EFAMA Comments on Rapporteur Wolf Klinz Draft Report on Credit Rating Agencies: future perspectives EFAMA is the representative association for the European investment management industry. Through its 27 member associations and 46 corporate members, EFAMA represents about EUR 14 trillion in assets under management, of which EUR 7.7 trillion was managed by approximately 53,000 funds at the end of September 2010. The European investment management industry supports a reduction of overreliance on credit ratings, and EFAMA adopted in December 2008 together with the Investment Management Association (IMA) and the European Securitisation Forum (ESF) the Asset Management Industry Guidelines to Address Over Reliance upon Ratings 1, providing guidance for asset managers on the responsible use of ratings for securitisation, structured finance and structured credit products. The guidelines address the role in the investment process of asset managers who are agents, or fiduciaries, for their clients, the owners of capital. Those include pension funds, UCITS, insurers, corporates, sovereign wealth funds, hedge funds and credit institutions. The guidelines are written so as to be applicable across a wide range of securitisation, structured finance and structured credit products, whole business securitisations, insurance linked securities and credit linked notes. EFAMA members manage assets for a variety of investment funds and institutional clients. EU law and regulation applicable to a number of these institutional investors makes frequent reference to credit ratings. As a result, credit ratings have become the basis for the discretionary management mandates given to asset managers by the institutional investors, or are prerequisites for investment by institutionals in funds (UCITS and non UCITS), and therefore are used also in fund policies. Our members regret that mandatory references to credit ratings continue to be made. For example, CESR included them in its Guidelines for a Common definition of European money market funds as recently as May 2010 (CESR 10 049). However, as long as mandatory references to credit ratings exist, their predominance in institutional mandates will continue and investment managers will be obliged to act accordingly. It needs to be pointed out that investment management firms purely receive the terms of the mandate from the client and manage the portfolio accordingly. They do not give advice on how the mandate 1 http://www.efama.org/index.php?option=com_docman&task=doc_details&gid=834&itemid=35 18 Square de Meeûs B-1050 Bruxelles +32 2 513 39 69 Fax +32 2 513 26 43 e-mail : info@efama.org www.efama.org
2 should be structured, as institutional clients may get external advice from consultants regarding investment issues, including investment mandates. Pension fund trustees specifically may be required by regulation to take external advice when they do not have the appropriate skills on the board of trustees (that is for example the case in the UK). EFAMA largely agrees with the Rapporteur s Draft Report, but we wish to make the following comments: Macro level: financial market regulation: Over reliance Para. 3 Ratings are also widely embedded also in investment policies for institutional mandates, not just in regulatory capital requirements. However, as discussed above, it must be mentioned that this choice is imposed on investment managers by their institutional clients. EFAMA members do not believe it is appropriate to differentiate between small and large players when it comes to credit analysis. All investors in the credit markets need to engage in a minimum level of own credit analysis as the default risk rests with them (as correctly pointed out in Para 24) and their clients. Para. 4 It is not lack of due diligence by investment managers that leads to forced sales in case of downgrades, but the fact that a downgrade makes a certain instrument no longer investable (when the investment policies or fund rules are based on credit ratings due to investor preferences). If the references to ratings in legislation cannot be eliminated and continue to shape investment mandates, the market participants should be encouraged to engage in detailed analysis of the downgraded credit and should be allowed longer periods to sell assets. Intermediate level: industry structure European Credit Rating Foundation Para. 9 12 EFAMA members welcome an open discussion to expand the available range of CRAs in order to increase competition in the industry and increase the quality of credit ratings. There are differences of opinion among our members regarding the need for a European Credit Rating Foundation or Agency. A large majority of EFAMA members strongly disagree with the need to create an EU Credit Rating Agency. They believe that establishing credit rating agencies under the auspices of either European or Member States institutions, such as the ECB or National Central Banks, would have the effect of giving undue weight and endorsement to any ratings produced by those agencies by virtue of their quasi governmental status, and would only serve to discourage investors due diligence. Retail investors
3 in particular would be inclined to believe that such ratings carry some sort of implicit guarantee. Last but not least, credit rating agencies have to compete for staff with other financial institutions and the perception is that the better analysts quickly move to higher paid positions within investment banks or investment management firms. It is therefore questionable how a quasi state run agency could compete for the best staff. However, some of our members welcome the idea of an EU Credit Rating Agency (EU CRA), an EU financed and regulated institution which provides ratings on issuers/issues based in the EU (and perhaps later on foreign issuers/issues which are doing business in the EU). Intermediate level: industry structure: Network of European credit rating agencies Para. 14 The need to use specific CRAs could be reduced if lesser quality rating methodologies and results would become more transparent in the market place and would push business to the "good" CRAs. Some EFAMA members believe that besides the suggested network of European CRAs there could be a network of approved, external verification bodies which would verify and check rating methodologies and results. For example, the organisations which currently verify annual accounts of companies may also be in a position to verify and check CRA rating methodologies and CRA rating results applied to these companies: one of such bodies is the Deutsche Rechnungsprüfungsstelle (DPR). Intermediate level: industry structure Disclosure and access to information Para. 15 16 EFAMA agrees and supports the proposals. However, in order to assess the quality of a structured finance instrument (SFI) rating continuously and not only at its issuance, it is important that investors receive regular information on the performance of the asset pool relative to the base case. In depth research and monitoring reports on single issues are today limited to registered and paying subscribers only. EFAMA members believe that monitoring data should not be provided on a separate web platform and access to the data should not require extra payments to the CRA. Instead, this minimum after sales transparency should be a sine qua non condition to assign/maintain a rating even if there is no change in the credit quality of the transaction. We also consider it to be crucial to explicitly require issuers, arrangers, underwriters and sponsors of structured finance instruments to perform due diligence credit reviews themselves and disclose to investors and CRAs the steps taken. Moreover, our members believe that the ratings on all tranches of a structured finance deal should be disclosed by the CRA. This will help discourage rating shopping and cherry picking by the
4 issuer/arranging bank and improve information to the market place. Some types of structured finance ratings tend to be made available to the public by all CRAs only on the highly rated senior tranches. Lower ratings on junior tranches will usually not be made public. This is the result of the issuer/arranging banks pressure on the CRA to suppress the publication of ratings they do not deem necessary. Investors, however, would be much better equipped to assess the true risks of a specific deal if they were able to analyse all ratings assigned to a specific deal. Para. 17 EFAMA supports enhanced disclosure towards investors. In order to reduce the reliance of structured finance investors on CRA ratings and to allow for the establishment of internal ratings of comparable quality, issuers of structured finance instruments or related third parties should be required to give access to the information which they have given to the CRA for the purpose of rating structured finance instruments at least also to institutional investors which have registered their intention to invest in the structured finance instrument with the issuer of the structured finance instruments or the related third party. The registered investor being granted access to information should not use it for any other purposes than for the establishment of an internal rating on the structured finance instrument. Intermediate level: industry structure Two obligatory ratings Para. 18 We are concerned that the requirement to use two obligatory ratings for SFIs will lead to a significant increase in costs not only to issuers but also to investors without real benefits. The Capital Requirements Directive (2006/48/EU Annex VI Part 3) already effectively require the use of all ECAI ratings, which is very costly for investors in terms of rating fees. Investors already pay substantial cost for rating data feeds needed to monitor the ratings. The large CRAs have considerably increased the cost of ratings data over the past few years, which may amount to more than 1 million dollars in case of global data license to a large player. The cost for investors will increase with each newly registered CRA because no firm can take the compliance risk of not taking into account such ratings. Para. 19 It remains questionable whether ESMA would in fact select a new entrant CRA as second rating provider. In practice because of lack of track record, one of the big three CRAs is likely to be selected to provide the second obligatory rating. The second rating requirement will effectively cement the existing CRA oligopoly. Even if a new entrant CRA has established a track record in terms of time, it will most likely still lack coverage of the relevant credit sectors in order to be accepted by the market.
5 Intermediate level: industry structure Sovereign debt rating Para. 20 As pointed out above para.4, the stated cliff hanger effect of rating downgrades could be mitigated if users of credit ratings are encouraged to engage in detailed analysis of the downgraded credit and are allowed longer periods to sell off the downgraded assets. Para. 21 As long as the use of credit ratings is embedded in legislation, investment managers shall not be able to ignore them even for sovereign issuers. To facilitate internal assessment for sovereign issues, it must be ensured that all relevant information is truly available in the public domain and that such statistics are timely and correct. Micro level: business model Para. 22 We support the view that the co existence of various payment models is acceptable as long as the inherent conflicts of interest are properly addressed. However, it is not clear that an alternative to the issuer pays model is viable. In fact it is unlikely that there would be enough investors willing to pay for ratings to make the business a sustainable one. We would like to point out that even under the issuer pays model investors are already paying substantive fees to CRAs for ratings data. We strongly suggest that ESMA as part of the registration process should be authorised to approve the current and future rating and rating data delivery fees charged by CRAs. There is a need to establish fair data feed pricing by prescribing e.g. an a licensing model for the download of the regulatory required credit ratings file (i.e. all single ratings of a single issue without press release or other CRA research)on a cost recovery basis only. Given the importance of ratings to issuers in the financial services industry, it should also be ensured that the provision of ancillary services does not present conflicts of interest with the CRA s credit rating activity. For example, the CRA S&P is coupling end user license requests on US ISINs with its RatingXpress ratings data feed product. In this way S&P forces market participants wanting to buy ratings data only to accept also a US ISIN license in spite of the fact that such license request are under investigation by the EU Commission s DG Competition. Furthermore, because of their oligopolistic market powers, CRAs impose very advantageous conditions for them in the ratings data contracts with investors. The issues arising in the ratings data contract area could be addressed by firstly requiring in CRA regulation that legal entity or securities identifiers such as ISIN delivered with the corresponding rating information are provided free of any end user licenses and fees.
6 The dependence on specific ratings and the corresponding dissemination restrictions by the CRAs could be further reduced if a standardized rating scale and symbols (e.g. numerical 1 to 19) to which all commercial ratings could be mapped are introduced in all regulation requiring the use of CRA ratings. By using the regulatory provided rating scale and symbols data licence issues could be avoided as direct reference to CRA ratings is eliminated in practice. Finally, by establishing a central ratings database under the control of the EU financial services regulators (as a public utility model) which secures access to credit rating information and the corresponding rated legal entity and issue identifiers to all market participants the risk of data feed interruption will be eliminated This ratings database would only hold the rating of each single issue as required under regulation but not full rating opinions or other CRA research which the CRAs could continue to market freely. Micro level: Accountability, responsibility and liability Para. 23 The contractual liability provisions currently applied by CRAs in the European market are insufficiently harmonised. A single liability standard across Europe for the correctness of solicited and unsolicited ratings could help to insure a uniform application of CRA quality standards across its different analytical centers or to prevent moving CRA legal seats to low liability locations. The EU standard of care should not be materially different from the US in order to prevent distortions of CRA competition. Furthermore, liability standards which are too demanding will inhibit the growth of new CRAs. The standard needs to cover both solicited and unsolicited ratings as investors base their investment decisions on both kinds of ratings. The protection of ratings users needs to be strengthened with respect not only to civil liability on the correctness of ratings, but also with respect to CRA representations, quality standards and bad or no delivery of credit rating information services. Provision of credit rating data is currently provided contractually as is. Subscribers do not receive sufficient representations for the quality, quantity, completeness, accuracy or timeliness of credit rating data feeds. Because of their market power CRAs may successfully disclaim civil liability for information quality and delay of delivery. However, some EFAMA members believe that common standards of liability for EU CRAs should not be so strict as to increase the cost of credit ratings (possibly to the point that it becomes more difficult for issuers to raise much needed capital) or reduce the willingness of CRAs to rate more complex and risky instruments where ratings are arguably more critical. In their opinion, liability for gross negligence and intent appears to be a reasonable standard to apply. A minimum standard of liability regime should be the same for solicited as well as unsolicited ratings. Such members believe that imposing a high standard of liability on CRAs with users knowing that they will be able to seek compensation directly or through insurance, may have the undesired consequence of leading investors to undertake less rather than more
7 due diligence when using ratings. Imposing strict standards of liability is not an effective way to ensure the quality of credit analysis, but it may be possible to do so by an incentive mechanism that rewards quality rather than penalising failure. US regulation (the Dodd Frank Wall Street Reform and Consumer Protection Act) contains provisions that pertain to the regulation of CRAs and exposes CRAs to expert liability. CRAs do consider their rating products as opinions and therefore disclaim civil liability. Statutory liability is contested by CRAs and therefore excluded in bilateral data delivery contracts. CRAs require subscribers to incorporate a special disclaimer in the financial institutions communications whenever credit ratings data is disclosed to clients in order to contractually limit their liability. The huge costs of printing and mailing the requested disclaimers client statements and other materials are entirely borne by the financial institutions. Also implementing the requested disclaimers into the reporting systems of the financial services industry within a very short timeframe as required by the CRAs is operationally challenging and costly. Therefore, an EU liability rule should also insure that CRAs cannot contractually limit their liability and that financial services firms do not need to publish CRA liability disclaimers in the distribution of credit rating data to clients, business partners, etc. 17 January 2011 [11 4005]