (Option 2). 

3. 

CRAs should apply changes in methodology consistently to all ratings concerned.  

In order to avoid confusion among users of ratings, changes in methodology should be applied 
not only to new ratings, but also to the existing ones. Whilst a regular review of ratings would 
allow  CRAs  to  manage  their  workflow  in  a  steady  manner,  prompt  re-ratings  according 
following  changes  to  methodology  would  allow  investors  to  refer  to  the  more  accurate 
creditworthiness  assessments  (i.e.  more  valuable  for  investment  purposes).  A  simple 
obligation  to  disclose  whether  CRAs  apply  retroactively  methodology  changes  to  existing 
ratings would not appear sufficient. 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Disclosure 
obligation 

Re-rate regularly 

Promptly re-rate 

+ 

+ 

++ 

Efficiency 

++ 

+ 

+ 

- 

+ 

++ 

+ 

+ 

++ 

Option  3  requiring  the  CRAs  to  re-rate  credit  ratings  promptly  in  case  of  a  change  of 
methodology is therefore the preferred policy option. 

4. CRAs should use sound information to issue a specific rating. 

Mere reliance on a general standard requiring CRAs to use data of sufficient quality may be 
insufficient.  Measures  imposing  due  diligence  duties  directly  on  CRAs  (or  suitable  third 
parties working on their behalf) with regard to the information used in the ratings would likely 
lead  to  significant  improvements  in  the  quality  of  ratings,  but  at  the  same  time  create 
substantial  additional  burden  for  CRAs.  A  more  proportionate  solution  would  be  an 
expectation  that  CRAs  assess  and  factor  in  the  rating  process  underwriters’  representations 
about the level and scope of due diligence that has been performed on the underlying assets. 

EN 

36 

   EN 

 
In addition, high certainty would be brought to the markets, if CRAs abstained from issuing 
ratings when the data they have is not sufficiently sound. This late option would be consistent 
with US rules. More flexibility would be given to CRAs if an obligation of warning about the 
lack of sound information is imposed on them.  

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

General 
obligation to 
ensure quality of 
information 

Due diligence 
requirement 

Quality 
warranties 

Abstain from 
issuing ratings 
without sound 
data 

Warn if data not 
sufficiently sound 

- 

++ 

++ 

++ 

+ 

Efficiency 

++ 

-- 

+ 

- 

+ 

+ 

++ 

++ 

++ 

+ 

- 

++ 

++ 

++ 

+ 

The preferred policy option would be a combination of all the options presented.  

5. 

CRAs shall allocate adequate staff to the rating process. 

CRAs  will  need  to  ensure  that  employees  involved  in  the  rating  process  are  sufficiently 
qualified.  CRAs  should  deliver  on  their  commitments  of  increasing  staff  numbers  and 
strengthening  their  expertise,  as  necessary.  To  this  end,  an  obligation  for  CRAs  to  inform 
users  of  ratings  on  the  rating  and  monitoring  staff  numbers  –  at  least  on  a  periodic  basis  – 
would  seem  appropriate  to  achieve  the  effect  of  increased  market  scrutiny  and  it  would  be 
consistent with US rules. Introducing a specific professional qualification for rating analysts 
would  not  appear  particularly  effective  as  a  measure  triggering  higher  quality  of  the  rating 
staff. 

Criteria 

Effectiveness  Certainty 

Convergence 

Flexibility/ 

Option 

General obligation to 
employ appropriate 
staff  

Transparency 
requirement 

Formal Qualification 
for analysts 

- 

++ 

+ 

- 

++ 

++ 

Efficiency 

++ 

++ 

- 

+ 

++ 

+ 

The preferred policy option is a combination of Options 1 and 2. 

The analysis of an issuer or a product by the agency should take into account the 

6. 
impact of market developments and macro economic expectations.  

EN 

37 

   EN 

 
 
Requiring  additional  information  on  risks  characteristics,  assumptions  and  stress  testing 
would meet the expectations of investors and regulators and would help to restore confidence 
in  the  market.  It  would  imply  some  additional  efforts  for  CRAs.  CRAs’  assumptions  and 
scenario  analysis  about  economic  and  other  systemic  factors  are  an  important  part  of  the 
information that investors need if they are to use ratings properly. Investors should therefore 
have  access  to  the  assumptions  and  scenarios  underlying  the  rating  of  structured  finance 
products. On the other hand, although it could provide for a common framework of reference, 
the validation by public authorities of models and methodologies would be an extremely rigid 
solution. The shaping of the methodologies, models and assumptions that CRAs actually use 
should stay in the remit of the agencies themselves. 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Efficiency 

Additional information on loss and cash-
flow analysis  

Additional information on risk 
characteristics, model assumptions and 
stress testing 

Validation by public authorities of 
models and assumptions  

+ 

++ 

-- 

+ 

+ 

++ 

++ 

+ 

+ 

- 

- 

-- 

The preferred option would therefore be to have additional information on loss and cash-flow 
analysis and on risk characteristics model assumptions and stress testing (Options 1 and 2). 

6.1.3.  Analysis of the policy options in relation to transparency of the CRAs 

Transparency of the agency with respect to the functioning of internal processes 

1. 
and procedures. 

In principle, CRAs  should take primary responsibility for setting  the  minimum standards of 
transparency  with  the  markets  in  order  to  ensure  greater  market  discipline.  However,  this 
approach bears the risk of being ineffective, if not subject to some exacting adjustments. In 
particular,  a  more  formal  disclosure  in  a  periodic  report  (taking  into  account  justified 
confidentiality concerns) would facilitate the monitoring of CRAs activities by the markets as 
well as comparisons of competing CRAs. Such an option would be consistent with US rules. 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

General 
transparency 
obligation 

Periodic report 

+ 

++ 

+ 

++ 

+ 

+ 

Efficiency 

++ 

- 

The preferred policy options in this respect are to have a general principle on transparency in 
place  (Option  1)  coupled  with  the  obligation  to  publish  on  a  regular  basis  a  transparency 
report. Given the benefits of a transparency report in terms of effectiveness and certainty the 
moderate limitations of the CRA's flexibility seem to be proportionate. 

The information included in the ratings has to be relevant and sufficient in order 

2. 
to efficiently assess the probability of default of an instrument. 

EN 

38 

   EN 

The  disclosure  of  information  relating  to  the  credit  rating  is  important  to  restore  the 
confidence of the public on the credit ratings. It is broadly accepted that CRAs should provide 
sufficient  information  to  allow  investors  to  understand  the  basis  for  the  credit  ratings. 
However,  it  is  also  important  to  educate  the  investors  so  that  they  understand  better  the 
information released. More certainty would be introduced in the markets if CRAs would also 
share information on their key assumptions for the determination of the ratings.  

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

General 
obligation to 
inform investors  

Investors' 
education 

Additional 
technical 
information 

+ 

+ 

+ 

+ 

++ 

++ 

Efficiency 

++ 

+ 

+ 

+ 

++ 

+ 

All the three options are important and could be applied in parallel. 

3. 
Avoid investors'  confusion  that  has  been created because of the use of the same 
symbols for the ratings for structured products and the ratings for traditional products 
(corporate, sovereign).  

The problem of differentiating structured finance ratings from traditional ratings is among the 
most controversial issues in the current debate on CRAs. The use of different rating categories 
for structured finance ratings and the traditional products could enhance the market awareness 
of  the  specific  risks  implied  by  these  instruments.  A  more  flexible  solution  would  be  to 
provide additional information to the ratings for the structured finance products, although the 
result could be less comprehensible to market participants. A combination of these two later 
solutions would be consistent with US SEC recent proposal. The most flexible option would 
be  to  maintain  the  same  scales  and  inform  the  investors  about  the  particularities  of  specific 
ratings; however, this solution could not be sufficiently effective.  

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Differentiate 
symbols 

Same scale but 
adding 
information 

Educate investors 

++ 

++ 

- 

Efficiency 

- 

+ 

++ 

++ 

++ 

- 

++ 

++ 

+ 

The  preferred  option  is  to  leave  at  the  choice  of  each  CRA  whether  to  have  differentiated 
rating categories (symbols) for structured products and traditional products or the same scale 
with additional information. 

EN 

39 

   EN 

CRAs  should  make  available  for  market  participants  the  relevant  data  about 

4. 
their performance in a standardised manner to allow for industry-wide comparisons. 

CRAs should provide data about their performance; however, the data should be provided in 
such  a  way  that  it  is  understandable  and  suitable  for  comparisons  by  all  interested  parties. 
Thus,  the  most  effective  measure  would  be  the  disclosure  of  information  in  a  standardised 
format and the creation of a repository of ratings. Such a solution would create the necessary 
certainty  and  level  playing  field  as  all  the  agencies  would  report  according  to  the  same 
standards;  CRAs  would  thus  be  expected  to  adjust  their  existing  reporting  metrics.  Such  a 
solution would be consistent with US SEC proposal. 

Criteria 

Effectiveness 

Certainty 

Convergence 

Flexibility/ 

Option 

Self-initiative 

Obligation to 
publish individual 
data 

Disclosure of 
standardised 
performance 
information 

- 

- 

- 

- 

- 

- 

++ 

++ 

++ 

Efficiency 

++ 

+ 

- 

The preferred option is to require CRAs the disclosure of standardised information. 

6.2. 

Analysis of instruments  

To  a  certain  degree,  the  same  set  of  effects  will  be  observed  in  each  of  the  policy  options 
identified,  but  their  intensity  may  vary  depending  on  the  solution  pursued.  Analysis  in  this 
area will address only the most significant and distinctive impacts to assist the choice of the 
most  adequate  policy  option.  The  four  policy  options  identified  in  section  5.2  are  discussed 
and measured against the following pre-defined criteria:  

a) 

b) 

c) 

Effectiveness:  The  extent  to  which  the  measure  fulfils  the  objectives  formulated  in 
section 4. 

Certainty: There should be highest possible confidence of the relevant stakeholders 
as to the content of the rules to be respected and that the rules followed in practice 
are closely aligned with the objectives of the framework.  

Common framework: The framework for operation of CRAs should be governed by 
the  same  requirements  in  all  Member  States.  Such  approach  represents  a  series  of 
clear  advantages.  Firstly,  it  would  be  a  necessary  pre-condition  for  making  CRAs 
subject to any form of external scrutiny (public supervision, accountability vis-à-vis 
the  markets).  Secondly,  as  all  operating  CRAs  would  respect  certain  entry 
conditions,  it  would  create  the  necessary  basis  for  the  industry  to  rebuild  its 
credibility  after  the  subprime  crisis.  Furthermore,  unnecessary  obstacles  to  intra-
Community  activity  of  the  agencies  would  be  avoided  (as  a  uniform  set  of  rules 
would apply).  

d) 

Flexibility: A system should be established to facilitate the operation of CRAs across 
the  Member  States.  CRAs  should  have  a  level  of  flexibility  to  shape  their  internal 

EN 

40 

   EN 

organisation, but without hampering the achievement of objectives of the EU policy 
in this area. Flexibility, which captures simplicity, also is a cost indicator: the greater 
the flexibility left to CRAs, the more CRAs can make choices adapted to their needs 
and control their costs. 

In the tables, the options are measured against the above-mentioned pre-defined criteria. Each 
scenario is rated between “---” (very negative impact) and “+++” (very positive impact). 

6.2.1. 

Self-regulation (no policy change) 

6.2.1.1.  IOSCO code 

In an effort to follow the reforms of the IOSCO Code, CRAs would voluntarily provide for 
ensuing changes in their internal organisation, processes and mechanisms. As the scope and 
depth of these necessary adjustments would be largely decided at the level of the individual 
entity,  we  would  expect  that  the  implementation  and  on-going  compliance  costs  would  be 
reasonable  –  from  the  point  of  view  of  the  addressees  of  the  rules.  At  the  same  time  this 
option would demonstrate a number of serious weaknesses:  

First, the IOSCO Code of Conduct would remain as the only set of rules governing the CRA 
industry  in  the  EU.  The  manifest  deficiencies  of  this  non-binding  charter  as  well  as  its 
influence  on  the  actual  conduct  of  the  CRAs  in  the  context  of  the  subprime  have  been 
described in Section 3 of this Report. As a result of continuing the use of the IOSCO Code as 
the benchmark for CRAs' conduct the following problems would be observed: 

–  Compliance  with  the  Code  would  not  be  a  prerequisite  for  operating  as  a  credit  rating 

agency and competing for market share.  

–  The Code, based on 'comply or explain' principle, makes it possible for CRAs not to follow 
some  of  its  requirements.  There  are  examples,  where  some  of  the  leading  CRAs  have 
decided to diverge from the duties mandated by Code55.  

–  The  rules  to  be  followed  by  the  CRAs  are  often  formulated  in  a  very  broad  or  non-

committing way leaving much room for interpretation and discretion to the CRAs.56  

–  As there is no mechanism of external oversight of the CRA's actual compliance with the 

Code, CRAs would be only subject to internal oversight structures.  

–  As  there  is  no  mechanism  of  external  enforcement  and  sanctioning  CRAs  would  remain 
subject  only  to  market  discipline.  Essentially,  the  latter  could  be  triggered  by  negative 
developments  that  have  damaged  a  CRA's  reputation  (e.g.  consistently  overoptimistic 
forecasts,  incidents  of  collusion  with  the  rated  entities).  However,  given  the  oligopolistic 
structure of the CRAs' market, it is highly unlikely that market pressure alone is sufficient 
to discipline the CRAs to change their conduct.57  

55 
56 

57 

CESR report, paragraphs 211 to 225. See paragraph 225 in annex 9.6. 

For  instance,  under  Point  1.7  of  the  revised  IOSCO  Code  CRAs  are  required  to  "adopt  reasonable 
measures  so  that  the  information  it  uses  in  assigning  a  rating  is  of  sufficient  quality  to  support  a 
credible rating", but does not specify what those measures could be. 

At this stage there is no evidence of shifts of clients from one agency to other or from the big CRAs to 
new agencies. 

EN 

41 

   EN 

                                                 
Assessment 

The  continued  reliance  on  the  IOSCO  Code  does  not  give  sufficient  assurance  that  the 
objectives  formulated  in  Section  4  of  this  report  will  be  effectively  achieved.  The 
management of conflicts of interest by CRA would remain inappropriate; CRAs would not be 
obliged to improve the quality of the rating methodology and the ratings; the transparency of 
the  CRAs  would  remain  insufficient;  and,  there  would  be  no  supervision  and  enforcement 
mechanism  by  competent  authorities.  Therefore  the  existing  framework  does  not  ensure 
certainty and is not sufficiently effective. Nor does it ensure the level of common framework 
which  would  enable  CRAs  to  rebuild  their  credibility  and  restore  the  confidence  in  the 
markets.  However, it ensures flexibility  to CRAs for the organisation  and  operation of  their 
business, although the current environment, mainly based on reputation considerations makes 
it very difficult for new CRAs to enter the business.  

It is crucial to ascertain that any framework proposed for the activity of the CRAs will be duly 
implemented,  diligently  supervised  and  robustly  enforced.  These  premises  cannot  be  met  if 
the  IOSCO  Code  continues  to  be  the  central  element  of  the  regulatory  policy  approach  to 
CRAs' activity in Europe. Self regulation has been tested since 2006 and the outcome is not 
acceptable. 

6.2.1.2.  Industry-wide efforts – White Paper 

The  Industry  White  Paper  envisaged  a  series  of  quite  significant  and  helpful  commitments. 
The advantages of this solution are that it comes from the industry (see Annex 9.9). However 
the White Paper does not give a satisfactory answer to all concerns related to the conflicts of 
interest;  it  does  not  propose  differentiation  of  structured  finance  ratings  from  traditional 
ratings; it does not mention the need for comparability of CRA performance statistics; it does 
not solve the problems related to the poor quality in the information used by the CRAs, as it 
does not envisage any relevant measures applicable to the reliance on external data for rating 
purposes; and it does not provide for a satisfactory solution in relation to the proper treatment 
of existing ratings. In addition, the main weakness of this option is that it does not envisage 
any oversight and enforcement mechanism. It is important to notice that in practical terms the 
majority of the proposals from the White Paper have been included in the IOSCO code after 
its revision. Therefore there is no added value in this policy option. The criticisms mentioned 
in the previous point dealing with the assessment of the "no policy change" scenario are also 
valid for this solution. 

Assessment 

Such a solution would present a high level of flexibility for CRAs because they would be free 
to adapt to the new voluntary requirements. However, it would not be effective since it does 
not  envisage  any  enforcement  mechanism.  Despite  the  fact  of  being  a  joint  initiative  by 
industry,  it  would  ensure  a  common  framework  only  at  the  level  of  the  commitments  put 
forward in the Joint White Paper. Thus, no certainty would be ensured by this solution. The 
same arguments expressed in the precedent point would be valid. 

6.2.1.3.  Individual self-regulatory solutions proposed by CRAs: 

All  the  individual  initiatives  from  the  CRAs  referred  in  point  5.2.2  represent  the  advantage 
that  they  are  driven  by  commitments  coming  from  the  industry.  However,  these  initiatives 
cannot be considered as a satisfactory solution as the proposals by CRAs do not address in a 

EN 

42 

   EN 

consistent  way  each  of  the  substantial  problems  that  have  been  identified  in  this  Impact 
Assessment.  

Moreover, CRAs have failed to propose any credible system of oversight and enforcement of 
their initiatives. Proposals by the agencies concerning the fact that they would internalise the 
oversight function are not sufficient and would not guarantee rigorous scrutiny about whether 
CRAs  actually  observe  the  requirements  imposed  on  them.  To  strengthen  the  oversight 
framework, there should be sanctioning powers in case of non-compliance.  

Assessment 

This option, in spite of being very flexible (each CRA would implement individually its own 
improvements),  would  not  ensure  a  common  framework.  Limited  effectiveness  would  be 
achieved,  only  concerning  the  issues  where  the  CRA  has  committed,  although  no  certainty 
would  be  ensured.  The  same  arguments  expressed  in  the  point  dealing  with  the  "no  policy 
change" scenario would be valid. 

6.2.2.  European code of conduct  

The cost of implementation of the code of conduct for the CRAs would be comparable to the 
costs  of  the  other  self-regulatory  options:  it  would  arise  essentially  in  connection  with 
compliance duties and would depend on the concrete requirements of the code. However, this 
solution has the following limitations: 

–  The adherence to the code is voluntary. Therefore a CRA could step out of the agreement 

at any moment or challenge the authority of the oversight body.  

–  The monitoring body for CRAs would not be capable of ensuring vigorous supervision and 
enforcement.  Such  a  body  would  not  be  entitled  to  carry  out  investigations  with  the 
requirements  and  guarantees  of  a  procedure  carried  out  by  a  public  authority  and  should 
only  rely  on  the  information  provided  by  the  agencies.  Furthermore,  the  effectiveness  of 
the enforcement power of this body will be limited: in case an agency breaches any of the 
standards  of  the  code,  the  body  would  only  be  empowered  to  issue  a  statement  warning 
about  this  situation,  but  it  would  not  be  empowered  to  impose  the  cessation  of  such 
practice or a sanction.  

The  recent  events  have  unveiled  that  the  reputational  risk  is  not  sufficient  for  CRAs  to 
abandon harmful practices. A model of supervision where CRAs decide what should be the 
information that the oversight body will receive and where naming and shaming is the most 
severe penalty for their lack of compliance is not efficient.  

Assessment 

Such  a  solution  has  the  advantage  of  including  a  monitoring  body,  although  without  any 
enforcement  power,  so  its  effectiveness  would  be  limited.  It  would  ensure  certain  common 
framework,  although  no  significant  certainty  could  be  achieved.  High  flexibility  would  be 
ensured by this solution, because CRAs would draft the code. 

6.2.3.  Recommendation 

In  this  case  the  Commission  would  be  in  a  position  to  drive  the  process  and  to  align  the 
standards with the objectives that have been defined in Section 4 of this Impact Assessment. 

EN 

43 

   EN 

However, this solution has the same limitations that were pointed out in relation to the self-
regulatory  option.  A  recommendation  is  not  legally  binding  on  CRAs;  the  agencies  could 
choose not to follow it. It cannot set up a system of supervision and enforcement either.  

Assessment 

Such a solution would help establish a common framework to some extent, at least concerning 
the  reference  criteria  that  CRAs  would  have  to  fulfil;  however,  it  would  not  include  an 
enforcement  mechanism  and  thus  it  would  have  limited  effectiveness  in  achieving  the 
objectives set out in Section 4. It would allow for flexibility to CRAs, although no certainty 
would be achieved because CRAs would not be obliged to comply with the Recommendation. 

6.2.4.  Legislative proposal 

A  legislative  proposal  would  create  a  framework  for  supervisors  to  ensure  the  consistent 
application  of  the  new  set  of  requirements  for  the  issuance  of  credit  ratings  to  be  used  by 
financial institutions in the EU. CRAs would face sanctions by public authorities in the case 
of breach of the legal requirements (just as banks, investment firms, insurance companies or 
UCITS currently do in the EU). The compliance of the CRAs would not be at the discretion of 
the CRAs nor would it be subject to interpretation by interested parties. 

The same rules would be applied throughout the Community. The legislative proposal would 
create  legal  certainty  and  transparency.  The  registration  and  surveillance  system  would  be 
known  by  all  market  players  concerned  which  thus  could  have  greater  confidence  that  the 
CRAS  whose  ratings  are  used  for  regulatory  purposes  conform  to  established  regulatory 
standards.  

A  legislative  proposal  could  be  indirectly  beneficial  for  competition  for  the  small  CRAs. 
Smaller entities meeting the requirements laid down in the legislation would be registered and 
be able to issue credit ratings under the same conditions as big CRAs already established in 
the EU. If they comply with the registration requirements, the registration will act as public 
recognition  of  their  rating  capability  for  the  whole  market,  thus  facilitating  newcomers  to 
overcome  the  barrier  to  entry  of  the  oligopolistic  rating  business.  The  maintenance  of  the 
current situation would only preserve the existing oligopolistic market structure.  

Uniformity in the registration process and in the substantive requirements throughout the EU 
would also allow CRAs to make significant cost savings, both in the case of the creation of a 
new  CRA  and  in  the  operation  of  existing  CRAs,  if  compared  to  the  establishment  of 
individual national registration regimes (cost savings on the expert legal advice on individual 
national regimes).  

As  explained  in  section  5.2.4,  there  are  two  possible  options  regarding  the  supervisory 
architecture: the first option is that the Member States would be entrusted with the registration 
and  surveillance  of  the  rating  activity  performed  by  CRAs  and  CESR  would  play  a  strong 
coordination role. The second option is to set up a Community Agency (this could be either a 
new Agency or transforming CESR into one) for the registration of CRAs at central level (but 
supervision would remain with national regulators).  

The  first  option  appears  to  be  more  practical  because  the  securities  markets  supervisory 
authorities  of  the  Member  States  already  have  the  knowledge,  expertise  and  resources  to 
oversee  different  entities  and  activities  in  the  EU  securities  markets  (like,  for  example, 
regulated  securities  markets,  investment  firms  or  UCITS  managers).  The  option  of  the 

EN 

44 

   EN 

Community Agency has gathered little support taking into account the input from the public 
consultation.  In  addition,  the  European  Commission  has  committed  itself  to  carry  out  an 
evaluation  of  the  functioning  of  the  existing  Community  Agencies  before  it  will  envisage 
creation  of  a  new  one  (Communication  COM(2008)135  of  11.3.2008  "European  agencies  – 
The way forward"). 

CRAs  could  face  higher  compliance  costs  derived  from  the  registration  regime  and  the  on-
going  surveillance  by  competent  authorities.  Requirements  necessary  to  verify  compliance 
with  the  legal  provisions,  such  as  reporting  requirements,  record  keeping  and  transparency 
obligations could add new administrative costs to the operation of the CRAs. However, these 
additional  costs  would  be  mitigated  by  the  fact  that  CRAs  already  comply  with  similar 
requirements  in  other  jurisdictions  (like  the  US)  and  some  of  them  have  already  started  a 
process of improving their internal procedures and transparency in order to respond to current 
criticisms.  

All CRAs established in the EU issuing credit ratings intended for use for regulatory purposes 
by financial institutions in the EU will have to apply for the registration. This is essential in 
order to ensure a high level of investor confidence and consumer protection. As the rules in 
the  legislative  proposal  would  be  to  a  considerable  extent  based  on  IOSCO  rules  and 
convergent with US requirements, the adaptation costs for the established CRAs should not be 
too high, as CRAs are already subject to registration and supervision in the US.  

A legislative proposal could create the impression that supervisors endorse the ratings given 
by the CRAs. To avoid such an unintended consequence, it is essential that the independence 
of a CRA in issuing its credit ratings is preserved. Rating opinions and rating methodologies 
should not be subject to supervisory scrutiny or any form of regulatory influence. In addition, 
under  no  circumstances  will  a  competent  authority  of  a  Member  State  be  able  to  take 
measures  against  a  CRA  based  on  the  fact  that  the  CRA  issues  rating  opinions  that  may  be 
contrary to the interests of the Member State or specific issuers. 

A legislative measure is by definition less flexible than a self-regulatory solution. This lack of 
flexibility  could  make  it  more  difficult  in  the  future  to  adapt  the  standards  to  market 
innovation or new situations. However, the use of the Lamfalussy process could allow for a 
more  flexible  regulatory  regime,  by  the  elaboration  of  implementing  measures  through 
comitology  (Level  2).  Moreover,  the  legislative  proposal  should  be  principles  based  and,  to 
the extent possible, avoid unnecessary technical details. 

Assessment 

Such  a  solution  would  largely  ensure  a  common  framework  for  the  issuance  of  ratings  and 
legal  certainty  throughout  the  Community.  The  system  would  be  flexible  enough  to  allow 
CRAs  to  be  innovative  in  the  way  they  produce  their  ratings.  Such  a  solution,  including  a 
diligent supervisory system and robust enforcement mechanism, would ensure a high level of 
effectiveness  in  assuring  compliance  with  the  objectives  formulated  in  Section  4.  Finally,  a 
legislative  solution  would  be  convergent  with  the  US,  where  CRAs  are  regulated  entities 
subject to registration and supervision by the US Securities and Exchange Commission. 

6.3. 

Conclusion 

Self  regulation  has  already  been  tested  and  has  failed  to  guarantee  the  fulfilment  of  the 
objectives set out in section 4. A recommendation would not achieve the necessary level of 
uniformity and legal certainty and therefore would not be sufficiently effective. A legislative 

EN 

45 

   EN 

solution would be a proportionate measure to fulfil the objectives of providing for a uniform 
CRA  regime  across  the  EU.  It  would  be  based  on  consistently  applied  high-level  principles 
and largely inspired by the IOSCO Code. Thus, there would be only limited additional costs 
for  CRA,  in  particular  as  they  are  already  adapting  themselves  to  the  revised  IOSCO  Code 
requirements. Furthermore, the legislative solution would not impose on Member States any 
requirement  to  modify  their  existing  laws,  as  nowadays  there  are  very  few  requirements  at 
national level, but merely to introduce the new CRA registration and surveillance regime. 

Scenario 

Effectiveness 

Certainty 

Common 
framework 

Flexibility/ 

Efficiency 

Criteria 

Self-regulation: 

IOSCO 

White Paper 

Individual solutions  

(No policy change)  

EU code of conduct 

Recommendation 

- 

- 

- 

- 

- 

-- 

-- 

-- 

+ 

- 

+ 

+ 

-- 

+ 

+ 

Legislative measure 

++ 

++ 

++ 

++ 

++ 

++ 

+ 

+ 

+ 

In  order  to  meet  objective  4.1  (insufficiencies  in  the  internal  organisation  of  CRAs  and 
controls  in  relation  to  conflicts  of  interest),  CRAs  will  have  to  ensure  that  all  existing  and 
potential  conflicts  of  interests  are  identified  and  either  eliminated  or  properly  managed  and 
disclosed.  Specific  internal  governance  arrangements  will  need  to  be  put  in  place  to  assist 
changes to corporate culture and internal policies. CRAs  shall be prohibited from providing 
consultancy  and  advisory  services.  Rating  analysts  will  need  to  be  insulated  from  the 
commercial  aspects  of  the  CRAs'  activities  and  they  will  need  to  be  subject  to  more 
demanding rules regarding dialogue with the client. When they decide to leave to work for a 
former  client,  specific  safeguard  rules  should  apply.  Finally,  CRAs  clients  should  eliminate 
the negative 'shopping for ratings' practice.  

In  order  to  meet  objective  4.2  (improve  quality  of  the  methodology  and  the  ratings),  CRAs 
will  need  to  use  methodologies  that  are  rigorous,  systematic,  continuous,  and  may  be 
validated  based  on  historical  experience.  These  methodologies,  models  and  key  ratings 
assumptions will need to be kept up-to-date and subject to comprehensive regular review. An 
internal  review  function  will  be  established  to  monitor  compliance  in  this  area.  Changes  to 
rating  methodologies  shall  trigger  prompt  re-rating  of  all  existing  ratings  concerned. 
Moreover,  CRAs  will  have  to  monitor  and  update  individual  ratings  on  an  ongoing  basis. 
Greater  transparency  will  be  required  to  assist  users  of  ratings  in  understanding  what  due 
diligence of the asset level data has been undertaken and factored in the ratings. Staff levels 
will need to be disclosed by CRAs to trigger closer market scrutiny.  

Enhanced transparency of the CRAs' activities is needed in line with objective 4.3 (improve 
the  transparency  of  CRAs).  Relevant  measures  will  have  to  include  a  general  transparency 
obligation regarding the functioning of the CRA's internal processes and procedures coupled 
with a duty to publish a yearly transparency report. The information on analyses performed, 

EN 

46 

   EN 

 
 
 
 
 
 
 
 
 
any  limitations  and  specific  risks  involved  will  need  to  be  provided  to  the  users  of  ratings. 
CRAs should also use different rating categories for structured and traditional debt or provide 
investors  with  additional  information  when  rating  structured  finance  product.  Finally, 
historical  performance  statistics  will  need  to  be  prepared  using  metrics  that  ensure 
comparability between market players.  

The legislation will set up a registration procedure for CRAs issuing credit ratings to be used 
by  credit  institutions,  investment  firms,  insurance  and  assurance  undertakings,  collective 
investment schemes, pension funds and reinsurance undertakings within the Community. The 
objective  of  efficient  and  effective  monitoring  of  compliance  with  the  requirements 
(overarching objective 4.4) will be ensured throughout the EU. The registration will be carried 
out by the competent authority of a Member State, but all Member States’ regulators should 
be  able  to  express  their  opinion  through  the  CESR.  Surveillance  will  be  carried  out  by  the 
competent  authorities  of  the  Member  States.  Close  cooperation  between  national  regulators 
and coordination by CESR is a prerequisite for creating a common supervisory culture and an 
efficient  network.  National  regulators  should  be  empowered  to  apply  proportionate  and 
dissuasive sanctions where CRAs do not comply with the rules. Again, CESR should play an 
important  role  in  creating  a  common  enforcement  culture.  Therefore  a  legislative  measure 
would be the appropriate instrument to achieve the objectives set out in Section 4. 

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7. 

ANALYSIS OF IMPACTS OF THE PREFERRED OPTION 

7.1. 

Impacts on stakeholders 

The  following  table  compares  the  impact  of  a  legislative  measure  comprising  the  preferred 
policy options (see section 6) with the impact of a do nothing scenario (self regulation). 

Scenario 

Impact on Stakeholders 

CRAs 

Issuers/ Originators 

Investors 

Supervisors 

No policy change 

- 

-- 

-- 

0 

(self regulation) 

Legislative  measure 
comprising  preferred 
policy options 

CRAs find it difficult to prove 
that changes resulting from 
revised IOSCO code and their 
proposals effectively address all 
concerns identified. Continued 
lack of trust in their structured 
rating activity. 

Issuers continue to 
suffer from the lack of 
trust in ratings of their 
financial instruments. 
New issues limited as 
perception of ‘flawed 
rating risks’ still high 
in structured markets. 

Still affected by 
CRAs’ 
unpredictable 
treatment of 
structured ratings. 
Increasingly 
reluctant to rely on 
CRAs’ opinions in 
future investment 
decisions.  

Situation unchanged 

+ 

++ 

+++ 

+ 

Though CRAs would have to 
face higher adaptation costs, 
more interest in ratings from the 
investors will increase CRA 
profits in the long term. Long 
term benefits of legislation may 
outweigh higher administrative/ 
adaptation costs 

Issuers indirectly 
profit from greater 
investor interest and 
confidence and more 
competition within the 
rating market.  

Investors will 
directly profit from 
increase in quality 
of ratings and 
transparency. This 
will contribute to 
better investment 
decisions and 
increasing investor 
confidence. 

Supervisors able to 
monitor the CRAs 
conduct. Power to 
enforce legislation. 

In  the  tables,  each  scenario  is  rated  between  “---”  (very  negative  impact)  and  “+++”  (very  positive 
impact), being "0" neutral impact.  

It is not expected that the legislative proposal is going to have any direct impact on the natural 
environment, or on the social, employment or gender policy of the EU. 

7.2. 

Estimation of administrative costs 

The following requirements of the legislative proposal will create administrative costs for the 
CRAs, especially the compliance costs:  

–  Transparency obligations: annual transparency report, performance statistics; 

–  Disclosure  requirements:  on  going  disclosures  on  conflicts  of  interest,  methodologies, 

internal procedures, changes in the initial conditions of the registration; 

–  Enhanced standards for presentation of ratings; 

–  Record keeping requirements: recording devices or systems and data archiving system.  

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It  is  not  envisaged  that  CRAs  will  have  to  face  any  cost  or  losses  from  the  prohibition  to 
provide advisory services. In general, the holdings owning the big CRAs already have legally 
and operationally separated their rating business from the consulting activities. 

The  administrative  requirements  of  the  legislative  proposal  are  very  much  aligned  with  the 
requirements  set  up  in  the  US  Act  on  CRAs  of  2006  and  the  new  changes  proposed  by  the 
SEC (see Annex 9.5). On a global scale there will be few additional administrative burdens 
for the CRAs that are active in both the European Union and the US.  

Since  the  administrative  obligations  are  comparable  with  those  in  the  US,  they  are  also 
comparable in terms of administrative cost. The estimation below of the administrative costs 
for CRAs is based on the studies carried out by the US Securities and Exchange Commission 
in this regard.58 

The cost of compliance with these requirements would depend on its size and the complexity 
of  the  business  activities  of  a  CRA.  The  size  and  complexity  of  CRAs  vary  significantly. 
Therefore,  the  cost  could  vary  significantly  across  agencies.  The  main  CRAs  already  have 
established  policies,  procedures  and  record  keeping  systems  and  processes  in  the  US  that 
would comply substantially with the requirements of the legislative proposal, and they could 
easily translate the know-how and expertise from the US and apply them to their organisation 
in the  EU. The cost estimates below represent the average cost across all CRAs and do not 
take into account that some firms would only need to adjust existing policies, procedures and 
recordkeeping  systems  and  processes  to  comply  with  the  requirements  of  the  legislative 
proposal. 

It  is  expected  that  the  employers  executing  the  work  with  the  CRAs  are  highly  skilled 
professional staff that would roughly earn the same in all European countries.  

The wage figures used below are taken from the preliminary data of the measurement of the 
administrative costs in the Programme for Reducing Administrative Burdens in the EU.  

One time administrative burdens  

Obligation 

Wage p/h 

Hours  

Frequency  

Number 
companies 

of 

Admin cost 

Overhead 
25% 

TOTAL 
admin costs 

Adjusting 
disclosure 
systems, 
policies and 
procedures 

Record 
keeping 
device 

49.11 

300 

NA 

15 

220.995 

55.248,75 

276.243,75 

One time costs of 2.000 Euro 

NA 

15 

30.000 

7.500 

37.500 

Combined one time administrative burdens: 313.743,57 Euro.  

58 

17  CFR  Parts  240  and  249b  [Release  No.  34-57967;  File  No.  S7-13-08]  RIN  3235-AK14  Proposed 
Rules for Nationally Recognized Statistical Rating Organizations, pages 124 to 148. 

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Reoccurring administrative burdens  

Obligation  

Wage p/h 

Hours  

Frequency  

Number 
companies 

of 

Admin cost 

Overhead 
25% 

TOTAL 
admin costs 

49.11 

20 

1 

15 

14.733 

3.683,25 

18.416,25 

Additional 
transparency 
obligations for 
annual 
the 
report 
and 
performance 
statistics 

Combined reoccurring administrative burdens: 18.416,75 Euro per year.  

As  set  out  in  point  5.2.4,  there  were  two  possible  options  regarding  the  supervisory 
architecture. The first option would be built upon registration and surveillance by competent 
authorities  of  the  Member  States  with  coordination  by  CESR.  Therefore  its  implementation 
would not create substantial costs at EU level. The second option was to set up a Community 
Agency  that  would  issue  the  registration  for  CRAs  and  coordinate  the  national  supervisors. 
This would involve additional costs which cannot be estimated at this stage.  

8. 

MONITORING AND EVALUATION 

The Commission is the guardian of the Treaty and therefore will monitor how Member States 
have  implemented  the  legislation  on  CRAs.  Where  needed,  the  Commission  services  will 
offer  assistance  to  Member  States  for  the  implementation  of  the  legislative  proposal  in  the 
form  of  transposition  workshops  with  all  the  Member  States  or  bilateral  meetings  at  the 
request of any of them. When necessary and as the last resort, the Commission will pursue the 
procedure  set  out  in  Article  226  of  the  Treaty  in  case  any  Member  State  fails  to  respect  its 
duties concerning the implementation of Community Law. 

The  evaluation  of  the  consequences  of  the  application  of  the  legislative  measure  could  take 
place  three  years  after  the  entry  into  force  of  the  legislative  measure  in  the  form  of  a 
Commission  report  to  the  Council  and  the  European  Parliament.59  This  report  should  cover 
the issue of over-reliance on ratings by investors. However, CESR could keep producing the 
annual report on CRAs. In this case, the report should not be focused on the implementation 
of the IOSCO code by the CRAs, but on the application of the new legislation. 

The  main  elements  that  could  be  used  during  the  evaluation  could  be  the  evolution  of  the 
ratings  statistics  per  product,  the  trends  in  the  issuance  of  structured  finance  products,  the 
number of CRAs asking for registration in the EU (in particular whether there have been new 
comers into the rating business), the statistics on ratings volatility (with particular emphasis in 
sharp downgrades), the comparison of data on CRAs performance and enforcement record of 
the EU national authorities supervising the CRAs. 

59 

There are precedents in financial services legislation of such reviews. In accordance with Article 31 of 
the Prospectus Directive 2003/71/EC and Article 33 of the Transparency Directive 2004/109/EC, after 
five  years  of  the  entry  into  force  of  these  Directives  the  Commission  is  expected  to  assess  its 
application. 

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9. 

ANNEXES 

9.1. 

The legal framework for CRAs 

The current legal framework for CRAs is very different in the EU and in the US. While in the 
US  CRAs  are  subject  to  legislation,  there  are  not  directly  binding  rules  governing  CRAs 
activities as such in the EU. CRAs are affected only indirectly by sectoral regulation (Market 
Abuse and Capital Requirements Directives). 

The  regulatory  framework  in  EU:  IOSCO  code,  Market  Abuse  Directive  and 

1. 
Capital Requirements Directive 

In  its  Communication  of  2006,  setting  out  the  regulatory  approach  to  CRAs60,  the 
Commission invited the CRAs to subscribe voluntarily to the code of conduct for CRAs that 
was approved by the International Organisation of Securities Commissions (IOSCO) in 2004. 
However, the Commission stated clearly that it would monitor the developments in this area 
very  carefully.  At  present,  Community  law  addresses  only  specific  aspects  relevant  to  the 
activity  of  the  rating  business,  basically  measures  included  in  the  Market  Abuse  Directive61 
and the Capital Requirements Directive62.  

1.1. IOSCO code of Fundamentals for CRAs and CESR's role 

Since 2003 there has been a task force in IOSCO studying issues related to the activities of 
CRAs. In September 2003 the task force issued a report describing the role CRAs play in the 
global capital market together with a set of principles on  integrity of the  rating process and 
high  quality  of  ratings.  This  set  of  principles  –  addressed  to  supervisors,  CRAs  and  other 
market participants – was converted later into a code of conduct for CRAs in December 2004. 
The  IOSCO  CRA  Principles  are  high-level  and meant  to  be  used  by  CRAs  of  all  types  and 
sizes,  using  all  types  of  methodologies,  and  operating  under  a  wide  variety  of  legal  and 
market environments. IOSCO code is composed by more than fifty provisions aimed to avoid 
properly CRAs' conflicts of interest, ensure the consistent use of their rating methodologies, 
provide investors with sufficient  information on the quality of a CRA’s ratings, and help to 
ensure the integrity of the overall process. 

Against the background of various financial scandals in the US and the EU and following the 
resolution on CRAs adopted by the European Parliament in February 2004, the Commission 
considered very carefully whether or not fresh legislative proposals were required to regulate 
the activities of CRAs. One of the central principles of "Better Regulation" is that legislative 
solutions  should  be  applied  only  where  there  is  a  market  failure  and  where  legislation  is 
strictly necessary to address that market failure and to achieve public policy objectives. In line 
with  the  advice  received  from  the  CESR  in  March  2005,  the  Commission  decided  not  to 
present new legislative proposals in the area of CRAs considering that the existing financial 

60 
61 

62 

Communication from the Commission on Credit Rating Agencies (OJ C 59/2, 11.3.2006) 

Directive  2003/6/EC  of  the  European  Parliament  and  of  the  Council  of  28  January  2003  on  insider 
dealing and market manipulation OJ L 96, 12.4.2003, p. 16 

Article  80  et  seq of Directive  2006/48/EC of  the  European  Parliament  and  of  the  Council  of  14  June 
2006 relating to the taking up and pursuit of the business of credit institutions OJ L 177, 30.6.2006, p. 
33 

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51 

   EN 

                                                 
services  directives  applicable  to  CRAs  would  provide  an  answer  to  all  the  major  issues  of 
concern raised by the European Parliament.  

As  a  consequence,  in  2006  the  Commission  issued  the  Communication  on  Credit  Rating 
Agencies,  in  which  the  Commission  concluded  that  various  financial  services  directives, 
combined with self regulation by the CRAs themselves  on  the  basis  of  the  IOSCO  Code  of 
Conduct Fundamentals for CRAs (IOSCO Code), could provide an answer to the major issues 
of  concern  in  relation  to  CRAs.  It  was  stated  that  this  approach  would  require  continuous 
monitoring  of  developments  in  this  area  by  the  Commission.  In  addition,  the  Commission 
asked CESR to monitor compliance with the IOSCO Code and report back on an annual basis.  

It  was  concluded  that  CRAs  had  to  incorporate  all  the  provisions  of  the  IOSCO  Code  into 
their own internal Codes of Conduct. Where they choose not to do so, they had to explain how 
their Code nevertheless gives effect to the provisions of the IOSCO Code. It was considered 
imperative  that  CRAs  not  only  incorporate  the IOSCO  Code  in  their  own  Code  of  Conduct 
but fully comply with the IOSCO Code by enforcing their Code of Conduct in daily practice. 
Therefore, it was concluded that CESR's annual report should provide a thorough assessment 
of the level of day to day application of the IOSCO Code in practice, including consultation of 
all stakeholders.  

The  Commission  asked  CESR  to  specifically  address  in  its  report  the  following  issues  of 
concern: transparency of ratings disclosure as regards the level of participation of the issuer in 
the ratings process; timeliness of ratings disclosure as regards prior notification of issuer of an 
imminent rating; the procedures for fee arrangements, specifically the involvement of analysts 
in the fee negotiations with the issuer; separation of CRAs' business activities and handling of 
conflicts of interest; quality of the ratings process as regards structured finance instruments, 
i.e.  are  sufficient  resources  devoted  to  make  proper  rating  assessments  of  these  complex 
instruments  and  to  monitor  on  an  ongoing  basis  the  developments  in  the  area  of  structured 
finance;  treatment  of  confidential  information  within  the  various  departments  of  CRAs; 
disclosure of income structures; position of compliance officer. A more detailed explanation 
of CESR monitoring role can be found later in this IA. 

The  Commission  indicated  in  the  Communication  that  it  might  consider  introducing  new 
proposals  if  it  became  clear  that  compliance  with  EU  rules  or  IOSCO's  code  was 
unsatisfactory or if new circumstances were to arise – including serious problems of market 
failure or fresh developments in other parts of the world. 

IOSCO code has been recently revised in depth, as it is described further in this document.  

1.2. CRAs in Market Abuse Directive 

In accordance with article 6.5 of the Market Abuse Directive (2003/6/EC) the "persons who 
produce  or  disseminate  research  concerning  financial  instruments  or  issuers  of  financial 
instruments  and  persons  who  produce  or  disseminate  other  information  recommending  or 
suggesting investment strategy, intended for distribution channels or for the public, (should) 
take  reasonable  care  to  ensure  that  such  information  is  fairly  presented  and  disclose  their 
interests  or  indicate  conflicts  of  interest  concerning  the  financial  instruments  to  which  that 
information  relates".  The  technical  arrangements  for  the  fair  presentation  of  research  and 
other  information  recommending  investment  strategy  are  developed  in  the  Commission 
Directive  2003/125/EC  of  22  December  2003  implementing  Directive  2003/6/EC  of  the 

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52 

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European  Parliament  and  of  the  Council  as  regards  the  fair  presentation  of  investment 
recommendations and the disclosure of conflicts of interest.  

According  to  recital  10  of  the  Directive,  "Credit  rating  agencies  issue  opinions  on  the 
creditworthiness  of  a  particular  issuer  or  financial  instrument  as  of  a  given  date.  As  such, 
these opinions do not constitute a recommendation within the meaning of this Directive". As a 
consequence the ratings issued by the CRAs are not subject to the legal framework set out in 
this  Directive.  However,  in  accordance  with  the  quoted  recital,  CRAs  "should  consider 
adopting internal policies and procedures designed to ensure that credit ratings published by 
them  are  fairly  presented  and  that  they  appropriately  disclose  any  significant  interests  or 
conflicts of interest concerning the financial instruments or the issuers to which their credit 
ratings relate." 

1.3. CRAs in Capital Requirements Directive 

Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating 
to  the  taking  up  and  pursuit  of  the  business  of  credit  institutions  (Capital  Requirements 
Directive,  CRD)  provides  for  the  use  of  external  credit  assessments  in  the  determination  of 
risk weights (and consequential capital requirements) applied to a bank or investment firm's 
exposures. Only the use of assessments provided by recognised  External Credit Assessment 
Institutions  (‘ECAIs’),  mainly  CRAs,  will  be  acceptable  to  the  competent  authorities.  A 
recognition mechanism is also outlined in the Directive. 

The CRD sets out a number of requirements which ECAIs should meet before the competent 
authority  grant  them  recognition.  Article  81.2  of  Directive  2006/48/EC  states  that  the 
"competent authorities shall recognise an ECAI as eligible (…) only if they are satisfied that 
its  assessment  methodology  complies  with  the  requirements  of  objectivity,  independence, 
ongoing  review  and  transparency,  and  that  the  resulting  credit  assessments  meet  the 
requirements of credibility and transparency." These technical criteria and requirements are 
listed  in  the  Annex  VI,  Part  2  of  the  Directive.  The  competent  authorities  should  assess 
whether individual credit assessments are recognised in the market as credible and reliable by 
the users of such credit assessments and accessible at equivalent terms to all interested parties. 
Building  on  the  CRD,  the  Committee  of  European  Banking  Supervisors  (‘CEBS’)  has  been 
working  to  promote  convergence  of  the  recognition  processes  of  ECAIs  across  the  EU  by 
defining  a  common  understanding  on  the  criteria  necessary  to  implement  the  recognition 
requirements laid down in the CRD. In January 2006 CEBS published the Guidelines on the 
recognition of ECAIs. 

To date, the majority of the EU banking supervisors have recognised as ECAIs the four big 
CRAs (Standard and Poor's, Fitch, Moody's and DBRS). 

2. 

The legal framework in the US 

The US Credit Rating Agency Reform Act of 2006 entered into force on 27 June 2007. This 
Act  establishes  a  legal  framework  for  a  voluntary  registration  and  qualification  process  for 
NRSRO (Nationally Recognized Statistical Rating Organization).  

The  Act  establishes  a  framework  for  a  revised  NRSRO  (Nationally  Recognized  Statistical 
Rating  Organization)  registration  and  qualification  process.  The  SEC  has  exclusive 
supervisory and investigatory powers that are necessary for the exercise of its functions. The 
Commission’s rules implementing the Credit Rating Agency Reform Act took effect on June 
26, 2007. 

EN 

53 

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A CRA will be able to register with the SEC if the CRA has been in business as a credit rating 
agency for at least the past 3 consecutive years and issues credit ratings certified by at least 10 
qualified institutional buyers. 

The application for registration must contain information on: 

–  The credit ratings performance measurement statistics; 

–  the rating procedures and methodologies; 

–  the procedures in place to prevent the misuse of material non-public information;  

–  the organisational structure of the credit rating agency; 

–  whether or not the applicant has a code of ethics; 

–  list of 20 largest issuers and subscribers that use the CRA's services 

The  SEC  must  grant  registration  within  90  days  (possible  extension  to  120)  if  the 
requirements  are  satisfied  unless  the  applicant  does  not  have  adequate  financial  and 
managerial  resources  to  consistently  produce  credit  ratings  with  integrity  and  to  materially 
comply with the procedures and methodologies required. This indicates that the oversight of 
CRAs  by  the  SEC  does  not  cover  the  substance  of  the  ratings  or  the  procedures  by  which 
CRAs determine their ratings. Once registered, each NRSRO  must  certify every year that it 
still  complies  with  the  registration  criteria.  The  SEC  is  authorised  by  the  Act  to  suspend  or 
revoke the registration in case of non-compliance.  

On 24th September 2007, the SEC issued orders granting the registrations of seven CRAs as 
NRSRO. The firms are the first to be registered with the Commission under the CRA Reform 
Act of 2006. The seven  firms  registered as NRSROs are: A.M. Best Company, Inc.,  DBRS 
Ltd., Fitch, Inc., Japan Credit Rating Agency, Ltd., Moody’s Investors Service, Inc., Rating 
and Investment Information, Inc. and Standard & Poor’s Ratings Services. 

The US Act on CRAs is relatively recent and therefore there has not been enough time to test 
its  effectiveness;  it  entered  into  force  just  weeks  before  the  burst  of  the  subprime  turmoil. 
However, the SEC has recently proposed important changes in the legal framework for CRAs 
(see Annex 9.5) 

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9.2. 

The financial crisis and the ECOFIN Roadmap 

Since August 2007 financial markets worldwide are suffering a critical crisis of confidence. It 
is  generally  agreed  that  the  genesis  of  this  crisis  originated  in  the  US  subprime  residential 
mortgage market63. These mortgages with low underwriting standards were normally grouped 
in pools of assets and securitised as new products (structured products)64 that were sold in the 
financial markets worldwide. Over 80% of these subprime structured products were rated with 
the highest ratings by the CRAs.  

In summer 2007, financial markets experienced a sudden and turbulent re-assessment of risk 
by investors, as the default rate on US mortgage loans increased significantly. The rising risk 
aversion spread to other financial market segments as well, often through collateralised debt 
obligations  (CDOs)65,  which  are  frequently  based  on  those  high-risk  mortgages  which 
experienced  serious  downgrades.  CDOs  have  been  bought  in  large  quantities  by  financial 
institutions throughout the world in recent years. 

The  resulting  large  losses,  and  the  uncertainty  as  to  who  holds  the  risk,  affected  inter-bank 
lending in a negative way, which forced the central banks to provide liquidity to the banking 
sector in an unprecedented scale. The problems have spread to other segments of the financial 
system, such as commercial real estate securities, bond insurers and highly leveraged private 
equity  loans,  which  banks  continue  to  hold,  given  the  lack  of  other  investors  interested  in 
buying them. 

The  origins  of  the  current  turbulence  have  been  excessive  risk  taking  derived  from  low 
interest  rates  and  the  pursuit  of  high  returns.  A  specific  consequence  of  these  unusual 
favourable financing conditions has been an increase in borrowing for residential housing and 
a consequent boom in housing markets in many parts of the world. Demand for housing in the 
US  was  further  fuelled  by  a  generalised  relaxation  of  acceptance  criteria  for  lending,  the 
development  of  "teaser"  loans  with  relatively  low  initial  reimbursement  charges  and  other 
financial  innovations  that  have  made  mortgage  financing  more  accessible.  In  particular,  the 
existence of a secondary market for mortgage loans (markets where existing loans are sold to 
other  investors)  in  the  United  States  has  made  access  to  mortgage  financing  possible  for 
borrowers who were not previously deemed creditworthy, either due to a lack of credit history 

63 

64 

65 

The subprime sector provides housing loans to borrowers who due to their credit history do not qualify 
for conventional mortgages. 

The original lenders of sub-prime loans bundled the mortgage loans together and sold them to investors 
as mortgage backed securities – in essence these investors bought securities that would entitle them to a 
return from these mortgages in return for taking on all or part of the risk. These securities were rated by 
credit  rating  agencies  and  then  sold  to  other  financial  institutions  and  investors.  The  process  of 
packaging and pooling assets like mortgage loans, and selling them to investors as securities is referred 
to as 'securitisation'. Banks transferred most of these mortgage assets to off-balance sheet entities (so-
called  structured  investment  vehicles  or  SIVs),  which  financed  themselves  via  short-term  loans.  This 
made  them  vulnerable  to  a  sudden  financing  disruption  if  those  providing  the  loans  were  to  lose 
confidence, which is exactly what happened in August last year. 

Collateralised  debt  obligations  (CDOs)  represent  a  portfolio  of  different  debt  receivables.  Sub-prime 
loans were bundled together with other securities – e.g. based on prime mortgage loans or loans raised 
by  companies  –  to  create  CDOs.  These  CDOs  are  typically  subdivided  into  different  risk  categories, 
ranging  from  very  high  (junk)  to  very  low  risk  (AAA).  Each  tranche  is  assessed  by  a  credit  rating 
agency and sold on this basis to investors, including hedge funds, pension funds, insurance companies 
and  banks.  In  this  way,  the  credit  risk  associated  with  US  sub-prime  mortgage  loans  was  distributed 
around the global financial system. 

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55 

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or  previous  loan  defaults66.  This  was  because  banks  and  brokers  could  sell  their  sub-prime 
housing loans to outside investors, who were often willing to buy those loans with a higher 
interest rate attached in the prevailing low interest rate environment. 

An  important  downside  to  this  development  was  the  potential  for  widespread  defaults  and 
foreclosures among these marginal borrowers in the event of deteriorating broader economic 
and/or  financial  conditions  which  occurred  during  2006/2007  as  the  US  housing  prices 
weakened and interest rates rose. 

This  turmoil  has  hit  Europe  through  three  different  channels.  Firstly,  some  EU  financial 
institutions faced losses because they were exposed to the US sub-prime market, e.g. through 
credit lines on special purpose vehicles that had bought US sub-prime securities67. Secondly, 
the  US  sub-prime  problems  have  considerably  slowed  down  US  growth  prospects.  Given 
global trade inter-linkages this affects the EU economic growth as well. Thirdly, the general 
market  uncertainty  has  eroded  equity  market  prices  also  in  Europe  as  well  as  reduced 
consumer  and  business  confidence.  Data  on  the  trend  of  issuance  of  structured  finance 
products could be found in annex 9.11. 

CRAs  did  not  create  the  crisis  themselves;  however  they  have  contributed  to  it  through  the 
ratings they have attached to individual instruments. CRAs rate a wide variety of instruments, 
but  especially  in  the  area  of  complex  securitised  products  they  conduct  analysis  that 
sometimes  investors  do  not  have  the  means  to  conduct  themselves.  This  creates  a  strong 
dependence  on  the  rating  provided  by  CRAs.  The  amount  of  securitised  products68 
outstanding in Q1 2008 in the US surpassed 6,000 bn EUR, while the amount outstanding in 
Europe was around 1,200 bn EUR. Of the securitised products issued in Euros in 2007 almost 

66 

67 

68 

The  current  financial  turmoil  started  in  the  US.  To  bring  in  more  home  buyers,  lenders  in  the  USA 
began  offering  mortgages  with  less  scrutiny  of  the  borrower's  qualifications  and  inquiry  into  the 
borrower's repayment ability than had been customary in  the past. In both 2005 and 2006, lending to 
this so-called 'sub-prime' segment of the market for residential mortgages represented about 20% of all 
new US mortgage loans. These sub-prime mortgages provide housing loans to high-risk borrowers with 
weak  credit  or  a  bad  credit  history  that  do  not  qualify  for  conventional  mortgages.  Some  sub-prime 
loans  were  secured  by  the  ability  of  borrowers  to  roll-over  their  debts  backed  on  the  value  of  their 
houses rather than being based on their ability to repay them. Some sub-prime mortgage contracts had 
low starting interest rates that would rise over time. After the initial interest rates were reset to much 
higher interest rates reflecting normal market rates, a significant number of sub-prime borrowers were 
unable  to  continue  payments.  With  falling  house  prices  many  sub-prime  borrowers  could  not  sell  or 
refinance their mortgage as they owed more than their house was worth: delinquency and foreclosure 
followed. Sub-prime mortgages are generally only sold in the US and are relatively uncommon in the 
EU. 

Problems in the credit markets have had serious implications for the global banking system. Many of 
the  most  important  international  banks  are  exposed  to  credit  risk  from  collateralised  debt  obligations 
(CDOs). As problems in CDO markets have intensified, these banks have incurred significant financial 
losses through write-downs of their asset valuations. In accordance with data from Bloomberg in mid 
May, since the beginning of 2007 the biggest banks and securities firms have faced $379 billion in asset 
write  downs  and  credit  losses  (more  information  in  the  annex  9.10).  While  some  of  the  major  banks 
have managed to recapitalise, often by attracting investments from sovereign wealth funds, they remain 
vulnerable,  e.g.  to  further  deteriorations  in  the  CDO  markets  and  existing  commitments  to  finance 
highly leveraged private-equity deals. Bank profitability also suffers from the financial turmoil, as the 
outlook for non-interest income deteriorates and loan-loss provisions are set to rise from historical lows. 

These figures cover ABS, CMBS, RMBS and CDO. In the case of CDOs tailor-made (typically non-
public)  issues  and  issues  with  a  significant  element  of  derivatives  in  the  underlying  assets  are  not 
included due to data limitations.  

EN 

56 

   EN 

                                                 
90% were rated and of these more than 75% were rated AAA. In the US approximately 43% 
of the issuance was rated (excluding Agency MBS69) and of this 62% was rated AAA. The 
high proportion of AAA rated securitised products, which may have given investors a certain 
degree  of  reassurance  and  contributed  to  the  buy-decision,  clearly  demonstrates  the 
importance of ratings. The figures show that CRAs have by far failed more when assigning 
structured ratings than when issuing traditional ones (corporate, sovereign). During the period 
1 July, 2007 to 24 June, 2008, CRAs have downgraded 145,899 structured ratings compared 
with 1,445 in corporate ratings in the same period70. Hence, the problem has affected more the 
structured finance segment. 

Downgrades  hit  historical  numbers  only  from  the  3Q  2007  onwards,  when  financial 
turbulences started. Each CRA reached its biggest number of downgrades in structured ratings 
in  a  different  month.  For  instance,  S&P  registered  13,734  downs  in  January  2008.  The 
maximum in Fitch came in February 2008 with 8,165 downgrades. Finally, the worst month 
for  Moody’s  was  April  when  the  CRA  experienced  not  only  an  internal  record  but  also  a 
record among the CRAs by downgrading 15,015 issuances71. 

During  the  financial  crisis  there  has  been  a  considerable  shift  in  the  changes  of  ratings  for 
structured finance products. In the first half of 2007 Standard & Poor's reported 176 upgrades 
of  European  issues  and  134  downgrades.  In  the  second  half  of  2007  they  reported  167 
upgrades but 225 downgrades, and in the first quarter alone the number of upgrades was only 
44 while the number of downgrades was 482. In the US downgrades in relation to sub-prime 
has followed a similar but even more severe pattern. Standard & Poor's has reported, in 2007, 
a  total  of  1532  upgrades  and  6535  downgrades.  In  the  first  quarter  of  2008  there  were  216 
upgrades but 8895 downgrades. The number of upgrades/downgrades in 2007 and first quarter 
of  2008  for  Fitch  totalled  516/275  in  the  EU  and  2093/10.917  in  the  US  respectively;  for 
Moody's  totalled  304/507  in  the  EU  and  1714/14.406  in  the  US,  respectively;  and  for 
Standard and & Poor's totalled 387/841 in the EU and 1748/15.430 in the US, respectively.  

The  massive  downgrading  of  securitised  products  has  hampered  the  market's  confidence  in 
CRAs.  At  any  given  point  in  time  a  limited number  of  upgrades  and  downgrades  would  be 
expected,  and  as  general  economic  conditions  deteriorate  a  moderate  increase  in  the  net 
number  of  downgrades  would  be  expected.  However,  the  massive  downgrading  that  has 
occurred  seems  to  suggest  that the  rated  products  have  been  constructed  in  such  a  way  that 
they  have  barely  met  the  criteria  for  a  certain  rating  at  the  time  of  issuance  and/or  the 
assessment of the probability of default or expected loss was unrealistic. 

More data on the impact of the crisis on the economic activity in terms of asset write-downs 
and credit losses in the credit entities can be found in annex 9.10.  

In order to respond to the financial turmoil and to address the causes of that crisis EU Finance 
Ministers  in  October  2007  agreed  to  a  set  of  conclusions  ("Ecofin  Roadmap").  One  of  the 
main  actions  proposed  is  to  assess  the  role  played  by  CRA  in  particular  with  regard  to 
structured  financial  instruments  and  to  address  any  relevant  deficiencies.  More  specifically, 
the  Commission  was  asked  to  examine  possible  conflicts  of  interest  in  the  rating  process, 

69 

70 
71 

EN 

Mortgage  bonds  which  are  guaranteed  by  a  Government  agency  or  Government-sponsored  enterprise 
such as Fannie Mae or Freddie Mac. 

Source: Bloomberg. 

Source: Bloomberg. 

57 

   EN 

                                                 
transparency  of  rating  methods,  time-lags  in  rating  reassessments  and  regulatory  approval 
processes. 

EN 

58 

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9.3. 

Definitions 

For the purposes of this document, the following typology of products is used. The typology 
is not intended to have any official status.  

There is a great variety of instruments that could fall within the broad category of ‘securitised 
products’. The main categories are:  

•  ABS:  asset-backed  securities.  Securities  issued  against  the  revenues  from  an  underlying 

pool of assets which are used as collateral.  

•  ABCP: asset-backed commercial paper. This type of ABS has a maturity of less than one 
year  when  issued.  ABECP  refers  to  asset-backed  Eurocommercial  paper,  and  refers  to 
ABCP issued in the EU. In the rest of this paper, the terms ‘ABS’ and ‘ABCP’ are used in 
a mutually exclusive sense;  

•  CDS:  credit  default  swaps.  These  are  cash-settled  derivative  instruments  whose  payout 
function  depends  on  the  performance  in  ratings  terms  of  a  reference  credit  (often  an 
investment-grade issuer).  

The various types of collateral underlying ABS include:  

–  residential mortgages, underlying residential mortgage-backed securities (RMBS);  

–  commercial mortgages, underlying commercial mortgage-backed securities (CMBS): 

–  auto loans;  

–  credit card receivables;  

–  leases: including equipment and other leases; 

–  loans: including leveraged, commercial, consumer, corporate and other loans;  

–  receivables: including account, health care, insurance, oil, utility and other receivables;  

–  mixed  underlying  assets,  where  the  ABS  is  referred  to  as  a  collateralised  debt  obligation 
(CDO).  One  important  type  of  CDO  is  collateralised  loan  obligations  (CLOs),  a  specific 
type  of  CDO  whose  underlying  assets  are  leveraged  loans  or  middle  market  loans  only. 
Synthetic CDOs achieve credit exposures to debt instruments through credit derivatives. 

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9.4. 

Overview of the organization and structure of the big CRAs. List of CRAs 

Standards and Poor's 

1. Structure of S&P in the EU  

Standard & Poor's Ratings Services is not a legal entity. It is a separately identifiable division 
of  Standard  &  Poor's,  itself  a  division  of  The  McGraw-Hill  Companies,  Inc.  ("McGraw-
Hill"), a U.S. publicly listed publishing and information services group. 

Outside  the  U.S.,  Ratings  Services  does  business  through  a  number  of  local  subsidiaries  of 
McGraw-Hill  reflecting  differences  in  local  requirements,  including  legal  and  fiscal 
requirements. Provided below is a list of McGraw-Hill entities in the European Union through 
which  Ratings  Services  operates,  including  branches,  divisions  and  subsidiaries  that  are 
wholly owned by McGraw-Hill. 

–  Standard & Poor's España, S.A. (Spain) 

–  McGraw Hill International (U.K.) Limited (UK) 

–  Standard & Poor's AB (Sweden) 

–  The McGraw-Hill Companies GmbH (Germany) 

–  The McGraw-Hill Companies, SA (France) 

–  The McGraw Hill Companies, SRL (Italy) 

2. Number of people working for S&P in the EU and in each subsidiary 

As  of  the  end  of  June  2008,  Standard  &  Poor's  staff  total  in  the  European  Union  was 
approximately  1,000.  This  number  included  approximately  535  staff  in  Ratings  Services, 
including  analysts,  managers  and  analytical  support  staff  operating  out  of  offices  in  France 
(Paris), Germany (Frankfurt), Spain (Madrid), Italy (Milan), Sweden (Stockholm) and the UK 
(London).  The  numbers  of  Ratings  Services  staff  within  those  offices  are  the  following: 
France  approximately  70;  Germany  approximately  70;  Italy  approximately  25;  Sweden 
approximately 20; Spain approximately 25 and the UK approximately 325. These figures for 
staffing levels represent actual staff and do not include open positions. 

3. Presence in EU markets: 

Standard & Poor’s 2007 market penetration was 79% for all rated European debt. 

EN 

60 

   EN 

4. Number of new ratings per product in the EU on a quarterly basis since 2006. 

EU New Issue and Issuer Ratings 

Corporates 

Sovereigns  &  Public 
Finance 

Structured Finance 

Q1 2006 
Q2 2006 
Q3 2006 
Q4 2006 
Q1 2007 
Q2 2007 
Q3 2007 
Q4 2007 
Q1 2008 

34 
10 
30 
26 
24 
26 
35 
30 
30 

0 
0 
1 
1 
0 
0 
0 
3 
0 

618 
381 
568 
676 
965 
578 
908 
551 
338 

Moody’s Investors Service (“MIS”)72 

1. Moody's Investors Service Offices (excluding affiliates) in the European Union as at of 11 
July 2008:  

•  Moody's Investors Service Cyprus Limited (Limassol, Cyprus) 

•  Moody's Investors Service Ltd (London, United Kingdom) 

•  Moody's Investors Service Ltd (Madrid, Spain) 

•  Moody's Italia S.r.l (Milan, Italy) 

•  Moody's France SAS (Paris, France) 

•  Moody's Deutschland GmbH (Frankfurt am Main, Germany) 

•  Moody's Central Europe a.s. (Prague, Czech Republic) 

2.1 Number of people working for Moody's (global staffing as at 31 December 2007): 

United States 

International  Total 

Moody’s Investors Service 

1,869 

1,284 

3,153 

2.2 Number of people working for MIS in the EU and in each subsidiary 

MIS has some 550 staff employed in the EU of which 65% are employed in the UK, 12% in 
Germany, 10% in France and the remaining 13% across other EU offices. 

72 

Moody’s has reorganised its operating businesses to formalise the separation of the ratings-related and 
non-rating activities into two different business units – Moody’s Investors Service, the ratings related 
business, and Moody’s Analytics, the non-rating activities business. The information in this document 
refers only to MIS 

EN 

61 

   EN 

 
 
 
 
                                                 
3. Revenue for MIS for year ended 31 December (U.S. $millions):73 

United States 

EU 

Other 

2007 

1,119 

451 

210 

Global Total 

1,780 

4.1.  Number and issuance volume of selected new public structured finance ratings in the 
EU in 200774 

Total Number 

Volume 

ABS, 
CMBS deals 

RMBS, 

246 

€ 489.16 billion 

CDO deals 

128 

€46.21 billion 

Covered 
Programmes 

Bond 

23 

- 

4.2 

ABCP data as at 31 December 200775 

Total Asset Split in 
EU(US$bn)76 

ABCP 

200.57 

4.3 

Number of MIS public bank ratings in the EU as at 4 March 2008 

EU Bank Ratings 

Total 

52977 

73 

74 
75 

76 

77 

The global nature of capital markets makes it difficult to assign ratings/underlying assets to a particular 
jurisdiction  and  many  deals  have  exposure  to  numerous  jurisdictions  globally  thus  affecting  the 
accurateness  of  European  Union-specific  data.  The  EU  information  is  not  audited  and  has  been 
provided for this Impact Assessment on a best efforts basis. Moody's does not segment EU revenue and 
does not report it externally. 
Includes all MIS rated public deals in the EU. Excludes EU deals with global assets. 
ABCP  figure  includes  ABCP  issued  by  conduits  administered  by  banks  operating  through  their  EU 
branches and rated by MIS. Excludes EU deals with global assets. 
The  asset  amount  represents  the  actual  amount  of  assets  funded  via  ABCP  and  other  sources  (not 
including cash and short-term investments). 
This figure constitutes the total number of MIS public rated issuers domiciled in the European Union. 
The total number should be considered in the context of: 
- 
ultimate exposure may rest with an associate company in another jurisdiction or with an associate 

Including EU-domiciled legal entities in the form of, for example, finance vehicles, where the 

EN 

62 

   EN 

 
 
 
 
 
 
 
 
                                                 
Number of MIS public ratings in the EU as at 31 December 2007 for selected business 

4.4 
lines 

Total 

95578 

30679 

Corporate Finance 

Financial 
Institutions 
Banks) 

(Excl. 

Sub-sovereign 
(Excl. Sovereign) 

17380 

Managed Funds 

248 

Revenue  for  Moody’s  Corporation  (incorporating  Moody’s  Investors  Service  and 

5. 
Moody’s Analytics) for year ended 31 December ($ millions): 

2007 

United States 

1,361.8 

Europe 

Other 

Total 

659.3 

237.9 

2006 

1,277.8 

543.9 

215.4 

2005 

1,085.4 

456.0 

190.2 

2,259.0 

2,037.1 

1,731.6 

6.  Global  revenue  for  Moody’s  Investors  Service  for  the  year  ended  31  December  ($ 
millions): 

2007 

Structured Finance 

885.9 

Corporate Finance 

411.5 

Financial 
Institutions 

261.7 

2006 

883.6 

335.9 

222.1 

2005 

708.7 

277.4 

214.0 

company in another EU jurisdiction; 
- 
Including ratings assigned to subsidiary companies of a parent company that also maintains a 
credit rating and where the ultimate exposure may rest with the parent company in another jurisdiction 
or with a parent company in another EU jurisdiction; 
- 
separately assigned ratings, are counted as two or more separate ratings. 

Certain ratings may be inextricably linked to the rating of the parent but since they have 

78 
79 
80 

See previous footnote. 
Includes Insurance, Finance & Other non-bank. See previous footnote. 
As at 9 May 2008. 

EN 

63 

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220.8 

198.2 

184.8 

Public,  Project  and 
Infrastructure 
Finance 

Fitch Ratings 

Fitch operates through subsidiaries in the EU. The subsidiaries outside the UK are owned by 
Fitch Ratings Ltd. of the UK, itself owned by Fitch, Inc. of the US. These are the subsidiaries 
of Fitch Ratings in the EU: 

•  Fitch Ratings Limited (UK) 

•  Fitch Ratings CIS Limited (UK) 

•  Fitch Ratings España S.A.U (Spain) 

•  Fitch Ratings Deutschland GMBH (Germany) 

•  Fitch France (France) 

•  Fitch Italia S.P.A. (Italy) 

•  Fitch Polska S.A. (Poland) 

2. Number of people working for Fitch Ratings in the EU  

The European staff of Fitch comprised 678 employees at September 2007, from a worldwide 
total  of  2.361.  This  includes  offices  in  Istanbul,  Moscow  and  Tunisia  which  are  outside  the 
EU but where the staff is engaged on pan-European rating assignments.  

3. Revenues in the EU 

Fitch does not publish geographical breakdowns for the EU. In 2007 the revenues of Fitch in 
Europe, the Middle East and Africa were $332.5m (40% of global Fitch Ratings revenue of 
US$ 827.4m. In the first half of 2008 the European revenues of Fitch totalled US$145.6m, or 
43% of global Fitch Ratings revenue (US$ 335.5m). 

4. New ratings in the EU, 2006-07 

Public Finance 

Structured Finance* 

Corporate Finance 

2006 

Q1 

Q2 

Q3 

Q4 

2007 

Q1 

Q2 

2 

4 

7 

12 

4 

8 

EN 

23 

29 

27 

106** 

30 

23 

71 

164 

155 

174 

87 

150 

64 

   EN 

 
Q3 

Q4 

5 

7 

136 

61 

17 

28 

* 998 transactions, containing 4.279 tranche ratings 

**  Includes  64  ratings  assigned  simultaneously  to  Volkbank-Verbund  system  banks  within 
Austria. 

EN 

65 

   EN 

Global List of CRAs in April 2008 

(Source: www.defaultrisk.com) 

(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

(7) 

(8) 

(9) 

A.M. Best Company, Inc. 
US -- NRSRO 

Agusto & Co. Ltd. 
Nigeria 

Ahbor Rating 
Uzbekistan 

Apoyo & Asociados Internacionales S.A.C. 
Peru -- Fitch Associate 

Bank Watch Ratings S.A. 
Ecuador -- Fitch Affiliate 

BRC Investor Services S.A. 
Columbia 

Calificadora de Riesgo, PCA 
Uruguay 

Capital Intelligence, Ltd. 
Cyprus 

Caribbean Information & Credit Rating Services Ltd. (CariCRIS) 
Caribbean 

(10)  Central European Rating Agency (CERA) 

a/k/a: Fitch Polska, S.A. 
Poland 

(11)  Chengxin International Credit Rating Co., Ltd. 

China -- Fitch Affiliate 

(12)  China Lianhe Credit Rating, Co. Ltd. 

China 

(13)  Clasificadora de Riesgo Humphreys, Ltda. 

Chile -- Moody's Affiliate 

(14)  Class y Asociados S.A. Clasificadora de Riesgo 

Peru 

(15)  CMC International, Ltd. 

Nigeria 

(16)  Companhia Portuguesa de Rating, SA (CPR) 

Portugal 

EN 

66 

   EN 

(17)  Credit Analysis & Research Ltd (CARE) 

India 

(18)  Credit Rating Agency of Bangladesh, Ltd. (CRAB) 

Bangladesh 

(19)  Credit Rating Information and Services, Ltd. (CRISL) 

Bangladesh 

(20)  CRISIL, Ltd. 

f/k/a: Credit Rating Information Services of India 
India -- S&P Affiliate 

(21)  Dagong Global Credit Rating Co., Ltd. 

China 

(22)  Dominion Bond Rating Service (DBRS) 

Canada -- NRSRO 

(23)  Duff & Phelps de Colombia, S.A., S.C.V 

Columbia -- Fitch Affiliate 

(24)  Ecuability, SA 
Ecuador 

(25)  Egan-Jones Rating Company 

US -- NRSRO 

(26)  Equilibrium Clasificadora de Riesgo 

Peru -- Moody's Affiliate 

(27)  European Rating Agency (ERA) 

UK 

(28)  Feller Rate Clasificadora de Riesgo 

Chile -- S&P Affiliate 

(29)  Fitch Ratings, Ltd. 
US/UK -- NRSRO 

(30)  Global Credit Rating Co. 

S.Africa 

(31) 

(32) 

(33) 

Interfax Rating Agency (IRA) 
Russia 

Investment Information and Credit Rating Agency (ICRA) 
India 

Islamic International Rating Agency, B.S.C. (IIRA) 
Bahrain 

EN 

67 

   EN 

(34) 

(35) 

Japan Credit Rating Agency, Ltd. (JCR) 
Japan -- NRSRO 

JCR-VIS Credit Rating Co. Ltd. 
Pakistan -- JCR Affiliate 

(36)  Korea Investors Service, Inc. (KIS) 
Korea -- Moody's Affiliate 

(37)  Korea Ratings Corporation 

f/k/a: Korea Management Consulting and Credit Rating Corp. (KMCC) 
Korea -- Fitch Affiliate 

(38)  Lanka Rating Agency, Ltd. (LRA) 

Sri Lanka -- Subsidiary of RAM 

(39)  Malaysian Rating Corporation Berhad (MARC) 

Malaysia -- Fitch Affiliate 

(40)  Mikuni & Co., Ltd. 

Japan 

(41)  Moody's Investors Service 

US -- NRSRO 

(42)  National Information & Credit Evaluation, Inc. (NICE) 

Korea 

(43)  ONICRA Credit Rating Agency of India, Ltd. 

India 

(44)  P.T. Kasnic Credit Rating Indonesia -- Indonesia 

Indonesia -- Moody's Affiliate 

(45)  P.T. PEFINDO Credit Rating Indonesia 

a/k/a: PT Pemeringkat Efek Indonesia 
Indonesia 

(46)  Pacific Credit Rating (PCR) 

a/k/a: Clasificadora de Riesgo Pacific Credit Rating S.A.C. 
Peru 

(47)  Pakistan Credit Rating Agency, Ltd. (PACRA) 

Pakistan -- Fitch former affiliate 

(48)  Philippine Rating Services, Corp. (PhilRatings) 

Philippines 

(49)  RAM Rating Services Berhad (RAM) 
f/k/a: Rating Agency Malaysia Berhad 
Malaysia -- S&P Affiliate 

EN 

68 

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(50)  Rapid Ratings International, Inc. 

Australia/NZ 

(51)  Rating and Investment Information, Inc. (R&I) 

Japan -- NRSRO 

(52)  Rus Ratings 
Russia 

(53)  Seoul Credit Rating & Information, Inc. 

Korea -- JCR Affiliate 

(54)  Shanghai Credit Information Services Co., Ltd. 

China 

(55)  Shanghai Far East Credit Rating Co., Ltd. 

a/k/a: Xinhua Far East Credit Ratings 
China 

(56)  Slovak Rating Agency, a.s. (SRA) 

a/k/a: Slovenská ratingová agentúra, a.s. 
Balkans -- ERA Affiliate 

(57)  SME Rating Agency of India Limited (SMERA) 

India 

(58)  Sociedad Calificadora de Riesgo Centroamericana, S.A. (SCRiesgo) 

Costa Rica 

(59)  Standard and Poors (S&P) 

US -- NRSRO 

(60)  Taiwan Ratings, Corp. (TCR) 
Taiwan -- S&P Affiliate 

(61)  Thai Rating and Information Services Co., Ltd. (TRIS) 

Thailand 

(62)  TheStreet.com Ratings, Inc. 

f/k/a: Weiss Ratings, Inc. 
US 

(63)  Türk KrediRating (TCRating) 

Turkey 

(64)  Veribanc, Inc. 

US 

EN 

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9.5. 

 Consultation: CESR, ESME, IOSCO, FSF, SEC 

The  European  Commission  decided  to  mandate  CESR  in  September  2007  and  ESME  in 
November  2007,  to  provide  advice  on  the  various  aspects  of  CRAs'  activity  and  role  in  the 
financial markets and especially in structured finance. The Commission services followed the 
work of both groups throughout the entire process. Both groups have carried out an extensive 
consultation with stakeholders notably on the role of structured finance in the context of the 
subprime turmoil. CESR delivered its report on 13 May 2008 and ESME delivered its report 
on 4 June 2008. 

Apart  from  closely  following  the  progress  of  work  at  CESR  and  ESME,  the  Commission 
services  have  held  discussions  with  major  rating  agencies  and  other  stakeholders  (industry 
associations  from  the  insurance,  securities  and  banking  sectors,  information  providers,  etc). 
The Commission services have also received written inputs from a wide range of associations, 
market  practitioners  and  stakeholders.  On  the  international  side,  the  Commission  services 
have  followed  closely  the  developments  like  the  revision  of  the  code  of  conduct  for  CRAs 
approved  by  IOSCO  on  26  May  2008,  the  report  of  the  Financial  Stability  Forum  (FSF)81 
published on 7 April 2008 and the proposal for changes in the US Act on CRAs presented on 
11  June  2008.  The  Commission  services  have  been  also  following  the  consultations  carried 
out by both IOSCO and the FSF. 

In the following a summary of the content of the different reports and initiatives is given: 

9.5.1.  CESR report  

In the Communication from the Commission on CRAs of 2006 CESR was asked to monitor 
CRAs'  compliance  with  the  IOSCO  Code  and  report  back  to  the  Commission  on  an  annual 
basis. CESR published the first annual report in December 200682. The conclusion of this first 
report  was  that  –  despite  some  non-essential  deviations  –  the  main  CRAs  had  implemented 
the IOSCO code. 

In  May  2007,  the  European  Commission  asked  CESR  to  monitor  again  the  voluntary 
compliance  of  CRAs  with  the  IOSCO  Code  and  to  prepare  a  second  report  on  the  topic.  In 
September 2007 the Commission requested CESR to expand this report to review the role of 
CRAs in structured finance and re-evaluate regulatory options in this area. In February 2008 
CESR published a consultation paper83 ahead of preparing the report mandated by the COM. 
CESR has also held a public hearing on 26 March 2008. The public consultation on the draft 
findings was concluded with a significant number of contributions from market participants. 

81 

82 

83 

The Financial Stability Forum was convened in April 1999 to promote international financial stability 
through information exchange and international co-operation in financial supervision and surveillance. 
The Forum brings together on a regular basis national authorities responsible for financial stability in 
institutions,  sector-specific 
significant 
international groupings of regulators and supervisors, and committees of central bank experts. The FSF 
seeks  to  co-ordinate  the  efforts  of  these  various  bodies  in  order  to  promote  international  financial 
stability, improve the functioning of markets, and reduce systemic risk. 

financial  centres, 

international 

international 

financial 

CESR’s  Report  to  the  European  Commission  on  the  compliance  of  credit  rating  agencies  with  the 
IOSCO Code. December 2006 (CESR/06-545) 

The role of credit rating agencies in structured finance. Consultation Paper. 13 February 2008 

EN 

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CESR Chairmen approved the final advice for the Commission in the plenary of Ljubljana (13 
May 2008)84.  

CESR's report is divided in four sections: 

1. 

Summary of the main initiatives in the international market in relation to the role of 
CRAs  in  the  structured  finance  sector  (EU  countries,  Capital  Requirements 
Directive, US, FSF, IOSCO, CRAs initiatives, ESME, CGFS) 

2. 

Recommendations to CRAs in relation to the areas of: 

•  Transparency: CRAs should communicate the characteristics and limitation of the ratings; 
should  give  information  on  critical  model  assumptions;  ratings  should  label  the 
methodology  used;  information  on  rating  performance  should  be  provided  in  a 
standardised, publicly available format to the market. 

•  Human  Resources:  CRAs  should  disclose  selective  human  resources  indicators;  CRAs 
should  ensure  that  remuneration  structures  are  appropriate  to  promote  independence  and 
avoid conflicts of interest. 

•  Monitoring  of  Ratings:  CRAs  should  ensure  that  the  monitoring  of  their  ratings  remains 

effective. 

•  Conflicts of Interest: CRAs should ensure full transparency with regard to the exact nature 
of their interaction with issuers/arrangers of structured finance products as this interaction 
can give rise to conflicts of interest; CRAs should have strong policies and procedures in 
place to monitor and control this interaction ; there should be a common definition on what 
constitutes advisory practice and a definition of what constitutes ancillary business; CRAs 
should be transparent in the disclosure of the fees they receive from issuers. 

3. 

4. 

a) 

84 

85 

Monitoring of compliance of the CRA’s codes of conduct on those provisions of the 
CRAs' codes that CESR identified in its first report (January 2007) as areas of non-
compliance  with  the  IOSCO  Code:  CESR  conclude  that  the  four  big  CRAs’85 
internal codes of conduct comply to a large extent with the IOSCO Code, but there 
are  still  areas  where  the  CRAs'  internal  codes  of  conduct  could  be  improved;  thus, 
the initiatives undertaken by the CRAs are insufficient. 

CESR’s  proposal  to  the  European  Commission:  CESR  considers  that  IOSCO  (as 
revised)  should  be  regarded  as  the  minimum  upon  which  an  enhanced  framework 
should  be  built.  However,  CESR  makes  several  additional  recommendations  (see 
above point 2). CESR recommends the Commission "to form, as an immediate step, 
a CRAs standard setting and monitoring body with the following objectives: 

to develop international standards for the rating industry in line with the steps taken 
by IOSCO;  

CESR’s Second Report to the European Commission on the compliance of credit rating agencies with 
the IOSCO Code and the role of credit rating agencies in structured finance. May 2008 (CESR/08-277) 

CESR  report  analysed  the  codes  of  conduct  of  Standard  and  Poor's,  Moody's,  Fitch  and  DBRS  (see 
section 1.3) 

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b) 

to monitor the compliance of CRAs to those standards, using full transparency as the 
method for enforcement and having “name and shame” capacity. 

The  members  of  the  body  should  be  senior  representatives  of  investors,  issuers,  investment 
firms and CRAs (the latter only for the standard setting function). They would be appointed in 
their majority by the international regulatory community to ensure independence. 

9.5.2.  ESME report 

In November 2007 the Commission requested ESME's advice on certain issues concerning the 
role of CRAs and the importance of ratings in the financial markets, and in particular in the 
field  of  structured  finance.  The  report  of  ESME  was  approved  on  4  June.  It  covers  CRAs' 
operations and role on the markets, business incentives, internal organisation implications and 
market dynamics.  

ESME's  report  discourages  a  regulatory  approach  for  CRAs  by  the  EU  institutions.  While 
they are concerned with the lack of CRAs' accountability towards the market, they are equally 
concerned  by  possible  adverse  results  of  a  tighter  regulatory  regime.  The  self-regulatory 
regime already in place could still work but, in any event, the IOSCO code should be revised. 
Nevertheless, there is a need of further developments or requirements in certain areas going 
beyond the revision of the IOSCO code. Therefore, implicitly the report is advocating for a 
European code of conduct built upon IOSCO's. 

The report contains very detailed recommendations on methodology and analytics:  

•  CRAs should agree with market participants on the information that should be disclosed on 
a  pool  of  assets  being  securitized;  CRAs  should  disclose  the  fee  structure  for  rating  the 
security.  

•  The report makes a strong point on corporate governance; notably, each CRA should have 
an  independent  policy  function  accountable  for  policy,  criteria,  models  and  quality 
assurance;  this  policy  function  should  report  to  a  policy  sub-committee  of  the  Board, 
composed by a majority of non executive directors whose compensation would be a fixed 
fee; the chief executive officer and the chairman of the board should be different persons. 

•  Concerning the oversight, the report considers that CESR should keep its monitoring role 
in  relation  to  CRAs;  nevertheless,  this  role  should  be  reinforced  by  an  annual  external 
auditory on corporate governance in each CRA and by an advisory group that would advise 
CESR on:  

a) 

significant developments, trends and issues in the credit markets which are relevant 
to the activities of the CRAs, and;  

b) 

any rating trends/issues which are prompting concerns.  

•  Membership  of  this  group  would  comprise  investors/users,  issuers,  originating  banks, 
sponsoring  banks,  credit  experts,  academic  risk  experts  and  the  Securities  and  Exchange 
Commission (SEC). 

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9.5.3.  Revision of the IOSCO code on CRAs 

On  26  March  2008  the  Technical  Committee  of  the  International  Organisation  of  Securities 
Commissions  (IOSCO)  published  a  consultation  paper  on  the  role  of  CRAs  in  structured 
finance markets. After collecting evidence from market participants, the revision of the Code 
of  Conduct  Fundamentals  for  CRAs  of  2004  was  approved  by  the  IOSCO  Chairmen  in 
IOSCO's Annual Conference, held in Paris on 26-29 May. 

The IOSCO report describes the actual role played by the rating agencies in the credit markets 
(and structured finance markets in particular). It looks at the areas where deficiencies in the 
CRAs'  practices  were  observed  (transparency,  conflicts  of  interest  and  integrity  and 
competition  issues).  The  paper  does  not  present  particularly  strong  criticisms  against  the 
CRAs  (in  the  context  of  the  subprime  crisis)  but  rather  identifies  the  need  to  make 
adjustments to the IOSCO Code of Conduct in order to better address the legitimate concerns 
related  to  the  activity  of  the  agencies  (quality  and  integrity  of  the  rating  process;  CRA 
independence  and  avoidance  of  conflicts  of  interest;  CRA  responsibilities  to  the  investing 
public  and  issuers;  and  disclosure  of  the  CRA’s  code  of  conduct  and  communication  with 
market participants).  

The  report  first  offers  a  descriptive  presentation  of  the  CRAs'  role  in  the  structured  finance 
markets.  It  notes  the  overwhelming  reliance  of  market  participants  on  the  ratings  (even 
sophisticated institutions with capability to double-check the CRA analysis do not do it, as it 
is  time  consuming).  The  fact  that  the  CRA  analysis  is  model-based  and  largely  quantitative 
has also strengthened the common perception of objectivity of their opinion. The ratings have 
consequently become a seal of approval (rather than merely a third party opinion of the loss 
characteristics of the security). In this context the report notes that agencies rely entirely on 
the data provided by the issuers or even 3rd parties and that their methodologies do not take 
into  consideration  changes  that  may  have  an  impact  on  the  quality  of  the  information  they 
receive.  Moreover,  CRAs'  analytical  capacity  is  weakened  in  this  area  because  of  some 
specific difficulties with assessing structured finance instruments:  

–  difficulty  to  analyse  correlation  risk  within  a  portfolio  of  similar  loans  (further 

compounded in the case of CDOs),  

–  lack of secondary market data,  

–  limited historical performance data, 

–  no  universal  valuation  method  and  price  discovery  mechanism  for  structured  finance 

instruments.  

The  IOSCO  report  recognises  that  the  prominence  of  the  CRAs'  opinions  was  further 
strengthened as a result of Basel II86.  

86 

The Basel II Framework describes a more  comprehensive  measure and minimum standard for capital 
adequacy  that  national  supervisory  authorities  are  now  working  to  implement  through  domestic  rule-
making and adoption procedures (In the EU is mandatory since January 2008). It seeks to improve on 
the existing rules by aligning regulatory capital requirements more closely to the underlying risks that 
banks  face.  In  addition,  the  Basel  II  Framework  is  intended  to  promote  a  more  forward-looking 
approach to capital supervision, one that encourages banks to identify the risks they may face, today and 
in the future, and to develop or improve their ability to manage those risks. As a result, it is intended to 

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The  IOSCO  report  identifies  a  number  of  deficiencies  in  the  operations  of  CRAs  which 
should be considered from a regulatory perspective: 

•  Transparency  issues:  (i)  historical  performance  data  are  not  sufficiently  transparent  and 
comparable;  (ii)  there  are  major  differences  between  corporate  and  structured  finance 
ratings (in terms of methodology, data series available, and liquidity considerations); (iii) 
there is a lack of clarity in terms of CRAs' policies regarding the reviews of past ratings 
and methodologies.  

•  As  for  independence  and  measures  to  avoid  conflicts  of  interest,  the  report  reminds  the 
ever-present concerns related to the issuer-pays model (becoming even more acute in the 
case of structured finance) and the advisory services that could be inadvertently offered by 
the  CRAs,  but  does  not  go  beyond  proposing  complementing  measures  to  the  existing 
Code of Conduct provisions.  

•  When addressing competition issues, the IOSCO report reiterates the view that reputation, 
which needs to be earned from users of ratings, may be a more difficult to overcome as a 
barrier of entry than (potential) regulatory disciplines. It recognises that the inherently less 
transparent structured finance markets and limited competition among CRAs may combine 
to undermine the integrity of the credit rating process of these products.  

The amendments to the IOSCO Code may be grouped as follows: 

a) 

Conflicts of interest, integrity and governance: 

–  CRAs should prohibit analysts from making proposals or recommendations regarding the 

design of structured finance products rated by the agency; 

–  CRAs  should  have  "look  back"  policies  (when  an  analyst  leave  the  agency  and  joins  an 

issuer that he was rating, the agency would review his last year activity); 

–  CRAs  should  periodically  review  the  remuneration  policies  and  practices  for  the 

employees, so that they do not compromise the CRA’s rating process; 

–  CRAs  should  disclose  whether  any  client  make  up  more  than  10  percent  of  the  CRA’s 

annual revenue; 

–  CRAs should define what it considers and does not consider to be an ancillary business and 

give the reasons therefore. 

b) 

Transparency of CRA methodologies and ratings: 

–  CRAs should use a separate set of rating symbols for rating structured finance products; 

–  CRAs should disclose the rating methodology that they use for each product. 

c) 

Quality of ratings: 

be  more  flexible  and  better  able  to  evolve  with  advances  in  markets  and  risk  management  practices. 
(Excerpt from the Bank of International Settlements website). 

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–  The  decision-making  process  for  reviewing  a  rating  (and  potentially  downgrading  it) 

should be objective; 

–  CRAs should have an independent function for the periodic review of the methodologies 

and models; 

–  CRAs  should  ensure  that  the  information  they  use  is  of  sufficient  quality  to  support  a 
credible  rating;  ratings  involving  products  with  limited  historical  data  (like  subprime 
mortgages) should have these limitations made clear; 

–  CRAs should refrain from rating a product if the complexity or structure of a new type of 

rating makes the rating not feasible. 

d) 

Investor education: 

–  CRAs  should  give  investors  more  information  about  what  a  credit  rating  is,  its  attributes 
and limitations, and should inform to what extent it verifies the information provided to it 
by the issuer; 

–  CRAs  should  provide  investors/subscribers  with  all  necessary  information  for  them  to 

understand the basis for the CRA’s rating when rating a structured finance product. 

9.5.4.  Financial Stability Forum 

In its report of 7 April 2008 the FSF examines the causes and weaknesses that have produced 
the  current  financial  turmoil  and  sets  out  recommendations  for  increasing  the  resilience  of 
markets and institutions going forward. The FSF recommendations in the area of CRAs have 
been  based  substantially  on  the  inputs  of  IOSCO  and  Committee  on  the  Global  Financial 
System  (Bank  of  International  Settlements).  They  suggest  improvements  in  the  following 
areas: 

–  CRAs should implement the revised IOSCO Code to manage conflicts of interest 

–  CRAs  should  improve  the  quality  of  the  rating  process  with  periodic  reviews  of 

methodologies and models undertaken by an independent function;  

–  CRAs should separate consulting and rating activities;  

–  CRAs should have adequate resources in the initial rating and in the review function 

–  CRAs  should  differentiate  ratings  on  structured  products  from  traditional  ones  (different 

scales or additional symbols). 

–  CRAs  should  expand  the  initial  and  ongoing  information  (assumptions,  volatility  of  the 

rating, and limitation of analysis due to insufficient data or untested models). 

–  CRAs should enhance their review of the quality of the data input and of the due diligence 
performed on underlying assets by originators, arrangers and issuers involved in structured 
products. 

–  Investors should address their over-reliance on ratings (investors’ due diligence). 

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–  Regulators should review their use of ratings in the regulatory and supervisory framework 

(in order to avoid inducement to uncritical reliance on ratings). 

The FSF report welcomes the steps that have been made, individually and collectively, by the 
CRAs87 to address some of the problems but suggests that 'more is needed'.  

9.5.5.  US Securities and Exchange Commission (SEC) proposal  

The U.S. Credit Rating Agency Reform Act of 2006 entered into force on 27 June 2007. This 
new  Act  establishes  a  legal  framework  for  a  revised  voluntary  NRSRO  (Nationally 
Recognized  Statistical  Rating  Organization)  registration  and  qualification  process.  The  SEC 
has exclusive supervisory and investigatory powers for the exercise of its functions.  

On 13 March 2008 the U.S. President's Working Group (PWG) announced a set of measures 
involving  CRAs  in  order  to  enhance  integrity  and  transparency  on  the  rating  process  for 
structured credit products. The SEC presented the broad lines of its proposal on CRAs on 11 
June 2008. The SEC intends to implement the US Act on CRAs to better address conflicts of 
interest, quality of ratings and transparency: 

–  Rating analysts should not be involved in the structuring of a product;  

–  CRAs shall improve their transparency (public disclosure of rating actions, publication of 
periodical  performance  statistics)  in  a  way  to  allow  users  to  compare  among  rating 
agencies;  

–  CRAs shall disclose the frequency of the revision of ratings and shall be more transparent 

in the event of a revision of a rating;  

–  CRAs shall use adequate information about the underlying assets of a product that they are 
rating; they shall refrain from issuing a rating if the information on the underlying assets is 
not available and they shall disclose the due diligence performed to verify the information 
on the underlying assets;  

–  CRAs  shall  disclose  all  the  information  that  they  use  to  produce  a  rating  (including 
information  on  the  underlying  assets),  so  as  to  allow  broad  market  scrutiny,  as  well  as 
competitive  analysis  by  other  rating  agencies  that  are  not  paid  by  the  issuer  to  rate  the 
product;  

–  Analysts participating in determining a credit rating should refrain from negotiating the fee 

that the issuer pays for it (to avoid "shopping for ratings").  

–  Analysts cannot receive gifts from issuers in any amount over $25. 

–  CRAs should differentiate ratings for structured products than ratings for traditional debt 
(corporate, sovereign), by using different symbols or by disclosing the differences between 
ratings of structured products and other securities. 

On  1  July  2008  the  SEC  made  public  for  consultation a  package  of  amendments  in  the  US 
legislation with the aim to review all references to NRSRO ratings in US financial Law. SEC 

87 

See section 5.2.  

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considers that these references in the legislation might have contributed to an undue reliance 
on NRSRO ratings by market participants. Investors should improve the analysis of risks and 
should  have  clear  the  limits  and  purposes  of  credit  ratings  for  structured  products.  The 
proposal is divided in three kind of measures: 

–  Amend  various  rules  and  forms  under  the  Securities  Exchange  Act  of  1934  ("Exchange 

Act") to remove several references to NRSROs; 

–  Replace  rule  and  form  requirements  under  the  Securities  Act  of  1933  and  the  Securities 

Exchange Act of 1934 that rely on security ratings with alternative requirements; 

–  Amend five rules under the Investment Company Act of 1940 and the Investment Advisers 

Act of 1940 that rely on NRSRO ratings.) 

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9.6. 

Excerpts  from  ESME  and  CESR  report  in  relation  to  the  role  of  CRAs,  its 
business model and the meaning of ratings. References to the reports in the text. 

Role of CRAs and importance of ratings (pages 3 to 5 of ESME's report) 

CRAs are recognised as independent providers of credit opinions and they play an important 
role as their ratings are used by investors, borrowers, issuers and governments for a variety 
of  reasons.  For  example,  investors  use  ratings  to  determine  their  investment  appetite;  and 
governments require ratings in their financial markets and banking supervision regulation.  

Investors  vary  in  terms  of  their  own  credit  research  capacity  and  accordingly  the  level  of 
reliance  placed  on  CRAs  in  the  purchase  of  credit  assets.  Given  the  scale  of  the  total 
outstanding rated debt (estimated at US$40 trillion) the reliance on the CRAs in this regard 
has been very substantial.  

The  CRA  landscape  is  by  and  large  diverse  with  a  number  of  CRAs,  but  the  three  most 
recognised  are  Standard  &  Poor’s,  Moody’s  Investors  Service  and  Fitch  Ratings.  Between 
them,  they  effectively  dominate  the  market.  There  are  also  a  number  of  local  and  well 
established agencies in Japan and Canada as well as niche rating agencies such as AM Best 
in insurance in the US.  

Business models of CRAs  

The three CRAs above make all their public ratings on issuers available to the market free of 
charge  on  their  websites,  operating  under  the  “issuer  pays”  model.  Alternative  business 
models, typically described as “investor pays”, rely upon subscription revenues and thus the 
release of ratings to only those parties who have subscribed to that rating service. There has 
been a rapid growth in the number of structured finance transactions, which is reflected in the 
CRAs’  revenues:  CRAs  currently  earn  approximately  50%  of  their  revenue  from  structured 
finance ratings.  

A  corporate  would  typically  have  two  or  three  CRAs  rating  their  debt  and  an  annual  fee  is 
paid to each. In contrast, structured finance issuers would pay the bulk of the fee upfront with 
a  modest  annual  surveillance  fee.  A  portion  of  the  up-front  fee  may  be  recognised  on  a 
deferred  basis,  where  part  is  deemed  to  cover  subsequent  surveillance  cost.  Structured 
finance usually has more than one rating; exceptions include the use of securities in the repo 
market  where  the  ECB  only  demands  one  rating.  ESME's  general  view  is  that  in  principle, 
structured  finance  products  should  have  more  than  one  rating,  unless  there  are  specific 
commercial  reasons  for  having  just  one.  The  increased  number  of  rating  opinions  would 
improve  the  quality  of  the  ratings,  decrease  the  risk  of  conflict  of  interest  and  improve 
investor information. 

Meaning of ratings  

A. Definitions  

A credit rating is a current opinion and measure of the risk of an obligor with respect to a 
specific financial obligation based on all available information.  For this purpose, 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.  

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The CRAs emphasise that the rating is a relative measure of risk, i.e. BBB+ is a higher risk 
than A-, but better than BBB. It is not intended to be an absolute measure of risk; therefore, it 
does not mean that a specific rating, e.g. BBB, which for structured finance securities has had 
an average default rate of 0.18% between 1987 and 2007, is a mathematical prediction of the 
future  PD.  This  is  an  area  where  there  is  probably  an  understandable  disconnect  with  the 
users  of  ratings  where  they  tend  to  take  the  historic  long-term  default  experience  by  rating 
category as an indicator or a measure of future default.  

The  CRAs  state  that  ratings  have  the  same  meaning  across  asset  classes  (corporates, 
sovereigns  and  structured  finance);  therefore,  the  long-term  default  experience  through  the 
economic cycle should be similar.  

The appropriate measure of a CRA’s rating success is whether, at a portfolio level over the 
long-term,  its  ratings  are  correlated  with  the  actual  default  experience.  An  individual 
corporate collapse, which was not anticipated by the CRAs, is not in isolation an appropriate 
measure  of  success  or  failure.  An  individual  rating  is  ultimately  an  opinion,  with  a  default 
probability, and should never be viewed as a ‘certainty’, i.e. a total absolute endorsement of a 
particular security, even if it is rated AAA/Aaa.  

B. Differences between corporate vs. structured finance products  

The  two  broad  non-sovereign  categories  of  debt  rated  by  the  CRAs  are  corporate  and 
structured  finance.  While  the  CRAs  indicate  the  rating  of  corporate  debt  and  structured 
finance is similar, the rating issues are arguably fundamentally different. The characteristics 
of  both  and  the  differences,  which  have  relevance  from  a  rating  perspective  and  ESME’s 
mandate, are addressed below.  

Corporate debt  

–  Corporate debt is essentially a single asset to the investor, although there may be senior 

and junior debt as well as short-term debt all of which may have separate ratings.  

–  There  is  generally  a  relationship  dimension  between  the  CRA  and  management,  which 

usually extends over many years.  

–  Typically,  the  CRA  would  deploy  an  industry  specialist  with  extensive  knowledge  of  the 
industry. This ‘macro’ perspective places the analyst in a strong position to evaluate the 
‘business risk‘.  

–  The  rating  reflects  a  judgement  on  the  overall  balance  between  the  business'  risk  and 

financial risk (essentially leverage).  

–  While  the  gearing  level  can  change  substantially  over  the  life  of  the  debt  it  may  be 
constrained  by  bank/bond  covenants.  The  CRAs  have  in  any  case  benchmark  leverage 
ratios which indicate how the rating may respond to changed leverage levels.  

–  If  a  credit  problem  arises  there  are  a  range  of  remedies  and  management  have  the 
flexibility  to  respond  to  changes  in  the  climate  in  which  they  are  operating,  e.g.  the 
corporate may decide to raise new equity to address credit deterioration. This flexibility is 
typically not a feature of structured finance.  

Structured finance debt:  

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–  A structured finance security is usually an obligation of a Special Purchase Vehicle (SPV), 
which has a pool of assets; these assets will typically have been sold by an originator into 
the  SPV.  The  loan  obligations  underlying  an  individual  structure  are  typically  from  a 
single  asset  class,  e.g.  prime  or  subprime  residential  mortgages,  commercial  mortgages, 
credit card receivables, LBO loans, etc.  

–  Typically, the originator wishes to maximise the borrowing against the portfolio, subject to 
acceptable  pricing  on  the  debt.  The  level  of  debt  that  is  acceptable  to  the  market  on  the 
portfolio is essentially a function of the projected cash flow from the underlying loan assets 
relative to the debt service obligations on the SPV debt, taking account of stress scenarios. 
This  takes  account  of  the  quality  of  the  underlying  assets  (which  reflects,  inter  alia,  the 
original borrower LTV), the underlying interest spread, projected amortisation speed, etc. 
This  then  determines  the  level  of  equity  that  is  required;  in  the  case  of  credit  cards  this 
could  be  as  low  as  zero,  i.e.  the  originating  bank  may  be  able  to  leverage  the  portfolio 
100% essentially because of the combination of the speed of amortisation and the interest 
spread. More typically, the leverage would range up to a maximum of 95% for other asset 
classes and can be substantially lower.  

–  At this stage there are two layers of debt: one at the original individual borrower level and 
the other at the SPV level. In certain circumstances, there may be three layers of leverage, 
where the assets within the SPV are debt tranches in another CDO SPV.  

–  The  SPV  debt  only  has  recourse  to  the  underlying  assets  in  the  SPV.  Accordingly  the 
remedies are limited if the cash flow falls to a level that does not afford 100% debt service.  

–  The debt in the SPV is tranched ranging typically from senior (AAA) through progressive 
layers  of  subordination.  The  mix  and  structure  is  designed  to  reflect  the  market’s  risk 
appetite for the different tranches so as to minimise the cost of the overall borrowing to the 
originator.  

–  Unlike corporate debt, where the rating focus is on whether the corporate will default or 
not, the rating focus in structured finance is on determining the likely total level of defaults 
and losses on the pool of assets, i.e. will the level of losses impair the capacity to meet the 
debt ser-vice obligations on the different tranches of debt?  

–  One of the quoted advantages of structured finance over a corporate is that the purchaser 
of  the  paper  has  the  benefit  of  risk  diversification  from  the  pooling  of  assets.  The  CRAs 
address this issue as part of their rating process.  

–  Concentration risk is the other side of risk diversification and is a fundamental issue in the 
rating of structured finance. This is the extent to which the assets are correlated, i.e. may 
default simultaneously. It arises because of some common risk factor; usually, it is viewed 
by  many  on  a  sectoral  basis.  However,  risk  concentrations  can  arise  in  different  guises, 
e.g.  the  subprime  residential  mortgages  were  distinguished  by  the  fact  that  the 
acknowledged primary source of re-payment was not the borrower cash-flow, but instead 
‘refinancing’  which  ultimately  dried  up  as  a  source  of  repayment.  This  represented  a 
concentration of risk that ultimately proved fundamental in the crisis that ensued.  

–  The  ‘waterfall‘  repayment  arrangements,  with  priority  based  on  seniority,  determine  the 
debt service coverage on the different tranches, which in turn helps determine the rating of 
each individual tranche.  

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   EN 

–  The  rating  of  structured  finance  debt  has  been  much  more  model-driven  than  corporate 
debt  and  has  more  systemised  monitoring  focused  on  monthly  cash-flow  and  actual 
delinquency/default  experience  on  the  underlying  assets.  There  is  a  substantial  level  of 
complexity  in  the  rating  of  structured  finance  debt  which  requires  a  wide  range  of 
variables  to  be  taken  into  account  and  incorporated  in  the  model.  The  models  should 
reflect the cumulative expertise of the analysts in a CRA and data history to the extent that 
it is available and adequate.  

–  The CRAs typically do not do any due diligence themselves on the underlying SPV assets. 
They  rely  typically  on  the  assurances  and  due  diligence  work  by  the  originators  and 
sponsoring banks.  

Page  14,  second  and  third  paragraphs  of  Question  8:  It  may  be  that  the  strong  macro 
perspective  used  in  the  rating  of  corporates,  where  the  CRAs  have  a  long  record  of 
credibility,  was  not  considered  in  an  equivalent  manner  in  the  rating  of  structured  finance 
securities. The surveillance/review of structured finance securities appeared to have a heavy 
‘micro‘ focus on the monthly cash flow and delinquency experience as distinct from a broader 
strategic  consideration  of  the  big  macro  factors  impacting  the  quality  of  the  securities. 
Monthly cash flow and delinquency experience is essentially a lagging indicator rather than a 
leading indicator.  

There is limited evidence available to suggest that consideration was given to the particular 
concentration  risk  inherent  in  a  pool  of  subprime  residential  mortgages,  i.e.  the  primary 
source  of  repayment  was  the  ‘refinancing‘  market  which  ultimately  dried  up  and  proved 
fundamental  in  influencing  the  scale  of  default/loss  in  the  crisis  that  ensued.  The  CRA 
philosophy  of  ‘’rating  through  the  cycle‘’  may  have  encouraged  a  bias  where  non-cyclical 
deterioration was sometimes viewed as cyclical change, which would reverse over time. This 
may  have  been  a  contributory  factor  in  the  "misreading"  of  subprime,  which  resulted  in  a 
delayed recognition of fundamental deterioration and reflection thereof in the ratings. 

* 

* 

* 

The role of CRAs in structured finance (Points 90 to 96 of CESR's report) 

90. CRAs play a significant role in capital markets, providing a key source of information on 
credit  risk  to  investors.  As  a  reminder,  according  to  the  definition  included  in  the  IOSCO 
Code of Conduct, a credit rating “is an opinion regarding the creditworthiness of an entity, a 
credit  commitment,  a  debt  or  debt-like  security  or  an  issuer  of  such  obligations,  expressed 
using  an  established  and  defined  ranking  system”.  Therefore,  according  to  this  definition, 
CRAs  ratings  are  opinions  on  creditworthiness  but  not  on  the  price  or  liquidity 
characteristics. 

91. Structured finance consists of the pooling of assets and the subsequent sale to investors of 
tranched claims on the cash-flows backed by these pools, usually through a Special Purpose 
Vehicle  (SPV).  Over  the  past  5  years,  the  issuance  volume  of  structured  finance  products 
soared  partly  as  a  result  of  the  search  for  alternatives  in  the  context  of  the  declining 
attractiveness of returns, but also driven by the incentive for banks to take loans off balance 
sheets. The volume of structured finance issues in Europe was estimated at EUR 480 billion in 
2006, grew by 72% yoy (year on year: comparing the first half of 2007 with the first half of 
2006) in the first half year 2007 and then declined by 40% yoy in the second half of 2007. 

EN 

81 

   EN 

92. Two main characteristics of structured finance products are the pooling of assets and the 
tranching process which is designed to create seniority ordering among the different tranches 
of  securities.  Senior  classes  of  securities  are  designed  in  order  to  be  immune,  to  a  certain 
extent,  from  default  losses,  which  are  initially  borne  by  riskier  (equity  and  mezzanine) 
tranches.  This  segmentation  enables  the  product  to  appeal  to  investors  with  different  risk 
profiles. 

93. These characteristics however imply a high level of complexity, as the tranching process 
consists  of  legally  organizing  the  distribution  of  cash-flows  from  the  asset  pool  to  different 
tranche investors. In order to adequately assess these instruments, an investor needs to gauge 
the credit risk of the underlying (heterogeneous) collateral assets but also to have sufficient 
insight into the legal structure and the specific provisions of the transaction (e.g., implication 
of asset managers) that organize the different seniority levels of the tranches. 

94. Due to this complexity and the rising interest of larger categories of investors, which often 
do  not  have  the  resources,  time  or  expertise  for  a  thorough  analysis  of  the  risk  of  the 
available  securities,  the  market  has  come  to  heavily  rely  on  credit  ratings.  They  form  the 
easiest  source  of  information  and  a  standardized  evaluation  of  structured  finance 
transactions.  In  that  sense,  ratings  help  reduce  the  information  asymmetry.  Moreover, 
ratings, and particularly investment-grade ones, are also a requisite in order to market senior 
tranches to those asset managers with rating-based investment restrictions. However, ratings 
for structured finance products are designed purely to represent the likelihood of default and 
do not indicate market valuation and liquidity risk, meaning that risk assessment based purely 
on these ratings will not cover the full range of risks associated with these investments. 

95.  CRAs  have  thus  developed  and  continue  to  adapt  methodologies  (model-based)  to  rate 
structured finance transactions, which grew to account for an increasingly significant part of 
their  revenues  and  income.  In  2007,  despite  the  drop  in  activity  in  the  second  half-year, 
structured  finance  ratings  still  represented  40%  to  50%  of  the  CRAs’  revenue.  Fees  as  a 
percentage of the nominal value of the transaction are believed to be 2 to 3 times higher for 
structured finance than for traditional ratings. 

96. The difference in the rating process may explain this variance in fee levels. Not only are 
the ratings more complex and time consuming due to their very nature but also the rating of 
structured finance transactions distinguishes itself from the rating of traditional instruments 
by the greater flexibility to adapt the features of the transaction in order to achieve the rating 
level desired for each tranche of the structure. As opposed to traditional ratings, the rating of 
a structured finance transaction is a target, not the outcome of the rating process. Therefore, 
CRAs  have  taken  a  more  important  and  involved  part  in  a  deal's  structuring  process,  with 
criticism from some quarters that their involvement is now actually advisory. Arrangers use 
CRAs’ models to structure the deal and subsequently go through an iterative process with the 
CRA, with the ultimate goal for the issuer being to maximize the size of the tranche(s) with the 
highest  rating  or  minimize  the  cost/quality  of  assets  used  to  reach  a  high  rating  tranche  or 
minimize the level of credit protection needed for a certain tranche. Compared to their initial 
role of a third-party monitor of credit default risk on the basis of pre-existing financial and 
economic  conditions,  CRAs  seem  to  have  taken  a  much  more  interactive  role  in  the  deal 
process when it comes to structured finance transactions. 

EN 

82 

   EN 

References in footnotes 

106. The current crisis has again given rise to criticisms that CRAs were much  too slow to 
react,  as  was  alleged  to  be  the  case  in  previous  corporate  scandals.  The  delay  in  the 
downgrading  process  of  structured  finance  securities  backed  by  subprime  mortgage  assets 
raises questions on the efficiency of CRAs’ methodologies, the robustness of their historical 
default models in a relatively new market and their rating surveillance procedures.  

… 

136. When rating agencies revise their methodologies for the rating of a particular asset class 
of  structured  finance  they  do  not  necessarily  review  all  relevant  existing  rated  securities 
against  this  methodology.  The  CRAs  highlighted  the  fact  that  often  these  securities  will  be 
behaving as was expected at issuance and therefore reviewing these ratings against the new 
methodology  would  not  be  appropriate.  Past-issuances  would  be  reviewed  against  the  new 
methodology if they were performing outside of expected parameters.  

137. CESR found that whilst methodologies were freely available it proved difficult to track 
which  evolution  of  the  particular  methodology  had  been  used  to  rate/review  specific 
issuances.  This  clearly  could  pose  a  problem  to  market  participants  trying  to  assess  what 
value to place on a particular rating. 

… 

225. The four CRAs’ codes comply to a large extent with the IOSCO Code. Some CRAs have 
implemented  a  couple  of  improvements  in  their  respective  code  of  conduct.  There  are, 
however,  areas  or  provisions  where  the  CRAs'  codes  do  not  comply.  As  well,  CESR 
recognized  a  few  areas  of  minor  importance,  where  the  CRAs  do  not  formally  mirror  the 
IOSCO Code with their provisions but nevertheless reach the outcome the IOSCO Code aims 
at. However, CESR expected to see a more rigorous approach from CRAs in response to last 
year’s  report.  Thus,  CESR’s  expectations  for  improvement  were  only  partially  met  by  the 
CRAs. 

EN 

83 

   EN 

9.7. 

Individual initiatives of the CRAs 

1. 

Standards and Poor's' (S&P's) reform plan 

On  7  February  2008,  S&P  publicly  announced  a  set  of  actions  consisting  o  the  following 
steps:  

•  Appointment  of  an  Ombudsman  to  address  concerns  from  issuers,  investors,  employees 
and other market participants regarding potential conflicts of interest and S&P's analytical 
and governance processes.  

•  Engagement  of  an  independent  firm  to  conduct  periodic  reviews  of  compliance  and 
governance processes, the results of which will be publicly disclosed in a written opinion 
of the firm as to the independence of S&P's ratings.  

•  New  policies  to  strengthen  analyst  independence  and  prevent  long-standing  relationships 
from inadvertently affecting ratings, such as by providing for five year client rotations for 
all  analysts,  assigning  primary  analysts  to  new  structured  finance  transactions  so  that 
analysts are responsible for transactions managed by different arrangers and implementing 
“look back” reviews whenever an analyst leaves to work for an issuer.  

•  Additional identifier to the ratings of securitizations that will highlight to the market that 
the rating is on a securitization or a new type of instrument, with accompanying disclosure 
regarding the implications.  

•  Enhancing  ratings’  transparency  by  including  “what  if”  scenarios  to  explain  key  rating 
assumptions  and  the  potential  impact  of  unexpected  events,  to  help  investors  assess  an 
issue’s risk profile.  

•  Complementing  ratings  analysis  by  highlighting  non-default  risks  that  can  influence  the 

market performance of rated securities.  

•  Work  with  issuers  and  investors  to  improve  disclosure  of  information  on  collateral 

supporting securities.  

•  Investor education through actions such as the publication of a Credit Ratings User Manual 
& Investor Guidelines, to promote better understanding of the ratings process and the role 
of ratings in the financial markets.  

2. 

Steps taken by Moody's  

Moody's put forward two individual initiatives in the CRA debate. The first set of measures 
by Moody's was presented in September 2007: 

•  Moody's  would  look  for  additional  third  party  oversight  that  reviews  the  accuracy  of  the 

information provided by borrowers, appraisers and brokers to originators.  

•  Moody's  would  look  for  loan  originators  and  issuers  of  non-prime  mortgage  backed 
securitizations  requesting  ratings  from  Moody's  to  provide  investors  stronger  and  more 
uniform  representations  and  warranties  that  the  loan  information  provided  to  investors  is 
accurate and that the loans included in the transaction were appropriate for the borrowers.  

EN 

84 

   EN 

•  Prospectively, Moody's would look for services to provide monthly loan level performance 
information for all newly originated RMBS transactions. Moody's also recommended that 
for public transactions, loan level information both prior to closing and throughout the life 
of the transaction should be provided to all transaction participants requesting it.  

In February 2008 Moody's published a consultation paper in which it invited user's views on 
differentiating  the  rating  scales  for  structured  finance  products.  In  summary  the  options 
considered were:  

•  Move  to  a  completely  new  rating  scale  for  structured  securities,  for  example,  numerical 
rankings of 1-21. These would continue to contain ordinal rankings of expected credit risk 
and would probably map to corporate ratings.  

•  Add a modifier to all structured ratings utilizing the existing rating scale, e.g., Aaa.sf. This 

would designate the issue as structured, but add no other additional information.  

•  Add  a  suffix  to  the  existing  rating  scale  for  structured  ratings  that  contains  additional 
information  –  for  example,  estimates  of  multi-notch  rating  transition  risk.  This  could  be 
Aaa.v1, Aaa.v2, etc. We would derive these gradations through an analytical process that 
would be disclosed to the market.  

•  Use  the  existing  rating  scale  for  structured  securities,  and  put  additional  analytical 
information  in  a  separate  scale  that  would  exist  in  a  separate  data  field.  For  example,  an 
issue  could  have  an  “Aaa  rating,  with  a  ratings  change  risk  indicator  of  v1”.  The  added 
field would be analogous to our existing ratings outlooks and watch lists.  

•  Make no changes to the rating scale, but provide additional information and commentary 

through written research.  

On 26 March 2008 Moody's published further proposals which aim to better address the issue 
of the quality of the data used in the rating. In particular, following discussions with market 
participants,  Moody's  proposed  more  specific  enhancements  to  improve  transparency,  data 
integrity, and accountability: 

•  Stronger  representations  and  warranties  of  the  issuers  with  regard  to  how  they  address 
fraud,  misrepresentation,  data  quality,  early  payment  defaults  and  adherence 
to 
underwriting guidelines. 

•  Independent third-party pre-securitization review of underlying mortgage loans 

•  Standardized post-securitization forensic review 

•  Expanded loan-level data reporting of initial mortgage pool and ongoing loan performance 

•  More comprehensive originator assessments 

These five enhancements are intended to work together to provide more standard and reliable 
information  on  residential  mortgage-backed  securities  (RMBS)  transactions  than  that 
currently available. Moody's ability to rate a particular RMBS or assign a high or investment 
grade  rating  will  depend  in  part  upon  the  degree  to  which  issuers  incorporate  these 
enhancements.  

EN 

85 

   EN 

3. 

Steps taken by Fitch  

Fitch  has  separated  its  non-rating  businesses  into  a  separate  division,  Fitch  Solutions.  The 
CRA  has  implemented  senior  management  changes  in  its  structured  finance  operations  and 
introduced  a  series  of  Group  Credit  Officers  into  the  major  rating  groups  to  support 
objectivity and consistency in the rating review process. Fitch is working on further initiatives 
including  increased  analyst  and  manager  rotation,  enhancements  to  the  formal  internal 
training programs for analysts, greater external investor education efforts and is considering a 
broad range of feedback on other aspects of the current agency business model. 

An operational review of major asset class criteria has led to revision of the CRA’s approach 
to residential mortgage ratings in the US and to the ratings of collateralised debt obligations 
and market value products globally. Portfolio-wide stress-test analyses of CMBS transactions 
in the US and Europe have also been completed and published. Further work is underway to 
improve transparency of rating assumptions, including the publication of a series of additional 
“what-if”  scenarios  for  major  asset  classes,  the  roll-out  of  additional  electronic  tools  to 
communicate  surveillance  and  cross-transaction  comparisons  for  structured  finance  ratings, 
and the addition of Rating Outlooks at the tranche level across structured finance transactions 
in selected markets. The CRA also worked on the development of additional rating scales and 
indicators that will complement its opinions on structured finance 

EN 

86 

   EN 

9.8. 

Detailed policy options 

9.8.1.  Policy  options  to  remedy  CRAs'  insufficiencies  in  their  internal  organisation  and 

controls in relation to conflicts of interest 

The  general  policy  in  this  regard  is  that  CRAs  have  to  ensure  that  existing  and  potential 
conflicts of interest will not affect ratings.  

1. 

There should be some limitations for CRAs in order to avoid conflicts of interest.  

Options: 

a) 

b) 

c) 

General  principle:  CRAs  shall  identify  conflicts  of  interest  and  either  eliminate  or 
properly manage and disclose them.88 . 

Impose concrete limitations on CRAs activities: CRAs shall not be entitled to issue a 
rating in situations that can impair their independence, for instance, when an agency's 
rating revenues from a single client go beyond a certain limit, or when the agency or 
its  employees  involved  in  the  rating  process  have  ownership  interest  in  the  rated 
entity89. 

Impose high internal governance standards: CRAs shall have an independent review 
function  accountable  for  periodically  reviewing  the  methodologies,  models  and 
significant  changes  to  methodologies  and  models  it  uses,  as  well  as  the 
appropriateness  of  those  methods  and  methodologies  for  the  assessment  of  new 
financial instruments. The primary reporting line of the head of this function shall be 
to  a  policy  sub-committee  of  the  administrative  or  supervisory  board,  composed 
exclusively  of  non-executive  directors.  At  least  50%  of  the  non-executive  directors 
of each CRA shall have relevant expertise and experience in the risk business; their 
compensation  should  be  essentially  a  fixed  fee  (i.e.  they  should  not  qualify  for 
performance linked compensation, e.g. share options); they should have a fixed term 
of office.90 

To  eliminate  conflicts  of  interest  in  the  provision  of  advisory  services  CRAs 

2. 
should avoid human or technical link between the rating and advisory activities. 

Options: 

a) 

88 
89 
90 
91 

Obligation to separate business: A CRA shall separate, operationally and legally, its 
credit  rating  business  and  CRA  analysts  from  any  other  businesses  of  the  CRA, 
including  consulting  businesses.  It  shall  ensure  that  ancillary  business  operations 
which do not necessarily present conflicts of interest with the CRA’s rating business 
are subject to procedures and mechanisms designed to minimize the likelihood that 
conflicts of interest will arise91. 

This general obligation is inspired in IOSCO code, provision 2.6. 

The US Act on CRAs of 2006 contains similar limitations. 

Recommendations B1 to B4 from ESME report. 
Provision 2.5 of  the  IOSCO code.  In  this regard,  CESR  considers  that  a  clearer  consensus  over  what 
constitutes  an  advisory  activity  in  the  structured  finance  rating  process  would  be  beneficial  to  the 

EN 

87 

   EN 

                                                 
b) 

c) 

d) 

Separation  with  additional  caveats:  an  approach  analogous  to  the  one  followed  in 
Directive  2006/43/EC  on  statutory  audits  could  be  suggested92.  Article  40  of  this 
Directive  provides  for  the  publication  of  a  transparency  report  by  the  auditor  of 
public interest entities. CRAs could be required to publish a transparency report with 
relevant information. In addition, the provision of additional non-rating services may 
be prohibited in case this would threaten the agency's independence. 

Limited  prohibition:  CRAs  shall  not  provide  consulting  or  advisory  services  to 
issuers that they are rating.93  

Complete prohibition: CRAs shall not provide any consulting or advisory services94.  

CRAs  should  ensure  that  the  dialogue  of  the  analysts  with  the  rated  entity 

3. 
remains unbiased and objective. 

Options: 

a) 

b) 

c) 

92 

93 
94 
95 

96 
97 

Clearly  defined  role  of  the  analysts:  Analysts  shall  be  prohibited  from  making 
proposals or recommendations regarding the creation or design of structured finance 
products.95  

Transparency: CRAs shall ensure that they are fully transparent in terms of the exact 
nature  of  their  interaction  with  issuers/arrangers  of  structured  finance  products. 
CRAs  shall  also  ensure  and  demonstrate  that  they  have  strong  policies  and 
procedures in place to monitor and control this interaction and ensure it reflects their 
public position.96  

Record  keeping:  In  addition  to  the  introduction  of  an  express  prohibition  of  active 
analyst's role in structuring the product, CRAs shall record the event and substance 
of  the  dialogue  between  the  analyst  and  the  issuer.  Records  could  take  the  form  of 
audit trails subject to independent review by a third party.97  

market  as  this  would  clarify  market  and  regulatory  expectations.  Moreover,  CESR  supports  the  view 
that the IOSCO Code should provide greater clarity and act as a benchmark of acceptable practices for 
CRAs' interaction with issuers of structured finance products. 

Directive  2006/43/EC  of  the  European  Parliament  and  of  the  Council  of  17  May  2006  on  statutory 
audits  of  annual  accounts  and  consolidated  accounts,  amending  Council  Directives  78/660/EEC  and 
83/349/EEC and repealing Council Directive 84/253/EEC. This Directive contains several requirements 
in this regard: Article 40 provides for the publication of a transparency report by the auditor of public 
interest entities. This report includes financial information on the firm turnover divided into fees from 
audit and non audit services; Article 25 establishes that the fees should not influenced by the provision 
of additional services; Article 22 prohibits the provision of additional non-audit services if this threats 
the auditor's independence at unacceptable level. 

Recommendation B9 in the ESME report. 

Solution suggested by CRAs in the Joint White Paper. 

Provision 1.14-1 of IOSCO code, Recommendation B9 in ESME report and proposal from CRAs in the 
Joint White Paper. 

Paragraph 186 of CESR report. 

In  accordance  with  the  US  Act  on  CRAs  of  2006  the  CRA  is  obliged  to  keep  records  of:  a)  internal 
records  including  non-public  information  and  work  papers  used  to  form  the  basis  of  a  credit  rating  – 
including notes of conversations with management of issuers; b) internal records used to form the basis 

EN 

88 

   EN 

                                                                                                                                                         
d) 

Additional  safeguards  of  analysts'  independence:  the  analysts  and  any  other 
employees  directly  involved  in  the  credit  rating  process  shall  not  be  allowed  to 
participate  in  discussions  regarding  fees  or  payments  with  any  rated  entity98  The 
rating agencies should also envisage compulsory periodic rotation of analysts.99 

CRAs should avoid the negative impact of conflicts of interest  in relation to  the 
4. 
remuneration prospects and other economic incentives of persons involved in the rating 
process. 

a) 

b) 

c) 

5. 

a) 

b) 

98 

99 

100 
101 
102 

Reporting  lines  for  the  rating  staff  and  their  compensation  arrangements  shall  be 
structured  to  eliminate  or  effectively  manage  actual  and  potential  conflicts  of 
interest: in particular, analysts shall not be compensated or evaluated on the basis of 
the amount of revenue generated by the analyst.100  

Additional organisational requirements: the agency shall ensure the independence of 
the  analysts  and  persons  approving  the  ratings  in  the  design  of  the  reporting  and 
communication channels between them and the part of the agency responsible for the 
commercial interests of the entity;  

Increase  the  fixed  element  of  the  salary  for  the  top  managers:  change  the  mix  in 
compensation of the CRA top management towards a higher fixed salary component 
and substantially reduced performance related incentives.101  

The "shopping for ratings" practice should be mitigated: 

Disclosure  to  the  market:  an  agency  shall  disclose  on  a  periodic  basis  a  list  of  all 
cases  where  an  issuer  or  arranger  of  a  structured  finance  instrument  provided  the 
agency  with  information  about  a  proposed  structure  and  asked  it  for  a  preliminary 
rating of the proposed structure, but: (a) did not contract with the credit rating agency 
for a final rating, but contracted with another credit rating agency for a final rating of 
that same instrument; or (b) contracted with the credit rating agency for a final rating 
and did not publish the credit rating agency’s final rating, but published the ratings of 
another credit rating agency for that same instrument.102  

Encourage issuers to disclose all necessary information: CRAs shall in an industry 
effort exert pressure on structured finance issuers and arrangers of structured finance 
products to publicly disclose all relevant information regarding these products so that 
investors and other CRAs can conduct their own analyses independently of the CRA 
contracted by the issuers and/or originators to provide a rating. This would facilitate 

for the opinions expressed in these reports, and c) external and internal communications that relate to 
initiating, determining, maintaining, changing or withdrawing a credit rating. 

Similar  limitation  could  be  found  in  US  Act  on  CRAs  of  2006  and  in  the  provision  2.12  of  IOSCO 
code. 

See  recommendation  B6  in  ESME  report.  A  similar  requirement  in  article  42.2  of  the  Directive 
2006/43/EC  on  statutory  audits.  Standards  and  Poor's  announced  in  January  2008  that  it  would  be 
implementing a system of rotation. 

Provision 2.11 of IOSCO code and CRAs Joint White Paper. 

Recommendation E2 in ESME report. 

Proposal discussed in the CRAs task force of IOSCO. 

EN 

89 

   EN 

                                                                                                                                                         
the  appearance  of  unsolicited  ratings  which  would  help  to  avoid  the  "shopping  for 
ratings" practice103. 

c) 

Clients should refrain from shopping for ratings: issuers should not inquire several 
credit  rating  agencies  for  their  preliminary  rating  assessment  of  the  potential 
structured  finance  instrument  before  they  finally  decide  on  the  credit  rating  to  be 
published. 

The  independence  of  the  analysts  should  be  granted  even  when  he/she  joins  a 

6. 
rated entity: 

a) 

b) 

Cooling off period: During a certain period after leaving the agency the analyst shall 
not be able to accept key management positions from the previously rated entity.104  

Look back reviews: The agency shall review the past work of an analyst in the event 
that he or she leaves the agency to work for a client that he or she has rated.105 

9.8.2.  Policy options for improving the quality of rating methodologies and the ratings 

Methodologies, models and key rating assumptions should be appropriate and up 

1. 
to date for the rated instruments. 

Options: 

a) 

b) 

c) 

103 
104 

105 
106 
107 

CRAs shall put in place an independent review function: CRAs should establish and 
implement  a  rigorous  and  formal  review  function  responsible  for  periodically 
reviewing  the  methodologies  and  models  it  uses,  as  well  as  the  appropriateness  of 
those  methodologies  and  models  for  the  assessment  of  new  instruments.  Where 
feasible  and  appropriate  for  the  size  and  scope  of  its  credit  rating  services,  this 
function  should  be  independent  from  the  business  lines  that  are  principally 
responsible for rating various classes of issuers and obligations.106  

CRAs  shall  review  their  methodologies  in  case  of  significant  changes:  CRAs  shall 
assess  whether  existing  methodologies  and  models  for  issuing  credit  ratings  of 
structured  products  are  appropriate  when  the  risk  characteristics  of  the  assets 
underlying a structured product change materially.107 In addition CRAs shall review 
all their methodologies on a regular basis, e.g. once a year. 

Methodologies and models should be validated by a public authority: to ensure that 
the  methodologies  and  models  used  by  an  agency  are  appropriate  and  up  to  date, 
such  methodologies,  models  and  assumptions  shall  be  validated  and  periodically 

Provision 2.8.c of IOSCO code. 

Similar  solution  in  the  Article  42.3  of  the  Statutory  Audits  Directive  2006/43/EC:  "The  statutory 
auditor or the key audit partner who carries out a statutory audit on behalf of an audit firm shall not be 
allowed to take up a key management position in the audited entity before a period of at least two years 
has  elapsed  since  he  or  she  resigned  as  a  statutory  auditor  or  key  audit  partner  from  the  audit 
engagement". 

Provision 2.17 of IOSCO code, recommendation in Q11 of ESME report, CRAs Joint White Paper. 

Provision 1.7-2 of IOSCO Code. 

Provision 1.7-3 of IOSCO code. 

EN 

90 

   EN 

                                                 
reviewed  by  the  securities  supervisor  of  the  Member  State  where  the  agency 
operates, at the request of the agency. 

2. 

CRAs should diligently monitor the existing ratings. 

Options: 

a) 

b) 

c) 

Require CRAs to have – when feasible – separate teams for the initial rating and the 
ongoing  surveillance  of  structured  finance  transactions108.  If  a  CRA  uses  separate 
analytical  teams  for  determining  initial  ratings  and  for  subsequent  monitoring  of 
structured finance products, each team should have the appropriate level of expertise 
and resources to perform their respective functions in a timely manner.109 

Require  CRAs  to  regularly  monitor  and  update  ratings:  A  CRA  shall  ensure  that 
adequate personnel and financial resources are allocated to monitoring and updating 
its ratings. Once a rating is published the CRA shall monitor on an ongoing basis and 
update the rating by: a) regularly reviewing the issuer’s creditworthiness; b) initiating 
a  review  of  the  status  of  the  rating  upon  becoming  aware  of  any  information  that 
might reasonably be expected to result in a rating action (including termination of a 
rating),  consistent  with  the  applicable  rating  methodology;  and,  c)  updating  on  a 
timely basis the rating, as appropriate, based on the results of such review.110  

Envisage  expiry  of  rating  after  a  certain  period:  In  addition  to  the  obligation  to 
review the rating on a regular basis, the CRA is required to update the ratings at least 
once in a specified time period (e.g. one year). 

3. 

CRAs should apply changes in methodology consistently to all ratings concerned.  

Options: 

a) 

b) 

c) 

108 
109 
110 
111 
112 

Impose disclosure obligation: CRAs shall disclose whether they apply retroactively 
model changes to existing ratings.111  

Re-rate regularly: Require CRAs to apply the changes to past ratings due to the new 
methodology in the course of the regular review cycle of ratings. After a change in 
methodology  CRAs  shall  update  the  ratings  in  a  timely  manner  using  the  new 
methodology. CRAs shall be transparent as to which methodology has been used for 
a current rating. CRAs should apply the changes in ratings criteria and assumptions 
where appropriate to both initial ratings and subsequent ratings.112  

Require  CRAs  to  promptly  re-rate  existing  ratings  according  to  new  methodology: 
Whenever  a  rating  methodology  changes,  CRA  shall  have  to  immediately  disclose 
the likely scope of ratings that will be affected. After the change in methodology the 
CRAs have to re-rate all the ratings that have been based on these methodologies. 

CRAs proposal from the Joint White Paper. 

Provision 1.9-1 of IOSCO code. 

Provision 1.9 of IOSCO code. 

Approach of US Act on CRAs of 2006. 

Provision 1.9 of IOSCO code. 

EN 

91 

   EN 

                                                 
4. 

CRAs should use sound information for the issuance of ratings. 

Options: 

a) 

b) 

c) 

d) 

e) 

113 
114 

115 
116 
117 
118 
119 

General obligation of ensuring good quality of information: A CRA shall make sure 
that the information it uses in assigning a rating is of sufficient quality to support a 
credible rating.113  

CRAs or a suitable third party shall undertake due diligence of information: CRAs 
shall  have  the  responsibility  to  ensure  that  the  information  which  underpins  their 
ratings is statistically sound. This requires independent and robust due diligence to be 
undertaken. The CRAs shall carry out this due diligence themselves (if disposing of 
the necessary competence) or delegate it to a suitable third party like for instance a 
recognised accounting firm or, if appropriate, the sponsoring bank.114  

Quality warranties: CRA shall require underwriters to provide representations about 
the  level  and  scope  of  due  diligence  that  they  have  performed  on  the  underlying 
assets.115 An agency shall clearly indicate the limits to which it verifies information 
provided to it by the issuer or originator of a rated security.116 

Abstention from issuing ratings if no sound data: If a CRA cannot obtain sound data 
or is not able to verify the data either itself or relying on a suitable third party, it shall 
refrain from issuing a credit rating or withdraw an existing rating.117 In cases where 
the complexity or structure of a new type of structured product or the lack of robust 
data about the assets underlying the structured product raise serious questions as to 
whether the CRA can determine a credible credit rating for the security, CRA should 
refrain from issuing a credit rating.118 

Warning if data limited or statistics sound: If the rating involves a type of financial 
product  presenting  limited  historical  data  (such  as  an  innovative  financial  vehicle), 
the CRA shall make clear, in a prominent place, the limitations of the rating.119 If an 
agency  cannot  obtain  sound  data  or  is  not  able  to  verify  the  data  either  itself  or 

Provision 1.7 of IOSCO code. 

ESME considers that it is essential that CRAs accept that they have the responsibility to ensure comfort 
is  given  to  investors  on  the  integrity  of  the  information  which  underpins  their  ratings,  taking  into 
account  the  crisis  of  confidence  in  ratings  and  the  collapse  in  the  volume  of  new  structured  finance 
issues.  This  would  require  independent  and  robust  due  diligence  to  be  undertaken.  In  this  regard  the 
CRAs could either: a) Obtain assurances from the sponsoring bank that it has undertaken appropriate 
due diligence, in circumstances where the sponsoring bank is deemed credible and capable of honouring 
their  obligations  under  their  indemnities;  or  b)  Commission  a  suitable  external  party,  e.g.  one  of  the 
internationally  recognised  accounting  firms,  to  undertake  the  due  diligence,  or  c)  Undertake  the  due 
diligence themselves. (Recommendation B7 in ESME report). 

First and second indents of the recommendation IV.6 of the Financial Stability Forum report. 

Provision 3.5.c of IOSCO code. 

Fourth indent of the recommendation IV.6 of the Financial Stability Forum report. 

Provision 1.7-3 of IOSCO code. 

Provision 1.7 of IOSCO code. 

EN 

92 

   EN 

                                                 
relying on a suitable third party, it shall disclose the limitations of the rating to the 
users.120 

5. 

CRAs shall allocate adequate staff to the rating process. 

Options: 

a) 

b) 

c) 

General  obligation  of  employing  appropriate  staff:  CRAs  shall  ensure  that 
employees  directly  involved  in  the  rating  process  have  appropriate  knowledge  and 
experience  for  the  duties  assigned.  In  particular,  the  CRA  shall  ensure  that  its 
monitoring function is adequately staffed.121  

Additional  transparency  requirement  with  respect  to  the  employees:  CRAs  shall 
disclose staff numbers and qualifications as allocated to the different functions of the 
rating agency122. CRAs have to keep record of the identity of any credit analysts that 
participated in the determination of any credit rating. 

Require  a  formal  qualification  for  rating  analysts:  A  specific  professional 
qualification  shall  be  developed  for  rating  analysts  defining  a  minimum  level  of 
knowledge  and  experience  that  credit  analysts  shall  have.  CRA  shall  rely  on  this 
qualification in order to employ suitable rating analysts.123  

The analysis of an issuer or a product by the agency should take into account the 

6. 
impact of market developments and macro economic expectations.  

Options: 

a) 

b) 

120 
121 
122 
123 
124 
125 

CRAs shall provide sufficient information about loss and cash-flow analysis related 
to  the  structured  finance  instrument:  Where  a  CRA  rates  a  structured  finance 
product, it shall provide investors with sufficient information about its loss and cash-
flow analysis so that an investor allowed to invest in the product can understand the 
basis for the CRA’s rating. A CRA shall also disclose the degree to which it analyses 
how  sensitive  a  rating  of  a  structured  finance  product  is  to  changes  in  the  CRA’s 
underlying rating assumptions.124 

CRAs shall expand the initial and ongoing information that they provide on the risks 
characteristics  of  structured  products:  CRAs  shall  include  additional  initial  and 
ongoing  information  on  rating  stability,  the  assumptions  underlying  a  structured 
these 
product 
assumptions.125They  shall  expand  the  information  they  give  on  model  assumptions 
and stress testing. CRAs shall provide information on critical model assumptions, in 

the  sensitivity  of 

to  changes 

rating  and 

rating 

the 

in 

Provision 3.5.c of IOSCO code. 

Provision 1.9 of IOSCO code. 

A similar approach is followed in the US Act on CRAs of 2006. 

Inspired in Statutory Audits Directive 2006/43/EC. 

Provision 3.5.a of IOSCO code. 

Recommendation IV.5 in the Financial Stability Forum Report of April 2008. 

EN 

93 

   EN 

                                                 
particular,  the  weightings  of  key  parameters  and  correlations  underlying  structured 
finance ratings.126  

c) 

Public  authorities  shall  validate  the  models  and  assumptions  applied  by  CRAs:  to 
ensure that the models and assumptions used by an agency include the information 
referred above, such methodologies, models and assumptions shall be subject to prior 
validation  by  the  securities  supervisor  of  the  Member  State  where  the  agency 
operates, at the request of the agency. 

9.8.3.  Policy options in relation to transparency of the CRAs 

A  number  of  options  may  be  considered  in  order  to  trigger  improvements  in  the  CRAs' 
transparency (as regards their internal policies, their performance and the presentation of the 
ratings).  

In particular, the following specific objectives should be fulfilled:  

The  agency  has  to  be  transparent  with  respect  to  the  functioning  of  internal 

1. 
processes and procedures. 

Options: 

a) 

b) 

General transparency obligation: CRAs shall publish sufficient information about its 
procedures,  methodologies,  models  and  assumptions  so  that  outside  parties  can 
understand how a CRA arrived at a rating. CRAs shall provide investors/subscribers 
with  the  necessary  information  to  understand  the  basis  for  the  CRA’s  rating, 
including  sufficient  information  about  the  internal  code  of  conduct  of  the  agency, 
methodologies and historic performance data.127 

Require  CRAs  to  disclose  a  periodic  report:  CRAs  shall  be  required  to  publish 
periodically a transparency report containing information such as legal structure and 
ownership of the agency, description of the internal quality control system, indicators 
on  staff  allocation,  description  of  credit  ratings  record-keeping  policy,  outcome  of 
internal  review  of  independence  compliance,  financial  information  on  the  agency's 
revenue, description of management and key analysts rotation policy and a corporate 
governance statement.128  

The information included in the ratings has to be relevant and sufficient in order 

2. 
to efficiently assess the probability of default of an instrument.  

126 

127 
128 

This  information  should  include  an  economic  explanation  for  the  assumptions  in  order  to  allow 
investors to fully understand the structured finance ratings and thus to make better use of them in their 
investment decisions. Information on the level of stress testing carried out during the rating process, to 
address concerns over tail risks would also provide investors with the information needed for them to 
judge the impact of economic events or market disruption on the volatility of the ratings (Paragraph 134 
of CESR report). 

Provisions 3.5 and 4.3 of IOSCO code. 

This  option  is  inspired  in  the  Directive  2006/43/EC  on  statutory  audits  of  annual  accounts  and 
consolidated accounts, article 40. There are similar requirements of disclosure for the registration of a 
NRSRO in accordance to US Act on CRAs. The agencies have to update this information annually in 
case there is any material change. 

EN 

94 

   EN 

                                                 
Options: 

a) 

b) 

c) 

Obligation  to  provide  information  on  loss  and  cash-flow  analysis  and  about 
sensitiveness  to  changes  in  rating  assumptions:  Where  a  CRA  rates  a  structured 
finance  product  it  should  provide  investors  and/or  subscribers  (depending  on  the 
CRA’s  business  model)  with  sufficient  information  about  its  loss  and  cash-flow 
analysis  so  that  an  investor  can  understand  the  basis  for  the  CRA’s  rating.  A  CRA 
should  also  disclose  the  degree  to  which  it  analyses  how  sensitive  a  rating  of  a 
the  CRA’s  underlying  rating 
structured  finance  product 
assumptions.129  

to  changes 

in 

is 

CRAs  to  be  more  engaged  in  investors'  education:  CRAs  shall  clearly  explain 
attributes  and  limitations  of  credit  rating  opinions  and  focus  their  efforts  on 
communicating better and educating rating users as necessary.130  

Require  additional  technical  information  in  the  ratings:  CRAs  shall  share 
information  on  the  key  assumptions,  including,  e.g.  ‘expected  loss‘  with  disclosure 
also  of  historic  ‘worst  case/best  case  scenarios‘  and  ‘break-even‘  credit  loss  for 
different  tranches.  They  should  include  ‘what  if’  scenario  analysis  to  convey  an 
understanding of the sensitivity of the rating to adverse or positive events.131  

3. 
Avoid  investors'  confusion  triggered  by  the  use  of  the  same  symbols  for  the 
ratings  for  structured  products  and  the  ratings  for  traditional  debt  (corporate, 
sovereign).  

Options: 

a) 

b) 

129 
130 

131 
132 

133 
134 

Use different symbols for traditional ratings and structured finance ratings: A CRA 
shall  differentiate  ratings  of  structured  finance  products  from  traditional  corporate 
bond  ratings,  either  by  introduction  of  a  different  rating  scale  or  with  additional 
symbols. A CRA shall also disclose how this differentiation functions.132 Instead of 
using different symbols the agency may disclose the differences between ratings of 
structured products and other securities133  

Use the same scale but aggregate additional information to the ratings: CRAs shall 
inform  users  of  the  greater  potential  volatility  associated  with  structured  finance 
instruments and the reasons for it. A label/rating suffix to measure and communicate 
the inherent volatility may be introduced, i.e. the likelihood of rapid and large rating 
transition.134  

Provision 3.5.a of IOSCO code. 

For example, user manuals may be needed to assist different investor groups in their use of ratings, due 
to  widely  varying  levels of  technical  capacity to  understand  the rating  complexities  (recommendation 
C9 in ESME report). 

Recommendations C1 and C2 in ESME report. 

Provision 3.5.b of IOSCO code and Recommendation IV.2 of the Financial Stability Forum report of 
April 2008. 

SEC proposal to implement the US Act on CRAs announced on 11 June 2008. 

Recommendation C6 of ESME report. 

EN 

95 

   EN 

                                                 
c) 

Educate  investors  in  the  particularities  of  the  ratings  for  different  products:  CRAs 
shall clearly indicate attributes and limitations of credit rating opinions.135 

CRAs should make available to market participants the relevant data about their 

4. 
performance in a standardised manner to allow for industry-wide comparisons.  

Options: 

a) 

b) 

c) 

Initiative  of  the  CRA  industry:  CRAs  shall  establish  a  centralized  repository  for 
ratings  performance  studies  to  allow  easier  market  comparisons  among  the  CRAs 
and make available ratings performance data to regulatory authorities, upon request, 
to allow regulatory authorities to conduct their own studies of ratings performance.136  

Obligation  to  publish  historical  default  rates:  CRAs  shall  publish  sufficient 
information about the historical default rates of CRA rating categories and whether 
the  default  rates  of  these  categories  have  changed  over  time.  If  the  nature  of  the 
rating  or  other  circumstances  makes  a  historical  default  rate  inappropriate, 
statistically invalid, or otherwise likely to mislead the users of the rating, CRAs shall 
explain  this.  This  information  shall  include  verifiable,  quantifiable  historical 
information  about  the  performance  of  its  rating  opinions,  organized  and  structured, 
and,  where  possible,  standardized  in  such  a  way  to  assist  investors  in  drawing 
performance comparisons between different CRAs.137  

Impose  on  CRAs  the  obligation  to  disclose  standardised  performance  information 
and create a repository of ratings at EU level: CRAs shall disclose information on 
their  performance  to  a  central  repository  that  could  be  created  and  managed  by 
CESR,  with  the  assistance  of  the  CRAs.  CESR  shall  issue  guidance  on  common 
standards on the historical performance data that CRAs would have to disclose. 

9.9. 

CRAs joint proposals in the White Paper. Summary 

In  October  2007,  a  group  of  CRAs  including  A.M.  Best  Company,  Inc.;  DBRS  Limited; 
Fitch,  Inc.;  Moody's  Investors  Service,  Inc.;  and  Standard  &  Poor's  Ratings  Services  began 
working  together  to  suggest  measures  to  enhance  confidence  in  the  credit  rating  process, 
particularly with respect to structured finance securities. They have communicated their views 
on those subjects to regulators and legislators, by circulating a discussion paper in December 
2007  in  which  the  participating  CRAs  made  certain  proposals  regarding  enhancing  the 
independence, quality and transparency of credit ratings.  

The main content of this discussion paper is as follows: 

135 
136 

CRAs Joint White Paper. 

CRAs Joint White Paper. ESME recommends that the major CRAs, with input from IOSCO and other 
relevant  market  sources,  should  agree  a  set  of  measurement  principles  and  framework  which  would 
become  the  market  norm  for  evaluating  the  performance  and  success  of  rating  agencies.  ESME 
suggested  that  the  framework  should  incorporate,  inter  alia,  ‘rating  accuracy‘,  the  incidence  of 
downgrades relative to a benchmark ‘norm‘ and the average downgrade in terms of number of notches 
moved (Recommendation D.1 in ESME report). 

137 

Provision 3.8 of IOSCO code. 

EN 

96 

   EN 

                                                 
Independence of the credit rating process 

–  CRAs  should  explicitly  forbid  credit  rating  analysts  from  making  proposals  or 

recommendations regarding the creation or design of securitization products. 

–  CRAs should not provide consulting or advisory services. 

–  CRAs should conduct "look-back" reviews, as appropriate, when analysts leave CRAs to 

work for issuers or advisers with whom they have regularly interacted. 

–  CRAs  should  conduct  formal,  periodic,  internal  reviews  of  remuneration  policies  and 
practices for analysts and other CRA employees who participate in rating committees to ensure 
that these policies and practices do not compromise analyst objectivity. 

Quality of credit ratings 

–  CRAs  should  conduct  formal,  periodic, 
methodologies to promote ratings quality. 

internal  reviews  of  rating  criteria  and 

–  CRAs should establish separate teams for initial credit ratings and ongoing surveillance of 

structured finance transactions, whenever feasible. 

–  CRAs  should  require  analysts  to  participate  in  continuing  education  programs  on  credit 

analysis, methodologies and CRA policies and procedures. 

–  CRAs  should  encourage  greater  market  understanding  of  securitization  products  by 
supporting  full  disclosure  by  issuers  to  the  market  of  the  information  needed  to  make 
informed investment decisions about structured finance transactions. 

Transparency øf credit ratings 

–  CRAs should help to establish a centralized repository for ratings performance studies to 

allow easier market comparisons among the CRAs. 

–  CRAs  should  make  available  ratings  performance  data  to  regulatory  authorities,  upon 

request, to allow regulatory authorities to conduct their own studies of ratings performance. 

–  CRAs should clearly indicate attributes and limitations of credit rating opinions. 

–  CRAs  should  play  an  active  role  in  raising  awareness  among  investors  and  other  market 
participants  about  the  meaning  and  intended  purpose  of  credit  rating  opinions,  the  credit  rating 
process and the CRAs' role in financial markets. 

EN 

97 

   EN 

9.10. 

Information on asset write-downs and credit losses since the beginning of 2007 
till mid May 2008.  

(Source: Bloomberg) 

The  following  table  shows  that  there  has  been  $379  billion  in  asset  write  downs  and  credit 
losses  since  the  beginning  of  2007,  including  reserves  set  aside  for  bad  loans,  at  more  than 
100 of the world's biggest banks and securities firms.  

The write-down column includes asset-value reductions that some banks list on their balance 
sheets rather than booking the losses against earnings. Regulatory filings show $35 billion of 
such balance-sheet write downs at 20 banks.  

All the charges stem from the collapse of the U.S. subprime- mortgage market. The figures, 
from  company  statements  and  filings,  also  reflect  some  credit  losses  or  write  downs  of 
mortgage  assets  that  aren't  subprime,  as  well  as  charges  taken  on  leveraged-loan 
commitments.  

All numbers are in billions of U.S. dollars. They are net of financial hedges the firms used to 
mitigate losses.  

Firm 

Citigroup 

UBS 

Merrill Lynch 

HSBC 

IKB Deutsche 

Royal Bank of Scotland 

Bank of America 

Morgan Stanley 

JPMorgan Chase 

Credit Suisse 

Washington Mutual 

Credit Agricole 

Deutsche Bank 

Write-down 

Credit Loss 

Total 

5.6 

12.6 

5.7 

4.2 

8 

37.3 

38.2 

37 

6.9 

16 

15.2 

9.2 

12.6 

5.5 

9.5 

1.1 

8.3 

7.7 

42.9 

38.2 

37 

19.5 

16 

15.2 

14.9 

12.6 

9.7 

9.5 

9.1 

8.3 

7.7 

EN 

98 

   EN 

 
 
 
 
 
 
 
 
Wachovia 

HBOS 

Bayerische Landesbank 

Fortis 

Societe Generale 

Mizuho Financial Group 

ING Groep 

Barclays 

WestLB 

Canadian Imperial (CIBC) 

LB Baden-Wuerttemberg 

E*Trade 

Dresdner 

Natixis 

Wells Fargo 

Lehman Brothers 

Bear Stearns 

National City 

Goldman Sachs 

BNP Paribas 

Lloyds TSB 

Nomura Holdings 

HSH Nordbank 

ABN Amro 

4.6 

6.9 

6.7 

6.6 

6.3 

6.2 

6 

5.2 

4.8 

4.2 

4 

2.5 

3.4 

3.4 

0.6 

3.3 

3.2 

0.5 

3 

2.1 

2.7 

2.5 

2.5 

2.4 

2.4 

0.9 

2.7 

2.6 

0.6 

7 

6.9 

6.7 

6.6 

6.3 

6.2 

6 

5.2 

4.8 

4.2 

4 

3.4 

3.4 

3.4 

3.3 

3.3 

3.2 

3.1 

3 

2.7 

2.7 

2.5 

2.5 

2.4 

EN 

99 

   EN 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Bank of China 

Commerzbank 

Royal Bank of Canada 

UniCredit 

DZ Bank 

Alliance & Leicester 

Dexia 

Caisse d'Epargne 

Hypo Real Estate 

Gulf International 

2 

1.9 

1.7 

1.6 

1.5 

1.4 

1.1 

1.2 

1 

1 

European  banks  not  listed  above 
(a) 

9.2 

Asian banks not listed above (b) 

7.5 

North  American  banks  not  listed 
above (c) 

3 

2 

1.9 

1.7 

1.6 

1.5 

1.4 

1.3 

1.2 

1 

1 

9.2 

7.8 

4.1 

0.2 

0.3 

1.1 

TOTALS* 

332.3 

46.9 (d) 

379.2 

*  Totals  reflect  figures  before  rounding.  Some  company  names  have  been  abbreviated  for 
space. 

(a) The following European banks have experienced losses of less than $1 billion each: Allied 
Irish  Banks,  Bradford  &  Bingley,  Aareal  Bank,  Deutsche  Postbank,  Standard  Chartered, 
Northern Rock, NordLB, Rabobank, HVB Group, Sachsen LB, Intesa Sanpaolo, Landesbank 
Hessen-Thueringen, SEB AB, Erste Bank, DnB NOR, Anglo Irish, KBC Group, LB Berlin, 
NIBC Holding.  

(b) Asian banks with write downs of less than $1 billion: Mitsubishi UFJ, Shinsei, Sumitomo 
Trust,  Aozora  Bank,  DBS  Group,  Australia  &  New  Zealand  Banking  Group,  Abu  Dhabi 
Commercial,  Bank  Hapoalim,  Arab  Banking  Corp.,  Fubon  Financial,  Industrial  & 
Commercial Bank of China, Citic International, BOC Hong Kong, Bank of East Asia, China 
Construction  Bank,  Sumitomo  Mitsui,  ICICI  Bank,  State  Bank  of  India,  United  Overseas, 
Wing Lung.  

(c)  North  American  banks  included  in  this  group:  Bank  of  Montreal,  National  Bank  of 
Canada, Bank of Nova Scotia, BB&T Corp., PNC Financial Services Group, SunTrust Banks, 
South Financial Group, Sovereign Bancorp, First Horizon. 

EN 

100 

   EN 

 
 
 
 
 
 
 
 
 
 
9.11.  Data on issuance of structured finance products 

European and US issuance of SF instruments (Euro, billions), from 2000 to first quarter 2008 

(Source: ESF Securitisation Data Report Q1:2008, p. 2) 

Year 

2000 

2001 

2002 

2003 

2004 

2005 

2006 

2007 

2008 

EU 

78,2 

152,6 

157,7 

217,3 

243,5 

327,0 

481,0 

453,7 

40,0 

US 

1086,0 

2308,4 

2592,7 

2914,5 

1956,6 

2650,6 

2455,8 

2404,9 

285,2 

The figures clearly show how the trend of issuance of structured products falls sharply in the 
first quarter of 2008, both in the EU and in US. The figures below show that this trend started 
in the second half of 2007 and how it evolved till the first quarter of 2008. 

European and US issuance of SF instruments (Euro, billions) 

2007 and 1st quarter 2008 

2007:Q1  2007:Q2 2007:Q3 2007:Q4 2008:Q1 

EU  128,7 

152 

98,2 

74,7 

40 

US  747,5 

811,5 

481,6 

364,3 

285,2 

EN 

101 

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9.12.  Comparative table with the Commission proposal, US rules and IOSCO code 

EU Proposal 

US rules/proposal 

IOSCO Code 

Other / Comment 

Organisational, corporate requirements 

Requirement for 
registration 

In line with SEC 
rules 

In line with SEC 
rules. CRAs 
(NRSRO are 
supervised by the US 
SEC) 

Not envisaged.  

Supervision by the 
competent authority 

Reporting lines and the 
compensation of the 
persons involved in the 
rating process to be 
separated from the 
business end of the CRA.  

Internal functions to: 

Not envisaged.  

Not required. The 
code is applied on a 
voluntary basis 
(Comply or explain 
principle) 

Not envisaged 

A general rule in the 
IOSCO Code 
(reporting lines for 
CRA employees and 
their compensation 
should be structured to 
eliminate or 
effectively manage 
actual/potential 
conflicts of interest).  

Broadly in line with 
IOSCO Code.  

Envisaged in the ESME 
report.  

EU measure would 
make the IOSCO 
principle more 
concrete.  

(i) develop the CRA rating 
policy, monitor 
compliance with internal 
procedures and processes 
for the rating activity, and 
review the feasibility of 
providing ratings for new 
instruments; 

(ii) review the 
methodologies, models 
and significant changes to 
methodologies and 
models. This function 
should be independent of 
the rating activities. 

A special function on 
rating policy for some 
members the board to 
monitor development of 
the rating policy, 
effectiveness of the rating 

Not envisaged.  

Not envisaged.  

Envisaged in the ESME 
report.  

A board committee, as 
the primary reporting 
line of the internal 

EN 

102 

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functions mentioned 
above, would increase 
profile of their 
activities and 
independence of these 
functions.  

A necessary tool for 
strengthening internal 
controls. Already a 
standard in most 
organisations.  

In line with the 
IOSCO Code. 

In line with the SEC 
rules. 

In line with the 
IOSCO Code. 

In line with EU 
approach in other 
areas (MiFID). 

internal quality systems, 
compliance and 
governance processes.  

Whistle-blowing 
mechanism for anonymous 
reporting of irregularities 
by staff.  

Conflicts of interest 

General policy: CRAs to 
ensure that conflicts of 
interest (existing, potential) 
will not affect ratings. 
Conflicts of interest to be: 

(i) identified and  

either (ii.1) eliminated or 
(ii.2) properly managed and 
disclosed.  

Disclosure when: 

5% or more revenue from 1 
entity 

Stricter in the SEC 
rules (prohibition if 
more than 10%). 

Broadly in line with 
the IOSCO Code 
(disclosure of more 
than 10%). 

Prohibition of offering / 
continuing rating when:  

In line with the SEC 
rules.  

In line with the 
IOSCO Code. 

1) analyst or person 
approving ratings has direct 
ownership in the rated entity, 

2) analyst or person 
approving ratings is a 
member of supervisory or 
management board of the 
rated entity 

3) CRA associated with the 
rated entity 

Provision of 
consulting/advisory 
prohibited.  

Broadly in line with 
the SEC rules. 

In line with the 
IOSCO Code. 

Rating staff prohibited to 

In line with the SEC 

In line with the 

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Look-back reviews, 
introduced by the 
revised IOSCO code, 
are an important tool 
to detect any 
irregularities on the 
part of analysts 
leaving the CRA to 
join a client.  

Envisaged in the 
ESME report.  

Rotation requirement 
follows the solution in 
the auditing 
profession. 

engage in fee negotiations.  

rules. 

IOSCO Code. 

Rules on rating staff 
conduct: 

- prohibition to engage in any 
transactions in instruments 
related to the rated entity, 

In line with the SEC 
rules (look-back 
reviews not explicitly 
mandated by the 
SEC).  

In line with the 
IOSCO Code. 

- handling confidential 
information (incl. 
unpublished ratings), 

- no gifts from the rated 
entity, 

- look-back reviews of ratings 
after an analyst has left to 
work for the rated entity. 

Rules excluding employees 
from the rating process. 
(triggered by conflicts of 
interest arising from owning 
financial instruments, recent 
employment, business or 
other relationship)  

Rules on rotation of 
analysts and other persons 
approving credit ratings. 
Max. 4 years on the same 
client, cooling-off 2 years 
minimum.  

Quality of ratings 

General policy: CRAs to 
use methodologies that are 
rigorous, systematic, 
continuous, and may be 
validated based on historical 
experience. Applied 
consistently by analysts. 
CRAs to ensure that 
methodologies, models and 
key ratings assumptions are 
up-to-date and subject to 
comprehensive review.  

In line with the SEC 
rules. 

In line with the 
IOSCO Code. 

Not envisaged.  

Not envisaged.  

Broadly in line with 
the SEC rules. 

In line with the 
IOSCO Code. 

Duty to re-rate: CRAs to re-
rate all ratings following 

Broadly in line with 
the SEC rules. SEC 

In line with the 
IOSCO Code: 

The duty to re-rate is 
consistent with the 

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changes in methodologies, 
models, assumptions.  

Monitoring activity: CRAs 
should monitor and update 
the rating on an on-going 
basis.  

Limits to rating activity: 
CRAs not to issue ratings / 
withdraw existing rating 
when (i) lack of robust data; 
(ii) a new structure which 
raises serious doubts re. 
ability to assess 
creditworthiness.  

CRAs to update 
ratings on a timely 
basis and to keep 
them consistent 
with applicable 
methodology. 

In line with the 
IOSCO Code. 

rules focus on 
disclosure of CRA's 
practice (CRAs to 
disclose if they 
apply retroactively 
model changes to 
existing ratings). 

Broadly in line with 
the SEC rules. SEC 
rules focus on 
disclosure of CRA's 
practice (duty to 
disclose monitoring 
frequency).  

Broadly in line with 
the SEC rules. SEC 
rules apply to 
structured finance 
ratings. 

Broadly in line 
with the IOSCO 
Code. IOSCO rules 
apply to structured 
finance ratings. 

IOSCO approach 
and only makes it 
more concrete.  

The duty to monitor 
ratings is consistent 
with the IOSCO 
approach. SEC-like 
disclosure is also 
required.  

It is necessary to 
extend the 
prohibition to rate 
when information 
insufficient also 
beyond the 
structured finance 
products.  

Communication with the markets 

Broadly in line with the 
SEC rules.  

Broadly in line with 
the IOSCO Code. 

Approach consistent 
with US and IOSCO 
approaches. It also 
covers situations where 
ratings are not provided 
to the public free of 
charge (subscriber-pays 
model). 

In line with the SEC 
rules.  

In line with the 
IOSCO Code 
(IOSCO indicates 
different symbols 
as the preferred 
way to differentiate 
between structured 
and traditional 
rating).  

General rule: if ratings 
are intended for 
distribution channels or for 
the public, any rating 
decision should be 
disclosed on a non-
selective basis and in a 
timely manner.  

Different rating 
categories (symbols) for 
structured and 
traditional debt (either 
using different symbols or 
a attaching each time a 
report on the differences 
between a structured and 
traditional rating).  

Record keeping obligations 

Internal records support 
rating opinions to be kept 
for at least 5 years (incl. 

Broadly in line with 
the SEC rules (3 
years).  

In line with the 
IOSCO Code. 

EN 

105 

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records of analysts' dialogue 
with the rated entity).  

Other malpractice 

of 

the 
Prohibition 
notching 
practice 
(discriminatory treatment of 
ratings 
issued  by  other 
CRAs  in  situations  where 
they  could  be  used  in  the 
CRA's rating process)  

In line with the SEC 
rules. 

Not envisaged.  

the 

prohibition 

– 
Such 
following 
US 
example  –  is  crucial  to 
eliminate  the  described 
anticompetitive  practice 
of the main CRAs.  

EU Measure 

US measure 

IOSCO 

Other 
Comment 

/ 

Disclosures and transparency  

Continuous disclosures 

The following disclosures would 
be required on a continuous basis: 

Methodologies, models and key 
assumptions in use. Any material 
modifications to methodologies 
and key assumptions.  

Potential and existing conflicts of 
interest.  

Definition of an ancillary service.  

General nature of compensation 
arrangements  

Information about rating staff 
numbers and allocation to different 
functions  

Other internal policies, significant 
for users of ratings e.g. policy on 
distribution of ratings.  

Annual transparency report  

Broadly in line with the 
SEC rules.  

In line with the 
IOSCO Code. 

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Agencies to produce a yearly 
report (publicly available) 
outlining its organisational 
arrangements, policies and 
practices with regard to rating 
activity and its quality and 
compliance aspects. Such report 
could describe:  

Legal structure and ownership 
(incl. significant direct and indirect 
shareholdings)  

Description of the internal quality 
system 

Information about rating staff 
numbers and allocation to different 
functions 

Description of record keeping 
policy  

Outcome of the annual internal 
review of independence 
compliance 

Financial information on revenue 
from rating fees and non-rating 
revenue.  

Management and analyst rotation 
policy.  

Other periodic disclosures 

Historical  performance  data 
(default and transition studies) to 
be  put  in  a  central  repository 
managed by CESR.  

Broadly in line with the 
SEC rules. While the 
reporting requirements 
imposed by the SEC 
may have a different 
scope (greater reliance 
on maintaining records 
facilitated to SEC 
inspectors), the 
transparency principle 
and the character of 
information provided to 
the markets is 
substantially similar.  

Broadly in line 
with the IOSCO 
Code. 

The transparency 
report is not 
envisaged by 
IOSCO Code, but 
most of the 
disclosures that 
would be included 
in the transparency 
report may be 
required by IOSCO 
on an on-going 
basis.  

The report 
would be 
useful for 
supervisory 
purposes and 
could also be 
referred to by 
users of ratings. 

Envisaged.

Envisaged 
as 
disclosure  on  website. 
(1,  3,  10  year  horizon 
each 
for 
required 
category). 
rating 
for 
used 
Methods 
calculation 
be 
to 
publicly explained.  

Standards for presentation of ratings 

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CRA  should  ensure  that  the  rating 
basic 
reports 
standards  for  presentation  of 
ratings. The elements to consider:  

respect 

some 

Name and job title of analyst 

All substantial sources and whether 
CRA  discussed  draft  rating  with 
the rated entity 

Methodology. 
version, any deviations explained 

methodology 

Rating  meaning,  definition  or 
default and recovery, risk warnings 
(sensitivity  analysis  and  what-if 
scenarios).  Best  case  and  worst 
case ratings. 

Limitations  of  the  rating  including 
the  CRA's  statement  whether  it  is 
information 
satisfied  with 
quality  and 
the 
if 
information in any way 

the 
it  verified 

Whether rating was unsolicited 

For  structured 
ratings, 
information  about  any  loss  and 
cash-flow analysis performed 

finance 

Broadly  in  line  with 
the  SEC  rules.  Other 
major  elements  like 
methodology (-ies) in 
monitoring 
use, 
frequency, 
what 
information is used to 
establish  ratings  for 
structured  products, 
and  how  CRA  relies 
on  due  diligence  by 
3rd  parties  to  verify 
are 
quality 
asset 
a 
disclosed 
on 
(not 
general  basis 
with 
to 
regard 
specific ratings). 

Broadly 
with 
Code. 

the 

in 

line 
IOSCO 

The  standards  for 
presentation 
of 
ratings  have  not 
been  envisaged  by 
IOSCO  Code,  but 
most 
the 
of 
that 
disclosures 
would  be  included 
in  the  rating  report 
anyway 
are 
by 
required 
IOSCO.  

The  alignment  of 
standards 
for 
presentation  will 
benefit  users  of 
ratings,  who  will 
be furnished with 
higher 
quality 
material (in terms 
of 
transparency 
and accuracy) for 
their  analysis.  It 
is  worth  noting 
similar 
that 
have 
standards 
been 
for 
set 
investment 
recommendations 
in 
the  Market 
Abuse Directive.  

finance 

For  structured 
ratings, 
CRA's statement if it has sufficient 
knowledge 
diligence 
processes  at  the  underlying  assets 
level (and outcome of any analysis 
performed).  

due 

of 

EN 

108 

   EN