Commission staff working document accompanying the Proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies - Summary of the impact assessment {COM(2008) 704 final} {SEC(2008) 2745}
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) 2746 

COMMISSION STAFF WORKING DOCUMENT 

accompanying the 

Proposal for a 

REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL 

on Credit Rating Agencies 

SUMMARY OF THE IMPACT ASSESSMENT 

{COM(2008) 704 final} 
{SEC(2008) 2745} 

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1. 

INTRODUCTION 

Credit  rating  agencies  (CRAs)  issue  creditworthiness  opinions  that  help  overcome  the 
information  asymmetry  between  those  issuing  debt  instruments  and  those  investing  in  these 
instruments.  CRAs  have  a  major  impact  on  the  financial  markets,  with  their  rating  actions 
closely followed by investors, issuers, borrowers and governments. It is essential, therefore, 
that they consistently provide top-quality, independent, and objective credit ratings. 

Since  August  2007  financial  markets  worldwide  have  suffered  a  major  crisis  of  confidence. 
This  crisis  is  a  complex  phenomenon  involving  multiple  actors.  CRAs  alone  cannot  be 
blamed  for  the  current  financial  turmoil;  other  actors  and  special  circumstances  were 
implicated.  The  crisis  originated  in  the  US  residential  subprime  mortgage  market  and 
subsequently spread into other sectors of the financial markets. CRAs were close to the origin 
of the problems with subprime markets: they were issuing excessively favourable opinions on 
structured instruments that were financially engineered to give high confidence to investors. 
This Impact Assessment considers what would be the most appropriate policy response to the 
problems identified.  

The Impact Assessment presents a number of options for addressing the situation at EU level. 
The  Commission  is  proposing  a  series  of  measures  targeting  conflicts  of  interest,  the 
transparency  of  CRA  activities  and  specific  quality  aspects  of  the  rating  process.  These 
measures would need to be underpinned by a registration and surveillance system for CRAs 
operating in the EU, to be introduced under EU legislation.  

2. 

PROCEDURAL ISSUES AND PUBLIC CONSULTATION 

Against the background of the financial scandals in the US and the EU at the beginning of this 
century  and  following  the  resolution  on  CRAs  adopted  by  the  European  Parliament  in 
February  20041,  the  Commission  considered  very  carefully  whether  or  not  fresh  legislation 
was  required  to  regulate  the  activities  of  CRAs.  In  line  with  the  advice  received  from  the 
Committee  of  European  Securities  Regulators  (CESR)  in  March  20052,  the  Commission 
decided  not  to  present  new  proposals  on  CRAs,  taking  the  view  that  the  existing  financial 
services directives applicable to CRAs provided an answer to all the major issues of concern 
raised by the European Parliament.  

Credit rating agencies are subject to various financial services directives, notably the Market 
Abuse3  and  Capital  Requirements  Directives;  they  are  also  subject,  on  a  voluntary  basis,  to 
the  International  Organisation  of  Securities  Commissions  (IOSCO)  Code  of  Conduct 
Fundamentals  for  credit  rating  agencies.  In  2006  the  European  Commission  issued  a 
communication  Credit  Rating  Agencies4,  in  which  it  concluded  that  this  approach  would 
require it to monitor developments in this area. The Commission also asked the Committee of 

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European Parliament resolution on the role and methods of rating agencies (2003/2081(INI)). 
CESR  technical  advice  to  the  European  Commission  on  possible  measures  concerning  credit  rating 
agencies,  CESR/05/139b,  March  2005.  The  CESR  is  an  independent  advisory  group  to  the  European 
Commission composed by the national supervisors of the EU securities markets, set up in June 2001. 
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). 
OJ C 59, 11.3.2006, p. 2. 

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European Securities Regulators to monitor compliance with the IOSCO Code and report back 
on an annual basis.  

The Commission indicated that it might consider proposing legislation if it became clear that 
compliance with EU rules or IOSCO’s code was unsatisfactory or if new circumstances arose 
—  including  serious  market  failure  problems  or  significant  changes  in  the  way  CRAs  are 
regulated in other parts of the world. 

In view of the recent events in the financial markets, the Commission asked the CESR and the 
European  Securities  Markets  Expert  Group  (ESME)5  in  autumn  2007  to  provide  advice  on 
various  aspects  of  CRAs’  activity  and  role  in  the  financial  markets  and  especially  in 
structured finance. The Commission followed the work of both groups throughout the entire 
process. Both groups widely consulted stakeholders notably on the role of structured finance 
in the subprime turmoil. The CESR reported on 13 May 2008 and ESME on 4 June 2008. 

As well as closely following the progress of work at CESR and ESME, the Commission held 
discussions with major rating agencies and other stakeholders (industry associations from the 
insurance, securities and banking sectors, information providers, etc.). It also received written 
inputs  from  a  wide  range  of  associations,  market  practitioners  and  stakeholders.  On  the 
international side, it closely followed other international developments such as the revision of 
the  code  of  conduct  for  CRAs  approved  by  IOSCO  on  May  26,  the  report  of  the  Financial 
Stability  Forum  (FSF)6  published  on  7  April  2008  and  the  proposals  for  changes  in  the  US 
Act  on  CRAs  presented  on  11  June  and  1  July  2008.  The  Commission  also  followed  the 
consultations carried out by both IOSCO and the FSF. It took into consideration the various 
initiatives  proposed  and/or  implemented  by  the CRAs  either  individually  or  on  an  industry-
wide  basis  and  benefited  from  intensive  informal  dialogue  with  rating  agencies.  It  also 
encouraged  comments  from  interested  stakeholders  in  a  public  consultation  starting  on  31 
July  2008,  receiving  82  contributions:  13  from  credit  rating  agencies,  52  from  stakeholder 
organisations  (banks,  associations,  investment  funds,  savings  banks,  etc.)  and  17  from 
securities regulators and national finance ministries. 

3. 

PROBLEM DEFINITION 

Evidence  shows  that  CRAs  have  performed  markedly  worse  in  assigning  ratings  to 
innovative, structured products than in issuing traditional ratings. The Commission’s analysis 
therefore  focuses  on  the  issues  that  have  arisen  from  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  credit  rating  agencies  have  little  or  no 
experience. Moreover, certain deficiencies apparent in structured finance ratings relate to the 
structure, business model and internal processes of the entities, i.e. may also affect the more 
traditional areas of CRA activity.  

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The  European  Securities  Markets  Experts  Group  (ESME)  is  an  advisory  body  to  the  Commission 
composed of securities markets practitioners and experts. It was set up in April 2006. 
The  Financial  Stability  Forum  was  convened  in  April  1999  and  brings  together  on  a  regular  basis 
national  authorities  responsible  for  financial  stability  in  significant  financial  centres,  international 
financial institutions, sector-specific groupings of regulators and supervisors, and committees of central 
bank experts. 

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3.1. 

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

All contributors, institutions and stakeholders consulted unanimously expressed the view that 
potential conflicts of interest when CRAs rate structured products have not been avoided or 
managed satisfactorily.  

3.2. 

Lack of quality in methodology and ratings  

The significant number of downgrades observed in the second half of 2007 and first quarter of 
this year as compared to the first half of 2007 clearly indicates that the ratings given before 
the  start  of  the  turmoil  were  overoptimistic  and  failed  to  reflect  market  conditions  in  the 
underlying assets. One cause of this poor performance is most probably the lack of quality in 
the methodologies used by the CRAs to issue a rating.  

3.3. 

Lack of transparency in CRAs’ activity 

CRAs do not communicate the characteristics and limitations of ratings for structured finance 
products with sufficient precision, nor do they provide sufficient information on critical model 
assumptions.  This  lack  of  information  hinders  market  participants’  understanding  of  the 
ratings’  significance.  CRAs  deliver  information  on  rating  performance,  but  this  information 
does not facilitate comparison of CRAs’ performance. 

4. 

OBJECTIVES 

To deal with the problems defined above, three specific objectives need to be translated into 
substantive requirements. 

(1) 

(2) 

Ensure that CRAs manage any conflict of interest appropriately.  

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

(3) 

Increase the transparency of CRAs.  

There  is  also  a  broader,  overriding  objective,  which  is  to  enhance  the  compliance  of  CRAs 
throughout the European Union with the measures taken to remedy the problems identified.  

5. 

POLICY OPTIONS 

In view of the above objectives, a number of alternative options were analysed. 

5.1. 

Policy options for substantive requirements 

5.1.1. 

‘Ensure that CRAs manage any conflict of interest appropriately’ 

A number of issues need to be tackled. 

1. 

2. 

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General approach to dealing with conflicts of interest.  

Conflicts of interest triggered by CRAs’ advisory activity.  

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3. 

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Dialogue between rating analysts and the rated entity.  

Independence of the people involved in the rating process.  

‘Shopping for ratings’.  

Analysts joining the issuers they have rated.  

5.1.2. 

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

A number of issues need to be tackled. 

1. 

2. 

3. 

4. 

5. 

6. 

Quality of methodologies, models and key rating assumptions.  

Rating surveillance.  

Impact of methodology changes.  

Quality of information used in ratings.  

Staffing issues.  

Impact of market developments and macro economic expectations.  

5.1.3. 

‘Increase the transparency of credit rating agencies’ 

A number of issues need to be tackled. 

1. 

2. 

3. 

4. 

The transparency of internal processes and procedures.  

Ratings content.  

Differentiating ratings for structured finance.  

CRA performance statistics.  

5.2. 

Instruments to put the policy options in place 

As  regards  the  overarching  objective  of  enhancing  CRAs’  compliance  throughout  the 
European  Union  with  the  measures  taken  to  remedy  the  problems  identified,  the  following 
options are examined. 

Option 1: Self-regulation, including: 

(a) 

the IOSCO Code of Conduct; 

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(b)  The  ‘industry  White  Paper’  —  it  would  be  assumed  that  the  agencies 
themselves would find appropriate solutions to the problems and concerns cited 
above7;  

(c)  Additional  initiatives  by  individual  CRAs  —  several  CRAs  presented 
regulators  and  the  market  with  a  series  of  proposed  improvements  and 
committed  themselves  individually  to  incorporating  them  in  their  internal 
practices and procedures. 

Option 2: A European Code of conduct for CRAs by which members of the industry would 
commit themselves to maintain a series of voluntary standards and to accept and follow the 
recommendations  of  a  monitoring  body  that  would  check  signatories’  compliance  with  the 
code. 

Option 3: Commission Recommendation setting out the standards that CRAs would have to 
comply  with  to  operate  in  the  EU  —  the  same  standards  as  in  option  4  (legislation).  The 
standards  would  build  on  the  revised  IOSCO  code  and  CESR  and  ESME  recommendations 
and would include additional standards considered essential by the Commission.  

Option  4:  EU  legislation  providing  for  a  comprehensive  regulatory  framework  covering  all 
existing (and prospective) CRAs with business operations in Europe whose ratings are used 
for regulatory purposes such as the Capital Requirements Directive8. The proposal would lay 
down conditions for the issuance of credit ratings, introducing a registration procedure and an 
external surveillance regime by EU regulators.  

6. 

ANALYSIS OF IMPACTS 

Given  the  technical  character  and  detail  of  the  policy  options  addressing  objectives  1  to  3, 
their particular impacts are not summarised here, but are set out in the Report. Here, we only 
analyse the various means of enforcement. 

Self-regulation 

The  IOSCO  Code  fails  to  meet  the  policy  objectives:  CRAs’  management  of  conflicts  of 
interest would remain as it is now, thus inappropriate; CRAs would not be obliged to improve 
their  rating  methodology  and  rating  quality;  the  transparency  of  CRAs  would  not  be 
increased;  and  there  would  be  no  supervision  and  enforcement  mechanism  for  competent 
authorities. The Industry White Paper and other initiatives are very flexible for CRAs as they 
would be free to adapt to new voluntary requirements. However, they would not be effective 
since they do not envisage a strong mechanism to monitor compliance with the standards set. 
Moreover, no common framework would be guaranteed. Self-regulation has been tested since 
2006 and the outcome is far from acceptable. 

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In January 2008 the five main CRAs 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 credit 
ratings. 
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). 

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A European code of conduct  

This solution would be highly flexible, because CRAs would be able to apply the ‘comply or 
explain’  principle.  It  has  the  advantage  of  including  a  monitoring  body,  albeit  without  any 
enforcement power so its effectiveness would be limited. It would ensure a reliable common 
framework, although no significant legal certainty could be achieved. The outcome would not 
be sufficient to satisfy the policy objectives. 

A Recommendation by the European Commission 

This solution would help establish, to some extent, a common framework, at least concerning 
the  reference  criteria  that  CRAs  had  to  fulfil;  however,  it  could  not include  an  enforcement 
mechanism and thus would have limited effectiveness in achieving the policy objectives. 

Legislation 

This solution would ensure a level playing field within the Community for all market players, 
instead  of  a  fragmented  legal  regime  for  CRAs  throughout  27  Member  States,  which  could 
arise if the EU does not act but keeps the current self-regulatory regime based on the IOSCO 
Code.  A  legislative  proposal  would  include  a  ‘diligent  supervision’  system  and  a  robust 
enforcement  mechanism  and  thus  be  effective  in  assuring  compliance  with  the  policy 
objectives.  It  would  ensure  that  the  framework  proposed  for  the  issuance  of  credit  ratings 
would be duly implemented, diligently supervised and robustly enforced. 

7. 

COMPARING THE OPTIONS — CONCLUSIONS 

After due consideration of the impacts of all specific policy options and their advantages and 
disadvantages compared with the baseline scenario, the following conclusions may be drawn.  

To  meet  Objective  1  (Ensure  that  CRAs  manage  appropriately  any  conflict  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  will  be  prohibited  from  providing  consultancy  or  advisory  services.  Rating 
analysts will need to be insulated from the commercial aspects of the CRAs’ activities and to 
be  subject  to  more  demanding  rules  regarding  dialogue  with  the  client.  Before  analysts  are 
employed  in  a  position  by  a  former  client,  specific  safeguard  rules  should  apply.  Finally, 
CRAs’ clients should be discouraged from harmful ‘shopping for ratings’.  

To  meet  Objective  2  (Ensure  that  CRAs  remain  vigilant  on  the  quality  of  the  rating 
methodology  and  the  ratings),  CRAs  will  have  to  use  methodologies  that  are  rigorous, 
systematic, continuous, and can be validated based on historical experience. 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 will trigger prompt re-rating of all 
existing ratings concerned. CRAs will also have to monitor and update individual ratings on 
an ongoing basis. Greater transparency will be required to help users of ratings understand the 
due diligence conducted on the asset-level data and factored into the ratings. CRAs will need 
to disclose staff levels to trigger closer market scrutiny.  

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To meet Objective 3 (Increase the transparency of CRAs) a general transparency obligation 
needs  to  be  imposed  on  CRAs  regarding  the  functioning  of  their  internal  processes  and 
procedures,  coupled  with  a  duty  to  publish  a  yearly  transparency  report.  Information  on 
analyses  performed,  any  limitations  and  specific  risks  involved  will  need  to  be  provided  to 
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 products. 
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 to ensure that their credit ratings 
can  be  used  by  credit  institutions,  investment  firms,  insurance  and  assurance  undertakings, 
collective  investment  schemes  and  pension  funds  within  the  Community.  Efficient  and 
effective monitoring of compliance with the requirements will be ensured throughout the EU 
(overarching objective). 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. Day-to-day supervision will be carried out by the competent authorities of 
the  Member  States.  Close  cooperation  between  national  regulators  and  coordination  by  the 
CESR  is  a  prerequisite  to  creating  a  common  supervisory  culture  and  an  efficient  network 
approach. National regulators should be empowered to act and apply efficient sanctions where 
CRAs  do  not  comply  with  the  rules.  Again,  the  CESR  should  play  an  important  role  in 
creating a common enforcement culture. 

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