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European Parliament and Council Approve Commission’s Ratings Agencies Regulations

The European Parliament and the European Council have both approved the recently proposed regulation on credit ratings agencies, tabled by the European Commission earlier this year. The new regulation will put in place a common regulatory regime for the issuance of credit ratings with a view to restoring market confidence in the sector and increasing investor protection.

Commission president José Manuel Barroso, explains: “Today’s approvals of the Commission’s proposals on credit rating agencies are the latest example of the EU leading the world in responding to the economic and financial crisis, restoring confidence and preventing a repeat. Our G20 partners agreed in London to move in the same direction the EU has taken. The regulation will help give investors the information, integrity and impartiality they need from credit rating agencies if they are to make prudent investment decisions that create growth and jobs instead of bubbles of excessive risk.”

It is expected that the regulation will impose stricter standards of integrity, quality and transparency on the much maligned ratings agencies, which have been blamed by many corners of the industry for exacerbating the financial crisis. These agencies will be subject to ongoing supervision of public authorities under the new legislation to ensure that users are adequately protected when making investment choices based on ratings data.

It has been a long road towards implementation. In October 2007, EU finance ministers agreed to a set of conclusions on the crisis (the ‘Ecofin Roadmap’), which included a proposal to assess the role played by credit rating agencies and to address any relevant deficiencies. The European Councils of 20 June and 16 October 2008 called for a legislative proposal to strengthen the rules on credit rating agencies and their supervision at EU level, considering it a priority to restore confidence and proper functioning of the financial sector.

As a long time campaigner for the introduction of stricter controls on this sector, Internal Market and Services Commissioner Charlie McCreevy has expressed his satisfaction that the regulation has finally got the green light. “The Commission has long insisted that profound changes were necessary to the framework in which the credit rating industry operates. With this regulation, the EU is setting an example to be followed and matched,” he says.

He claims that “intense” cooperation between the European Parliament, the Council and the Commission has allowed for the regulatory regime to be adopted swiftly. “We expect the conduct of the credit rating agencies to be significantly improved as a result of this regulation, with clear benefits to the integrity and stability of the financial markets,” McCreevy continues.

The new rules are largely based on the standards set in the International Organisation of Securities Commissions (IOSCO) code and they will be legally binding for the credit ratings agencies.

Following the introduction of the regulation, all credit rating agencies that would like their credit ratings to be used in the EU will need to apply for registration. The applications will need to be submitted to the Committee of European Securities Regulators (CESR) and decided upon in a consensual manner by the relevant securities regulators grouped in a college. The college of regulators will also be involved in the day to day supervision of credit rating agencies, says the Commission.

Specific, albeit sufficiently exacting, treatment is envisaged and may be extended, on a case by case basis, to credit rating agencies operating exclusively from non-EU jurisdictions provided that their countries of origin have established regulatory and supervisory frameworks as stringent as the one now put in place in the EU.

Once they have been registered, ratings agencies will be required to abide by a number of rules to remain in the fold. These include making sure that their ratings are not affected by conflicts of interest, proving that their methodologies are of a sufficiently high quality and that they are acting in a “transparent manner”. To this end, these firms must disclose the models, methodologies and key assumptions on which they base their ratings. They must differentiate the ratings of more complex products by adding a specific symbol and they will be compelled by the regulation to publish an annual transparency report.

Furthermore, ratings agencies will also have to create an internal function to review the quality of their ratings. In terms of governance, they will be required to have at least two independent directors on their boards whose remuneration cannot depend on the business performance of the rating agency. These directors will be appointed for a single term of office, which can be no longer than five years. They can only be dismissed in case of professional misconduct and at least one of them should be an expert in securitisation and structured finance.

As well as specifying what they must do, there is also a list of prohibited actions in the new regulation. This includes the rule that credit rating agencies may not provide advisory services and another that they will not be allowed to rate financial instruments if they do not have sufficient quality information to base their ratings on.

Just to make sure that these firms are doing what they say, regulators will be keeping a close eye on these areas via an “effective surveillance regime”, says the Commission.

The regulation and surveillance model may also prove useful for the Securities and Exchange Commission (SEC), which is also looking at the oversight of credit ratings agencies in the US.

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