How worthwhile are credit ratings?

A number of jurisdictions implemented new rules and regulations governing credit rating agencies (CRAs), with the European Securities and Markets Authority (ESMA) taking responsibility for CRA regulation since 2011.

However in its recently published second annual report on the supervision of credit rating agencies in the European Union (EU), the organisation warns improvements are still required in a number of areas including the consistent application and comprehensive presentation of rating methodologies and the monitoring and surveillance of ratings.

ESMA is currently responsible for the supervision of 19 registered and one certified CRA in the EU and is assessing applications for registration, with expectations of additional applications in the course of 2013. Steven Maijoor, chair of ESMA, notes: “While CRAs have made progress in meeting the regulatory requirements on integrity, transparency, responsibility and good governance, they have not sufficiently embedded in their organisations those changes necessary to address the concerns about the conflicts inherent in CRAs business models.

“Considering the continued importance of credit ratings in financial markets it is extremely important that CRAs identify and remedy those issues in their businesses which may undermine the independence, objectivity and the quality of credit ratings. This will contribute to building confidence in the transparency and smooth functioning of EU financial markets while ensuring a high level of financial consumer protection.”

The annual report identified progress in terms of improved disclosure of methodologies and ratings, and internal control resources, among others, but notes more needs to be done.

Therefore the report states these issues will form the basis of much of ESMA’s supervision activities in 2013, alongside its already announced plans for work on thematic reviews on the rating processes for structured finance products ratings – due to concerns stemming from high outstanding volumes and ratings fluctuations – and sovereign credit ratings.

The focus on sovereign ratings was announced a month before the February downgrade of the UK, but the latest developments are likely to make it even more of a focus for the regulator. It notes the reason for reviewing sovereign ratings has been “prompted by concerns on the growth in volatility in the past 12 months, their importance for credit markets and financial stability, and their impact on other rated entities and products”.

Meanwhile the recent report highlights the results of ESMA’s thematic investigation of bank rating methodologies, which it says was a key focus due to their links with sovereign ratings, the number of methodological changes between September 2010 to August 2012 and the significant rating activity in financials in the second half of 2011 and first half of 2012.

ESMA examined the bank rating methodologies of Fitch, Moody’s and S&P regarding a number of processes including: set up, monitoring and review of rating methodologies; implementation of methodologies throughout the rating process; internal mechanisms to ensure consistent application of rating methodologies; and disclosure of methodologies. It concludes: “These enquiries revealed shortcomings in the processes of disclosure and implementation of changes in bank rating methodologies, the rigorous and systematic application of methodologies and the review process of methodologies.

“The remedial action plans ESMA has put in place require the CRAs to: incorporate all relevant factors, models, assumptions and criteria in their methodologies; improve public disclosure of the methodologies; maintain adequate records with reference to analytical specifications of rating instruments; develop proper procedures relating to changes in methodologies; improve the internal review process of performance of the methodologies; and ensure minimum standards of information quality and timeliness.”

The original regulations on CRAs passed in 2009 by the European Parliament and the Council of the European Union notes: “Credit rating agencies are considered to have failed, first, to reflect early enough in their credit ratings the worsening market conditions, and second, to adjust their credit ratings in time following the deepening market crisis.”

Nyree Stewart is deputy features editor at Investment Adviser