The recent publication of a Commission Report on Credit Rating Agencies (CRAs) has highlighted the importance of the EU's ongoing effort to reduce the reliance on external credit ratings and to assess the effect of rules introduced to increase investor protection and restore market confidence following the financial and sovereign debt crisis. The report, which was published on 19 October, also takes stock of the state of the credit rating industry, in particular regarding competition and governance.

The use of ratings in the financial market 

Credit rating agencies play an important role in financial markets, providing investors with information on the creditworthiness of issuers and their debt. In particular, external credit ratings provide a common language to investors to compare the credit risk of different debt instruments, such as bonds or securities.

Credit rating agencies also rate a country on the strength of its economy. More specifically, they assess how likely a country's government is to pay back its debt. A rating affects how much it costs governments to borrow money in the international financial markets. In principle, a high credit rating means a lower interest rate (and vice versa).

Tackling weaknesses in CRA industry

The financial crisis of 2008 and subsequent sovereign debt crisis showed that over-reliance on external credit ratings may have reduced incentives for investors to develop their own capacity for credit risk assessment and due diligence and cause systemic disruption to financial systems.

In addition, a number of weaknesses inherent to credit rating agencies' business model contributed to the global financial meltdown. These included significant flaws in the methods and models used by CRAs, a lack of independence and conflicts of interest due to the issuer-pays remuneration model. Insufficient transparency and inappropriate internal governance also played a role.

In response to the major deficiencies that were observed in the rating industry, the EU CRA regulatory framework was considerably enhanced in the period 2009-2013. The CRA regulation established a common regulatory approach in order to enhance the integrity, transparency, responsibility, good governance, independence of credit rating activities and competition in the rating industry. These rules gave the European Securities and Market Authority (ESMA) sole, central supervision of CRAs, which can only operate if authorised by ESMA.

An enhanced EU regulatory framework

The European Commission has recently adopted three Implementing Technical Standards (ITSs) to facilitate the use of ratings in the calculation of capital requirements for banks and insurance companies. In particular, the Commission adopted two ITSs that map the credit ratings scales used by CRAs to the risk weights categories under the Capital Requirement Regulation (CRR) and Solvency II Directive and a third ITS to map the credit rating scales for securitisation positions under the banking legal framework. This mapping will create more opportunities for the use of smaller CRAs and stimulate market development.

The Commission report published in October reviews key measures of the CRA regulation aimed at increasing investor protection and restoring market confidence. In particular, the report assesses to what extent remaining references to external credit ratings in EU legislation may trigger over-reliance as well as the feasibility of available alternatives in the market. Furthermore, it examines certain key measures of the CRA regulation on the good governance of credit rating activities and on competition in the credit rating industry. These include, for instance, requirements for the prevention of conflicts of interests, the use of alternative remuneration models and measures to promote the use of smaller CRAs among issuers and investors.  The report confirms that in general, the provisions of the CRA regulation offer a positive long-term impact on the credit rating market.

The Commission will continue to monitor developments in the market in response to the implementation of the CRA regulation before considering whether to adopt further measures. In particular, it will assess the impact of measures which might constitute potential barriers to entry and create disproportionate costs to smaller credit rating agencies.  This is also important as some of the regulatory remedies are still in the process of implementation.  

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