Santander response to the European Commission s Public Consultation on Credit Rating Agencies General comments Santander welcomes the opportunity to comment on the Consultation on Credit Rating Agencies (CRAs) launched by the European Commission on November 5, 2010. Santander supports the efforts made so far to improve the functioning of the ratings markets and strengthen these areas where weaknesses have been identified during the last crisis. Thus, we welcome the enhancement of the CRA s regulatory and oversight framework already adopted in 2009. There has been no time yet to test the effectiveness of this new framework but for sure it will help to mitigate the problem of ratings being influenced by conflicts of interest, to strengthen the quality of the rating methodology, and to increase transparency in the rating process, and, for structured products, transparency of underlying assets. However, we acknowledge that while the measures already taken will improve CRA s credit assessments it is impossible to make an assessment immune to errors. That s why we agree that it would be good to reduce system overreliance in a few number of assessments, no matter these came from the private or the public sector. To avoid that a single valuation mistake had systemic consequences authorities should encourage a broader range of assessments in the capital markets, rather than to align opinions around a limited number of methodologies, information sources or assessments. We think that encouraging market participants (banks, asset managers, central banks etc): 1) to make use of internal risk assessments when appropriate, and, 2) to thoroughly consider their use of external ratings otherwise, would help to reduce the systemic risk of assessments errors. However, care should be paid not to force the use of internal models beyond what is sensible. Moreover, convergence in the validation of internal models by supervisors should be ensured to avoid uneven playing field and regulatory arbitrage issues. When the use of internal models is not appropriate the best way to reduce overreliance is to require that valuations do not mechanistically rely on external ratings but take them as an input that need to be complemented with other information sources and expert judgement. We think that it would also be good to encourage the entry of new players in the independent rating agencies market. However, this should not be done at the expense of quality in assessments or at a disproportionate cost. Making financial information more comparable through standardizing definitions and financial statements more homogeneous and easily available (e.g. making the annual reports web versions more user-friendly and searchable) could help to reduce the entry costs in this market. Moreover, more transparency and comparability on CRA s methodologies and performance could also help investors to broad the spectrum of CRAs they used. In conclusion, the removal of the cases of excessive reliance on external ratings, while desirable, needs to be pursued judiciously in order to avoid unintended consequences, in particular to avoid undermining the risk-sensitivity of capital regulations, increased compliance and supervisory costs, and introduction of barriers in the access to capital markets. Specific comments 1. Should the use of standardized approaches based on external ratings be limited to smaller/less sophisticated firms? How could the category of firms which would be eligible to use standardized approaches be defined? 1
We think that encouraging market participants (banks, asset managers, central banks etc): 1) to make use of internal risk assessments when appropriate, and, 2) to thoroughly consider their use of external ratings otherwise, would help to reduce the systemic risk of assessments errors. Santander shares the European Banking Federation (EBF) view that the Basel II framework already provides the right incentive-based structure to move towards internal models and that even the largest banks must not be required to rate their entire portfolio internally. It is not efficient neither prudent to rate internally those instruments that constitute only a small proportion of the overall risk exposure. Instead, a more sensible approach is to lead institutions to use external ratings as an input to be complemented with additional information sources (e.g. CDS) and expert judgement. Care should be paid not to force the use of internal models in those cases where their quality is questionable and would most likely underperform an assessment based on external ratings complemented by additional criteria and expert judgement. Finally, convergence in the validation of internal models by supervisors should be ensured to avoid uneven playing field and regulatory arbitrage issues. 2. How do you assess the reliability of internal models/ratings? If negatively, what could be done to improve them? We think that current regulatory requirements for authorising the use of internal models provide a good framework to ensure that they are reliable and robust enough. However, further efforts are still necessary in ensuring convergence in the internal and supervisory validation processes, as well as in improving transparency on the internal rating methodologies that makes easier comparisons among them but also between them and the external rating methodologies (e.g. the relationship between the ratings and the probability of default, the use of through the cycle or point in time estimations, the treatment of credit rating migration are examples where more disclosure should be warranted). The use of internal ratings inevitably implies that different risk weights are applied by different institutions for the same financial instruments. This reflects the diversity of opinions in the market about the prospects of different investment projects. This is a good outcome as overreliance on one single opinion is reduced. However, this leaves more room for arbitrage. Supervisors should ensure that institution s internal policies are consistent with the assessments used for regulatory purposes through performing use test and thus reflect the true institutions prospects. Supervisory convergence in model validation becomes even more essential to ensure the level playing field. Regulatory standards need to be defined in such way that all banks will conduct broadly comparable assessments of credit-worthiness for similar exposures and that their assessments will be susceptible of rigorous supervisory review. 3. Do you agree that the requirement to use at least two external ratings for calculating capital requirements could reduce the reliance on ratings and would improve the accuracy of the regulatory capital calculation? We think that more important that the use of two o more external ratings is that the methodology and shortcomings of these ratings are well understood by users and that they complement this information with other sources, taking into account the correlation among them and its relative reliability and quality and applying its own expert judgment. This is the philosophy that has always been in place at Santander when approaching the use of external ratings. 4. What alternative measures of credit risk could be used in regulatory capital frameworks? What are the pros and cons of market based risk measures (such as bond prices, CDS spreads) compared to external credit ratings? How could pro-cyclical effects be mitigated if market prices were used as alternative measures of credit risk in regulatory capital regimes? 2
We think that as much information is taken into account in the assessment the better, thus we don t agree with replacing the use of external ratings by a single indicator based on market data. Instead regulation should encourage the use of a broader set of information and expert judgement. Judgement should help to qualify the different sources attending to its quality and to take into account correlation among them when coming to the final assessment (e.g. correlation among rating agencies, or among ratings and CDSs developments). In order to limit the pro cyclicality of market values enough long time averages, ideally through the cycle, should be used in the assessments. Santander assessments already are based on a broad set of market (e.g. bond spreads, CDS), balance sheet and additional information provided from market analysts. Regarding pro cyclicality is worth to remind that ratings are only an ordinal measure and therefore less cyclical than cardinal risk measures such as the probability of default (PD s) that suffer from cyclicality similarly to market prices. The process through which PD s are mapped against the ratings (Point In Time or Through The Cycle) is crucial in mitigating the pro cyclicality and so it would be in using market prices. We think that assessments less dependent on the cycle should be encouraged in general, in the credit ratings agencies methodologies, in the internal models and in the internal assessments based on market data. Moreover, it is important to ensure that assessments used for regulatory purposes are well integrated in the institutions management and agents behaviour more generally. 5. Would it be appropriate to restrict institutions'/insurance or reinsurance undertakings' investment only to those securitisation positions for which capital requirements can be reliably assessed? To what extent could the requirement to internally rate all or at least most underlying exposures restrict the potential investor base for securitisations? As a general rule institutions should understand the risk profile of their investments and refrain to enter in positions that they are not able to properly assess. However, we think that the requirement to internally rate all underlying exposures is disproportionate and indeed will restrict the base for potential investors. A more sensible approach would be to require investors understand the product and it risk profile and perform the due diligence to ensure that the originator comply with the minimum requirements. 6. Can the existing "supervisory formula" based approach in the Capital Requirements Directive be considered to be sufficiently risk sensitive to become the standard for all securitisation capital requirements? If not, how could its risk sensitivity be improved without placing reliance on institutions' internal estimates other than default probability and loss for the underlying exposures? In the insurance sector, how do you assess the approach to credit risk for structured exposures used in QIS 5? We agree with the EBF view that it is not realistic to require this approach for all securitisation products. In view of the extensive work load that this approach requires, many investors would likely refrain from buying the respective products, meaning to put further stressed on the securitisation market. 7. Should firms be explicitly obliged to carry out their own due diligence and to have internal risk management processes in place which do not exclusively rely on external ratings? 3
We agree that firms should be required to carry out their own due diligence and to have in place strategies to avoid over-reliance on external assessments. However, regulatory requirements to this effect must be proportionate to the risks. When the use of internal models is not appropriate, the reduction in the role played by external ratings should not be at the expense of a less risk sensitive framework. In the case of banks the replacement of external ratings for supervisory valuations would imply a backward step towards Basel I and the arbitrage and incentives problems attached to it. The best way to reduce overreliance is to require that valuations do not mechanistically rely on external ratings but take them as an input that need to be complemented with other information sources and expert judgement. In addition, a proper understanding of the credit rating agencies methodologies and awareness of their shortcomings should be required to the users of those ratings. These requirements should be proportionate to the risks in order for the assessment process to be efficient as well as effective. Moreover, regulation should not be over prescriptive regarding which additional information sources or methodologies should be used as far as the sources are reliable and the methodologies robust. 8. What information should be disclosed to supervisors in order to enable them to monitor the internal risk management processes of firms with particular focus on the use of external credit ratings in these processes? The CRD already sets detailed reporting requirements regarding the internal risk management processes; however more supervisory guidance regarding how to validate internal models would help to achieve more convergence. Information about which and how additional sources of information feed into the process, correlation among these sources, assessments of its quality and reliability, etc could be useful in assessing the over reliance on external ratings. 9. To what extent do firms currently use credit risk models for their internal risk management? Are the boards of directors or other governing bodies of these firms involved in the review of the use of credit ratings in their investment policies, risk management processes and in investment mandates? In Santander we make an extensive use of internal credit risk models for risk management. These models are internally validated by an independent Committee and externally by the supervisors. Both are extremely rigorous processes that are updated regularly and ad hoc when circumstances so advised. Santander senior management is fully and regularly informed on any development regarding the use of credit risk models and the policies regarding the use of external ratings. Moreover they are fully engaged in the decision process regarding the establishment of credit risk models policies (e.g. use of external ratings, risk management processes and risk tolerance). Internal models should be approved by a Board s members special Commission. Moreover, in the development of credit risk models users of these ratings are engaged from the beginning in order to ensure that the ratings are useful risk management tools fully integrated in the credit policies. 10. What further measures, in addition to the disclosure proposals included in Articles 8a and 8b41 of the proposal amending the current CRA Regulation could be envisaged? We share the EBF view that there is scope to further enhance the disclosure of rating agencies to the market. While it is fully acknowledged that rating agencies must not be mandated to disclose to the market the detailed parameters of their models, a useful level of disclosure should allow users of ratings to consider the overall design of the models and their underlying assumptions against their own expectations about the further developments of the markets. 4
It is crucial to ensure the independence and transparency of the credit rating agencies valuations. For this regulation should require: 1) Disclosure of the minutes of the committee together with the publication of a rating, 2) A minimum number of independent council members 3) The decision should be taken with a qualified majority and signed by all the members in the meeting 4) The decision should be taken by a minimum number of persons from the rated company home country 11. Would you agree with the assessment that sovereign debt ratings are primarily based on publicly available data, implying that rating agencies do not have advanced knowledge? Do you consider that all financial firms would be able to internally assess the credit risk of sovereign debt? We think that sovereign debt ratings have an added value over publicly available data. First, publicly available data does not always offer a complete picture. Second, the interpretation and comparison of public accounts is not always easy and knowledge of the local peculiarities reveals to be crucial. Third, experience and a good modeling background are of essence to reach an accurate assessment. Finally, the gathering of qualitative information through interviews with different stakeholders still plays an important role in the final assessment. We think that the use of sovereign debt ratings should be subject to the same principles that any other ratings. That are, internal risk assessment should be justified by the materiality of the risk. Otherwise the use of external ratings complemented by other information sources plus expert judgment should be the preferred option. Mechanical reliance on external sovereign ratings should be discouraged as with other exposures. However, it should be taken into account that is unavoidable that external ratings influence some of the institutions internal policies as far as these ratings are still used by other bank counterparties (e.g. central banks). 12. Should there be a "flexibility clause" in investment mandates and policies which would allow investment managers to temporarily deviate from external rating thresholds (e.g. by keeping assets for a limited time period after a downgrading)? We agree with the EBF view that greater flexibility for asset managers should be considered further. Encouraging alternative views on the market would lead to a greater variety of opinions expressed in market prices, as well as providing asset managers with greater scope to differentiate themselves from their competitors. However, this should be done by ensuring legal certainty. Investors should be protected against mismanagement and for this it is essential the investor could monitor and control that the manager is acting within the scope of the received mandated and flexibility is not used to follow policies outside the mandate not justified. We think that in a longer term perspective the use of other triggers based on internal ratings or external ratings defined or contracted by the investor should be encouraged and promoted. 13. Should investment managers be obliged to introduce measures to ensure that the proportion of portfolios that is solely reliant on external credit ratings is limited? If yes, what limitations could be considered appropriate? Should such limitation be phased in over time? We think that the same considerations we make in question 1 apply here. 5
14. What alternative measures of credit risk could be used to define the minimum standard of credit quality for a portfolio? Are rolling averages of bond prices/cds spreads a suitable risk measure for this purpose? We think that the same considerations we make in question 4 apply here. 15. What other solutions could be promoted in order to limit references to external credit ratings in investment policies and mandates? As noted above, it would be most useful to (a) allow greater scope for investors own risk assessments; and to (b) encourage competition in the ratings market. For this is essential to enhance disclosure on the investor s policies, monitoring and management, debt issuer s and rating agencies. 16. What is your opinion regarding the ideas outlined above? How can the transparency and monitoring of sovereign debt ratings be improved? We think that more transparency and comparability as per the public financial accounts across countries would help to improve the sovereign debt rating and avoid volatility, and undue political interference. 17. Should sovereign debt ratings be reviewed more frequently? If so, what maximum time period do you consider to be appropriate and why? What could be the expected costs associated with an increase of the review frequency? We don t think that sovereign ratings should be treated differently from other debt issuers. 18. Which could be the advantages and disadvantages of informing the relevant countries three days ahead of the publication of a sovereign debt rating? How could the risk of market abuse be mitigated if such a measure were to be introduced? See answers to questions 16 and 17. 19. What is your opinion on the need to introduce one or more the proposed measures? See answers to questions 16 and 17. 20. More specifically, could a rule, according to which credit ratings on sovereign debt would be published after the close of business of European trading venues be useful? Could such a rule be extended to all categories of ratings? See answers to questions 16 and 17. 21. Could a commitment of EU Member States not to pay for the evaluation by credit rating agencies reduce potential conflicts of interest? We share the EBF view that it is not appropriate that rating agencies be generally mandated to rate sovereign debt for free. Fee structures are part of CRAs business model. Interference on this aspect is not justified in a free market economy. Besides, sovereign issuers should not be given preferential regulatory treatment. If there is a commercial incentive for CRAs to provide sovereign debt ratings for free, then this will be done. Where there is no such incentive, sovereign issuers are in the same situation as corporate issuers. 6
22. What other measures could be considered in order to enhance investors' understanding of a sovereign debt rating action? See answers to questions 16 and 17. 23. How could new players be encouraged to enter the credit rating agency sector? We think that it would also be good to encourage the entry of new players in the independent rating agencies market. However, this should not be done at the expense of quality in assessments or at a disproportionate cost. The current market structure reflect among other things the large scale economies both in the collection and processing of information from the rating agencies, and on the assessment of the quality of the credit rating agencies themselves from the external rating users. The economies of scale in the collection and processing of information would be less if the cost of accessing, processing and understanding financial statements lowers. These could be achieved by making financial information more comparable, standardizing definition, making financial statements more homogeneous and easily available (e.g. making the annual reports web versions more user-friendly and searchable). Similarly, scale economies in the assessment of a credit rating agency could be lessening with more transparency and comparability on their methodologies and performance. We think that improvements in those areas would encourage the entry of new players. Moreover we think that other models like the subscriber/investor/trading venues-pays models, which work similarly to the equity research model, should be promoted. In this respect, we think is worth to further explore the options mentioned in the document and assess whether they could effectively encourage the introduction of these models without having unintended consequences. 24. Could it be useful to explore ways in which the ECB would provide ratings to be used for regulatory purposes by European financial institutions? If yes, which asset classes (corporate, sovereign, structured finance instruments etc) could be considered? We opposed to a solution whereby the ECB would provide ratings to be used for regulatory purposes. The ECB assessment policies already influence institutions liquidity policies through the collateral discount, extending the influence the institutions credit policies could reduce institutions incentives to conduct their own assessments and make ECB valuations more systemic. Moreover, this could raise conflict of interest and increase the need for central bank convergence in their valuation assessments to avoid uneven playing field. 25. Could it be useful to explore ways in which EU National Central Banks would be encouraged to provide in-house credit rating services? Could the development of external credit rating services also be considered? If so, which asset classes (corporate, sovereign, structured finance instruments etc.) could be targeted? What are the potential advantages and disadvantages of this approach? See answer to question 24. 26. Could it be useful to explore ways in which Member States could be encouraged to establish new credit rating agencies at national level? How could such agencies be structured and funded and what entities and products should they rate? What are the potential advantages and disadvantages of this approach? 7
We agree with the EBF view that is sceptical about such an approach in view of: (a) The risk of over-reliance on ratings that are seen to carry an approval stamp of the public authorities; (b) The need for market acceptance by a new rating agency; and (c) The need for any new entrants to offer fundamentally different models than those offered by the largest rating agencies. Moreover, we think that the establishment of such nacional agencies could generate doubts around the credibility/confidence, especially in foreign investors. 27. Is there a need to create a new independent European Credit Rating Agency? If so, how could it be structured and financed and what entities and products should it rate (corporate, sovereign, structured finance instruments)? Should it be mandatory for issuers to obtain ratings from such a credit rating agency? What are the potential advantages and disadvantages of this approach? See answer to question 26. 28. Is further intervention needed to lower barriers to entry or expansion in the credit rating agency sector in general or as regards specific segments of the credit ratings business? What actions could be envisaged at EU and at Member State level? See answer to question 23. 29. Would the creation of a European Network of Small and Medium Sized Credit Rating Agencies help increase competition in the credit rating agency sector? What are the potential advantages and disadvantages of this approach? We think that this approach could suffer from the same shortcomings as the others previously discussed. 30. Do you consider that there are any further measures that could be adopted to enhance competition in the rating business? See reply to question 23. 31. Is there a possible need to introduce a common EU level principle of civil liability for credit rating agencies? We think that it should be good to have a common EU level principle of civil liability for credit rating agencies provided that CRAs must not be made responsible for mistaken assessments as such, but should rather be held liable for significant problems in the process of rating elaboration. 32. If so, what could be the appropriate standard of fault? Should rating agencies only be liable for gross negligence and intent? 8
See question 31. 33. Should such a potential liability regime cover solicited as well as unsolicited ratings? Yes 34. Do you agree that there could be a distorting influence of a fee-paying issuer over the determination of a credit rating? See question 23. See question 23. Other issues 35. What is your opinion on the proposed options/alternatives to reduce conflicts of interest due to the issuer-pays model? If so please indicate which alternatives appear to be the most feasible ones and why. 36. Are there any other alternatives to be considered? If so please explain. (37) Are there any other issues that you consider should be tackled in the forthcoming review of the CRA Regulation? None 9