The legal framework applicable to Credit Rating Agencies in the EU

(1)

THE LEGAL FRAMEWORK APPLICABLE TO

CREDIT RATING AGENCIES IN THE

EUROPEAN UNION

Overview of the legal framework on Credit Rating Agencies in the European Union and its omissions

and side-effects

B.M. Dikker 6120563

Master Thesis for the Master ‘Privaatrecht: richting Privaatrechtelijke Rechtspraktijk (2014) Supervisor: M.G.C.M. Peeters

(2)

Preface

Over 12 months ago I started working on this thesis, inspired by a documentary on the causes of the financial crisis in which Matt Damon seemingly effortless described all that had gone wrong in the financial world over the last decade. His explanations of the relationship between families not being able to pay their mortgage-loans and a top investment bank’s bankruptcy as a (distant) result, intrigued me.

With a lot of enthusiasm and slightly naive I aimed to understand everything that had happened to cause the crisis, the workings of the financial system in general, the legislative response to the crisis and whether this response is in fact the correct one.

The road was long and finding a focus for this thesis proved difficult. I would like to thank my supervisor professor Peeters for all his comments and long talks about what this thesis should be about. Also, many thanks to Hasse, Eveline and Uladzimir, for their moral support, and for listening and proof reading so many times.

(3)

Abstract

As a result of the recent financial crisis, Credit Rating Agencies (CRAS) have been scrutinised. A general conclusion of governments was that regulatory intervention was necessary. This thesis aims to provide an overview of the problems associated with CRAs, the legislative response to these problems and aims to discuss potential side-effects and omissions of the legislative initiatives in the European Union.

Using legal and economic research papers, the function of CRAs and their working methods are introduced. Subsequently, the EU regulatory framework on CRAs is described based on the regulations as well as on reports of authoritative bodies. This regulatory framework is then compared to the earlier identified problems with CRAs, thus exposing the gaps of the framework and the possible side-effects of several introduced measures.

This leads to the conclusion that even though the EU regulatory framework on CRAs is extensive and addresses many issues that are considered to have a negative influence on the quality of ratings, the primary cause of the conflicts of interest, the issuer-pays model is yet to be attended to. Alternative remuneration policies should be considered. Additionally, the possible side-effect of increasing over-reliance on ratings by investors as a result of the increasing regulatory demands to CRAs, should be further reflected on by the European legislator.

(4)

Chapter 1 Introduction

It is undeniable the world has gone through some significant changes since 2007. What started with the bursting of the real-estate bubble in the United States, resulted in a global financial crisis that caused bankruptcy, unemployment and a general decrease of household incomes all over the world. According to many academics, credit rating agencies (CRAs) played a key role in both the run-up to and the unfolding of the recent financial crisis.1_This

caused the CRA market to be scrutinised. CRAs contributed substantially to the rise and fall of structured finance products (securitisations).2_{Securitisation refers to the financial practice}

of bringing significant amounts of debts off the balance sheet, pool them together, repack and streamline them in order to make them fit to sell to investors.3

By attributing high ratings to these instruments, the securitisation market grew to a 9 trillion dollar market between 2001 and 2007.4_{Apparently, investors relied blindly on these ratings}

and failed to conduct their own research into the creditworthiness of the securitisations they purchased. Even though many of these products received ratings that would indicate a small credit risk, from late August 2007 until the fall of 2008, 1.5 trillion dollar worth of securitisations were downgraded to a level that implies repayment of the initial investment is unlikely.5_{These downgrades suggest that CRAs deluded investors with inflated ratings.}6

Legal and economic academics have conducted extensive research on the role of CRAs in causing the recent financial crisis. This resulted in the overall consensus that both the operational structure of CRAs and the structure of the rating market exposed financial markets to certain risks. It was concluded that the quality of ratings was adversely affected by, inter alia, conflicts of interest, the oligopolistic market structure and the heavy reliance on ratings by investors. Prior to the crisis, these risks were known to some extent, but considered to be corrected by the market itself. However, with hindsight, the European Union (EU) concluded that regulatory intervention was necessary and accordingly subjected CRAs to an extensive regulatory regime.

1_{Amtenbrink & de Haan 2009, p. 1915.} 2_{Coskun 2008, p. 615.}

3_{Boersma 2010, p. 10-11.} 4_{Idem, p. 4.}

5_{Idem, p. 5.}

(7)

The focal point of the European legislation is to restore investors’ faith in CRAs and increase investor protection. The EU decided to adopt rules that increase the previously barely present supervision on CRAs and, simultaneously, improve the quality of ratings. Additionally, the investors’ reliance on ratings should be reduced.

This thesis aims to provide a coherent overview of the current EU legal framework on CRAs and to identify its omissions and undesirable side-effects. It is therefore firstly relevant to establish the working methods of CRAs and in the ways in which these are related to the role of CRAs in the recent financial crisis. As the role of CRAs in the crisis is most visible in structured finance, this thesis focusses on securitisation.

In order to understand the EU legislation, it is crucial to consider the rating process, the function of CRAs in financial markets, and the risks associated with CRAs. Chapter 2 provides an overview of the rating process as described by the most influential CRAs, being Moody’s, Standard & Poor’s and Fitch, and outlines the structure of the CRA market. This chapter ends with a reflection on the problems related to the rating processes and the way the CRA market is organised.

Chapter 3 elaborates on the legal framework that applies to CRAs in terms of the key frictions associated with CRAs. The policy hitherto implemented is outlined in Regulation (EC) No 1060/2009 on Credit Rating Agencies (CRA I)7_{, and in its amendments, Regulation (EU) No}

513/2011 (CRA II)8_{and Regulation (EU) No 413/2013 (CRA III)}9_{. The consolidated version}

of these regulations is in this thesis referred to as Credit Rating Agency Regulation (CRAR). The CRAR provides an extensive supervisory system, as well as rules of the conduct for CRAs and punitive measures that can be taken in case the CRAs do not comply.

Chapter 4 provides an analysis of the legal framework. It debates omissions and questions certain measures taken by the EU. Omissions include the addressing of the issuer-pays model. The stimulation of competition and the viability of the supervisory system are called into question.

7_{[2009] OJ L 302/1.} 8_{[2011] OJ L 145/1.} 9_{[2013] OJ L 146/1.}

(8)

This thesis aims to provide a coherent overview of the current EU legal framework on CRAs and to identify its omissions. This means that it can be qualified as descriptive research. The sources consist of primary sources, such as EU regulations, and secondary sources, namely legal and economic research.

Chapter 2 Credit Rating Agencies

§1. Introduction

Research pertaining to the causes of the recent financial crisis, indicates that the financial system in general as well as individual financial products, became extremely complex. Therefore, even the most informed specialists failed to accurately assess to which risks investors were exposed.

CRAs were considered to be the best informed on the quality of financial products and therefore they were expected to bear a certain responsibility. This responsibility consists of overcoming the information asymmetry between the issuers of debt instruments and investors. Their crucial role in the financial system has contributed to the fact that CRAs were criticised for their role in causing the financial turmoil. Governments worldwide commissioned research groups to determine what went wrong, including the role of CRAs. This resulted in, amongst others, the Turner Review and the Larosière Report.10_{It appears that the accusations}

were not unfounded. The reports, as well as independently conducted legal and economic research, suggest that the oligopolistic market, the issuer-pays model and the lack of supervision had a negative effect on the quality of the ratings.11

This chapter first discusses the function of ratings. Thereafter, it examines the rating process and possible problems. Finally, the structure of the rating market and its effects on the quality of ratings are ascertained.

§2. The Function of Ratings

10_{Turner Review 2009, De Larosière 2009.}

(9)

CRAs have several functions. Nevertheless, there is little consensus on which function is predominant. The perspectives taken can be divided into two basic groups: (1) those who believe the information mediation function to be the most important and; (2) those who regard the certification or regulatory licence function to be predominant.12

First, CRAs fulfil the function of information mediation, which means that their prime responsibility is to contribute to overcoming the existing information asymmetry between investors in, and issuers of debt instruments.13 _{Issuers of debt instruments have more}

information on their products than investors and may benefit from hiding this information from potential investors.14_{This leaves the quality of investment products difficult to discern at}

the outset and as a result, investors are unable to distinguish between high-quality products and low-quality products.15_{Without intervention by CRAs, issuers would be able to ask the}

same price for both. Consequently, high-quality products would be driven out of the market.16

As CRAs are professional companies with large research facilities and extensive access to information they are well equipped to assist investors with overcoming this asymmetry.17_In

this regard, CRAs are information mediators that pledge their reputation to generate investors’ confidence in their ratings.18 _{Reputation plays a key role in the information}

mediation perspective as ratings are only useful if they increase the investors’ confidence in the rated product. Investors will only do so if they trust the opinion of a CRA. If the reputation of a CRA is damaged, investors will no longer be willing to rely on ratings produced by this agency and switch to another CRA.19_{Hence, maintaining an excellent}

reputation is crucial to CRAs.

From the perspective of information mediation, CRAs can also be qualified as ‘gatekeepers’. Kraakman (1986) defines gatekeepers as ‘private parties who can disrupt misconduct by withholding co-operation from wrongdoers’.20_{CRAs are watchdogs that assess the statements}

12_{Amtenbrink & Heine 2012, p. 4; Coffee 2010, p. 231.} 13_{Amtenbrink & Heine 2012, p. 4.}

14_{Ashcraft 2008, p. 7.} 15_{Chiu 2014, p. 271.} 16_{Tuch 2010, p. 13.}

17_{Amtenbrink & Heine 2012, p. 4.} 18_{Coffee 2010, p. 232.}

19_{De Haan & Amtenbrink 2011, p. 17.} 20_{Kraakman 1986, p. 53.}

(10)

of their client and vouch for their credibility. Investors rely on the verifications made by CRAs rather than on statements of issuers themselves, as CRAs have less incentive to make misrepresentations.21_{In their function of gatekeeper, CRAs are similar to accountants}22_,

classification societies23_{, and banks when issuing fairness opinions}24_{. The similarities include}

a strong third-party reliance on their public expert opinions. Additionally, they face the same potential conflicts of interest, since they are all paid by the entity they give their opinion on. From a different perspective, however, CRAs are regarded as intermediaries who provide certification of financial products. This is referred to as the certification or regulatory licence function.25_{By enacting rules that depend on credit ratings, governments have given a handful}

of CRAs a substantial degree of market power and a quasi-governmental responsibility of (indirectly) determining which products are fit for investment. Consequently, by rating a product, CRAs determine whether professional investors have access to it.26_{Partnoy (1999)}

describes these regulatory licences as ‘valuable property rights associated with the ability of a private entity, rather than the regulator, to determine the substantive effect of legal rules’.27_As

a result of the obligation for investors to only purchase financial products from a certain rating category, ratings became an indispensable part of financial transactions. Ratings started to function as a form of governmental approval of financial products.28

The perspectives of information mediation and certification are not mutually exclusive. From both perspectives, CRAs could be considered gatekeepers. However, the performance of gatekeepers depends to a large extent on the functioning of the reputational mechanism. The increased use of ratings for regulatory purposes hampers the functioning of this mechanism, and therefore obstructs CRAs from acting efficiently as gatekeepers.29_{Which function is}

believed to be predominant tends to influence legislative choices. Starting from the information mediation perspective, reforms aimed at reducing conflicts of interest are

21_{Coffee 2002, p. 5.} 22_{Bakker 2008, p. 14.}

23_{Basedow & Wurmnest 2005, p. 2.} 24_{De Serière 2011, p. 267.} 25_{Coffee 2002, p. 5.} 26_{Boersma 2010, p. 9.} 27_{Partnoy 1999, p. 623.} 28_Idem. 29_{Payne 2014, p. 5.}

(11)

favoured. In contrast, those who take the regulatory licensing perspective prefer deregulation by eliminating references to CRAs from legislation, thus stimulating investors to use alternative risk measurement methods.30

§3. The Rating Process

Issuers of debt instruments request CRAs to certify the creditworthiness of their products to persuade investors to invest. The creditworthiness of securities refers only to the risk that the issuing entity would not be able to meet the obligations associated with the instrument; market risks and liquidity risks are excluded.31_{Ratings are typically serviced according to the}

issuer-pays model. This means that a rating is made at the request of an issuing entity that remunerates the rating agency.32_{When CRAs issue a rating upon request, these ratings are}

called solicited ratings. There is a contractual relationship between the issuer and the CRA. In this case, the CRA bases the rating both on publicly available data as well as on information provided by the issuer. Due to this extra information, solicited ratings are deemed to be more accurate than unsolicited ratings.33_{Unsolicited ratings are issued at the initiative of the CRA}

itself. They are therefore only based on information that is publicly available. When issuing solicited ratings on securitisations, CRAs receive information from the issuer regarding the product to rate and evaluate the legal structure, the practices, policies, and procedures of the entity that will service and manage the underlying assets.

This analysis should provide the investors an idea of the exposure to risks. CRAs use rating symbols to assign products to a ‘risk group’. Each symbol represents a group in which the level of the credit risks is similar. The highest rating (Aaa or AAA) indicates an exceptionally low default risk and is only designated to products that are unlikely to be adversely affected by foreseeable events. When products are classified within the lowest categories (C and D), investors have little or no chance to regain their initial investment or interest.34_Different

CRAs use different systems of classification and use distinct symbols. Moreover, the two biggest CRAs use different ways to categorise the risks. Moody´s designates the following symbols to express credit risks: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, and appends numeric

30_{Partnoy 1999, p. 623; Coffee 2010, p. 233.} 31_{Van Rongen 2012, p. 11.}

32_{Hill 2004, p. 50.}

33_{De Haan & Amtenbrink 2011, p. 11.} 34_{Moody´s 2009, p. 8.}

(12)

symbols 1, 2 and 3 across rating categories Aa to C. S&P uses the following symbols: AAA, AA, A, BBB, BB, B, CCC, C, and D for the risk groups and adds ‘+’ and ‘-’.35

Major criticism on the rating process involved the lack of incentives to enhance integrity. There appears to be consensus on the notion that the failure of CRAs is at least partially attributable to serious conflicts of interest.36_{These conflicts are primarily caused by the}

issuer-pays model and the advisory services CRAs provided. As a corollary of the issuer-pays model, the CRA has an incentive to maintain good relationships with the issuers of debt instruments, which can impair the impartiality of its ratings.37_{Pleasing issuers by producing}

ratings beneficial to them could result in inflated ratings. This leaves investors bearing risks without compensation.38_{However, as mentioned earlier, reputation is a prime asset of CRAs.}

The reputational mechanism was considered to alleviate some of the concerns regarding the integrity of CRAs.39_{However, according to Coffee (2011), the 2008 financial crisis indicates}

that this hypothesis is not viable. CRAs appeared willing to risk their reputational capital for enhanced revenue and were able to do so as long as entry barriers remained high and their legal liability stayed low.40

The second factor that influences the independence of CRAs is the fact that CRAs formulate proposals and recommendations regarding the design of structured financial products, prior to rating the debt instrument.41 _{When the CRA is involved in the design, subsequently rating the}

product impairs impartiality and independence. Moreover, the models CRAs used in rating structured credit were available to investment banks. This created the possibility to structure the products to meet a specific rating hurdle.42 _{Advisory services had high revenues, thereby}

inclining CRAs to maintain their business relationship by producing favourable ratings.43

Through providing these services, the CRA industry came to be less independent, which potentially decreased the quality of its ratings.

35_{S&P 2012, p. 5.}

36_{Coffee 2011, p. 232; Jaakke 2012, p. 54.}

37_{Boersma 2010, p. 3; Becker & Milbourn 2009, p. 2.} 38_{Lynch 2010, p. 247; De Larosière 2009, p. 9.} 39_{De Haan & Amtenbrink 2011, p. 17.}

40_{Coffee 2011, p. 233.} 41_{De Larosière 2009, p. 20.} 42_{De Larosière 2009, p. 79.} 43_{EC 2008, p. 13-14.}

(13)

§4. Market Structure

Aside from the problems arising from the conflicts of interest that is associated with CRAs’ working method, the structure of the market CRAs operate in is also considered to negatively influence the quality of ratings. This section provides an overview of the problems identified with the market structure of CRAS. These problems include the oligopolistic market structure of the rating market, the excessive reliance of investors on ratings and the lack of supervision.

4.1 Oligopoly

The market structure of CRAs can be characterised as a ‘natural oligopoly’.44_{In 2013,}

Moody’s, S&P and Fitch dominated approximately 90% of the EU market: Moody’s and S&PS&P each had a share of circa 35%, and Fitch had 20%.45_{The remaining 10% consisted}

of circa 150 other CRAs.46 _{Moody’s, and S&P have been market leaders since their}

inception.47_{The reason for this oligopoly is that access to the CRA market is hampered by}

natural and legal barriers. First, a natural barrier is caused by the fact that reputation is built over time and is associated with large investment costs. Hence, newcomers to the CRA market have a hard time to contest with well-established firms.48_{Investors have no way of}

assessing the performance of new entrants. Therefore, issuers may be inclined to avoid entering into business with them. It could, after all, result in investors not relying on the rating of their security.49_{The regulatory use of ratings is considered to erect a legal barrier that}

hampers market access and therefore reinforces the oligopolistic nature of the market. This resulted from the registration requirements in the United States, when, from the mid-seventies to date, CRAs are required to register as a Nationally Recognized Statistical Ratings Organizations (NRSROs).50_{This requirement hampers market access. Currently, CRAs have}

to register in the EU as well. They have to meet certain standards regarding the legal structure

44_{Partnoy 2006, p. 90.} 45_{ESMA 2013, p. 6.} 46_{White 2010a, p. 228.} 47_{Ryan 2012, p. 14.} 48_{Dittrich 2007, p. 80-83.}

49_{García Alcubilla & Ruiz del Pozo 2012, p. 7.} 50_{Partnoy 1999, p. 623.}

(14)

of their company and to implement the rules of conduct provided for in the CRAR.51

Consequently, the oligopoly is nowadays sustained and underpinned by EU legislation.

The lack of competition could reduce the quality of ratings and increase their price.52_{It may}

deprive the public from having an effective check on the quality and integrity of the rating process.53_{Additionally, it allows issuers to manipulate CRAs.}54_{Research does indeed indicate}

that firms assess the rating their product will receive prior to putting out the order for an official rating to an agency. The agency that offers them the most lucrative business deal will be selected. This may cause the CRAs to behave strategically by striving for the most beneficial preliminary rating.55 _{Moreover, with limited competition, there is hardly an}

incentive to improve used methodologies. The oligopolistic structure of the market therefore negatively affects innovation, as well as the diversity of thoughts and opinions.56_{The idea}

within the EU is that with more competition, different approaches will be tested, and innovation will flourish.57

4.2 Reliance

Reliance on ratings is closely related to their certification function.58_{Governments employ}

ratings for regulatory purposes, as high ratings (investment grade ratings) imply a certain level of quality. Hence, regulation ensures that investors are forced to consider ratings when making investment decisions, which resulted in them gradually becoming more reliant on CRAs.59

Before the recent financial crisis started, Partnoy (1999) argued that increased reliance on ratings would impair the functioning of the reputational mechanism and as a result would

51_{ESMA 2011, p. 1.} 52_{Hill 2004, p. 44.} 53_{Rousseau 2009, p. 44.} 54_{EC 2010a, p. 19.} 55_Idem. 56_{Rousseau 2009, p. 44.} 57_{EC 2011b, p. 4; Hunt 2009, p. 19.} 58_{Partnoy 1999, p. 683.}

(15)

reduce the value of ratings.60_{The idea is that, the more regulators use ratings in legislation,}

the more CRAs are concerned with maintaining their licence to operate. Provided it does not endanger their licence, the CRAs will charge high fees to assist issuers in their search for strong but potentially inflated ratings.61_{The functioning of the reputational mechanism is thus}

impaired. Without reference to credit ratings in legislation, CRAs would have to rely stronger on their reputation. Hence, CRAs would guard their reputations cautiously. The consequence should be a careful and conservative rating process.

From the perspective of the certification function of CRAs, over-reliance is also identified as a problem. This is because it caused investors to assume that the quality of ratings was well based on the reliance of governments. Hence, there is less incentive for investors to conduct their own research. This resulted in persistent reliance on ratings and investors assumed they were accurate based on the presumed regulatory approval. The reliance on ratings was supported by the idea that governments are not equipped to analyse issuance of securities and that using ratings would fine-tune the regulations.62_{The CRAs continuously emphasised that}

investors should consult multiple sources to form their opinion,63_{yet investors mostly ignored}

this.64_{Reducing over-reliance is necessary to allow alternative considerations regarding the}

quality of financial products and to move investors to take better-informed decisions.65

4.3 Supervision

Before the crisis, CRAs were barely supervised in the EU, although their activities and relevance were recognized by three Directives.66_{Policy makers relied on the ‘comply or}

explain’ model of industry self-regulation. The framework for the operation of CRAs in the

60_{Partnoy 1999, p. 623.}

61_{De Haan & Amtenbrink 2011, p. 24-25; Partnoy 1999, p. 623.} 62_{Partnoy 1999, p. 683.}

63_{S&P 2012, p. 3.}

64_{Amtenbrink 2011, p. 36.} 65_{FSB 2010, p. 3.}

66_{The Directives are: the Market Abuse Directive (MAD), Directive 2003/125/EC, the Capital Requirements}

Directive (CRD), 2006/48/EC, and the Markets in Financial Instruments Directive (MiFID), 2004/39/EC. See: ESME 2008, p. 7-9.

(16)

EU was mostly based on the International Organisation of Securities Commissions (IOSCO) Code of Conduct for CRAs.67_{CRAs could voluntarily subject to the regime.}68

The IOSCO code includes three sections. The first is called Quality and Integrity of the Rating Process and contains rules regarding the quality of the methodology and the continuity of monitoring the products after the initial rating.69_{The second section consists of rules}

regarding Independence and the Avoidance of Conflicts of Interest, including the separation of rating services and advisory services, as well as rules regarding remuneration policies.70_The

last section, CRA Responsibilities to the Investing Public and Issuers reflects inter alia on the separation of structured finance ratings from traditional corporate bond ratings.71

Even though the code addresses the key matters that could influence the quality of ratings, it is formulated in a rather generic manner. Moreover, as it is based on a comply-or-explain mechanism, lacks substantive enforcement prospects. In 2009, IOSCO published a report on the extent to which CRAs had incorporated the IOSCO Code into their own codes of conduct in the period prior to 2007. This report revealed that the option of non-compliance with explanation was much used.72_{In addition, it concludes that the ‘big three’ had substantially}

implemented the code73_{, and it stresses that compliance does not constitute}

non-implementation.74_{S&Ps for example, did not comply with 4 of the 11 discussed provisions.}75

However, they were still considered to have correctly implemented the code according to IOSCO76_{as well as the Committee of European Security Regulators (CESR)}77 _{and its}

successor, the European Securities Market Authority (ESMA).78

67_{Sy 2009, p. 24.}

68_{De Savornin Lohman & Van ‘t Westeinde 2007, p. 5.} 69_{Section 1 under A B and C IOSCO Code.}

70_{Section 2 under A B and C IOSCO Code.} 71_{Section 3 under A and B IOSCO Code.} 72_{IOSCO 2009, p. 1-14.} 73_{Idem, p. 5.} 74_{Idem, p. 6.} 75_{Idem, p. 10-14.} 76_{Idem, p. 5.} 77_{CESR 2005, p. 52.} 78_{ESME 2008, p. 23.}

(17)

§5. Conclusion

This chapter introduced CRAs and provides an overview of their functions, working methods, and debates on issues that allegedly had a negative influence on the quality of the ratings. In conclusion, the function of CRAs is to certify and overcome the information asymmetry between investors and issuers. The following negative effects on ratings have been identified, namely: 1) the issuer-pays model makes CRAs vulnerable to conflicts of interest; and 2) the oligopolistic market structure prevents the development of methodologies and causes investors’ over-reliance on ratings. Additionally, CRAs were barely subject to supervision or regulatory requirements. In conjunction, that has led to the questionable quality of ratings and formed the basis for the regulatory intervention by the EU.

Chapter 3 Regulation (EC) No. 1060/2009 and Subsequent

Amendments

After the start of the financial crisis in 2007, the European Commission concluded that the self-regulatory system had substantial shortcomings.79_{The European Commission considered}

that CRAs should be obliged to deal with conflicts of interest, develop sound rating methodologies and increase the transparency of their rating activities.80_{Regulation (EC) No}

1060/2009 on Credit Rating Agencies81_{(CRA I), took effect in November 2009 and primarily}

aims to protect the financial system and investors by introducing a system of registration and supervision.82_{The Regulation provides a set of rules on the conduct of CRAs, aiming to}

ensure that credit ratings used in the EU are independent, objective and of adequate quality.83

As a result of the findings of the High Level Group, chaired by Jacques de Larosière84_{, the}

Regulation was amended. The De Larosière Group conducted extensive research into the causes of the crisis and recommended the creation of an overarching EU framework of

79_{EC 2008, p. 2.} 80_{EC 2008a, p. 4.} 81_{[2009] OJ L 302/1.} 82_{Recital (7) CRAR.} 83_{Recital (1) CRAR.} 84_{De Larosière Report 2009.}

(18)

supervision. The EC acknowledged the relevance of this research and, based on its findings, issued a series of regulations and directives.85 _{Particularly relevant for this thesis is}

Regulation (EU) No. 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority), amending Decision No 716/2009/EC and repealing Commission Decision 2009/77/EC86 _{(Regulation 1095/2010), as it established ESMA.}

Regulation (EU) No. 513/2011 amending Regulation 1060/2009 on credit rating agencies (CRA II)87_{brings existing legislation into conformity with the revised architecture of EU}

financial supervision.

In May 2013, the regulatory framework was concluded with a regulation package consisting of Regulation (EU) No. 462/2013 amending Regulation 1060/2009 on credit rating agencies88

(CRA III) and Directive 2013/14/EU amending Directive 2003/41/EC on the activities and supervision of institutions for occupational retirement provision, Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) and Directive 2011/61/EU on Alternative Investment Funds Managers in respect of over-reliance on credit ratings89_{. The}

Regulation aims to reduce over-reliance on ratings and further addresses conflicts of interest.90

This chapter discusses the regulations on CRAs in terms of the problems associated with them. Therefore, the regulations put forth by the EU are cross-referenced with the problems identified with CRAs introduced in the previous chapter. These are: the lack of quality of ratings due to conflicts of interest, the oligopolistic structure of the CRA market, the lack of supervision and over-reliance on ratings by investors.

§2. Increasing Supervision

85_{See for example regulation (EU) No. 1092/2010 European Union macro-prudential oversight of the financial}

system and establishing a European Systemic Risk Board, Recital (5).

86_{[2010] OJ L 331/84.} 87_{[2011] OJ L 145/1.} 88_{[2013] OJ L 146/1.} 89_{[2011] OJ L 174/1.} 90_{Recital (5) CRA III.}

(19)

The EU moved quickly regarding the introduction of a supervisory structure, considering that before 2009, CRAs were mostly unsupervised91_{and that, after its introduction in 2009, the}

supervisory structure has already been revised entirely since. This section provides a brief overview of the current supervisory system applicable to CRAs and discusses the registration requirements imposed on CRAs.

2.1 ESMA

ESMA is a part of the European System of Financial Supervision.92_{It was established with}

the objective to ensure the rules applicable to the financial system are adequately implemented by all member states. ESMA has direct supervision authority over CRAs operating in EU markets. They are responsible for the registration93_{and supervision of all}

CRAs wishing to conduct business in the EU. ESMA continuously monitors compliance with the methodological requirement of the Regulation.94 _{In order to effectively exercise its}

supervisory responsibilities, ESMA can request information95_{, conduct general}

investigations96_{and carry out on-site inspections}97_{. When conducting a general investigation,}

ESMA is authorised to examine data and records, request telephone data and interview people.98

2.2 Registration

The registration process is the first mechanism to ensure the CRAs’ compliance with the CRAR. It is a prerequisite for CRAs to issue credit ratings in the EU.99_{Any firm that is}

established in the EU and is carrying out credit rating activities in the EU without prior registration is operating in breach of the CRAR. This leads to supervisory measures and fines imposed by ESMA.100

91_{Utzig 2010, p. 8.}

92_{Art. 1 Regulation (EU) No 1092/2010.} 93_{Art. 15 (1) CRAR.}

94_{Art. 22a (1) CRAR.} 95_{Art. 23b CRAR.} 96_{Art. 23c CRAR.} 97_{Art. 23d CRAR.} 98_{Art. 23c (1) CRAR.} 99_{Recital (43) CRAR.}

(20)

The procedure allows the EU to effectively exercise control over CRAs` registration and ensure that their policies are in accordance with the requirements of the CRAR. ESMA is currently administering the registration process.101_{ESMA decides on registration within a}

maximum of 45 working days after receiving the complete application.102_{The registration}

process consists of an assessment of the CRA`s corporate and operational structures. Annex II CRAR stipulates all the requirements. The assessment covers, inter alia, the applicant’s policies and procedures to identify, manage and disclose any conflicts of interest103_{, corporate}

governance104_{and transparency. In case of non-compliance, registration is refused.}

Additionally, ESMA has the authority to withdraw the registration should its approval rests on false statements made by the CRA105_{. When the CRA no longer meets the requirements of the}

CRAR, ESMA can also withdraw the registration.106

2.3 Enforcement

ESMA is responsible for ensuring CRAs’ compliance with the CRAR. ESMA is therefore authorised to sanction CRAs that breach certain provisions of the regulations. Annex III CRAR lists three types of infringements: (1) infringements related to conflicts of interest, organisational or operational requirements107_{; (2) infringements related to obstacles to the}

supervisory activities108_{; (3) infringements related to disclosure provisions}109_.

ESMA's Board of Supervisors can take a supervisory measure in accordance with Article 24 CRAR and/or impose a fine in accordance with Article 36a CRAR in case a CRA breaches the provisions listed in Annex III.110_{These include the requirements regarding the management of}

101_{Art. 15 CRAR.} 102_{Art. 16 CRAR.} 103_{Annex II (11) CRAR.} 104_{Annex II (6) CRAR.} 105_{Art. 20 (1) b CRAR.} 106_{Art. 20 (1) c CRAR.}

107_{Annex III, I (1) -(62) CRAR.} 108_{Annex III, II (1) -(8) CRAR.} 109_{Annex III, III (1) -(11) CRAR.} 110_{Art. 23e (5) CRAR.}

(21)

conflicts of interest, organisational and operational requirements, the hindering of supervisory activities and the breaching of a disclosure provision.

The supervisory measures include the withdrawal of registration and the prohibition from issuing ratings. Additionally, ESMA can suspend the use of ratings issued by a certain CRA from being used for regulatory purposes and they can issue public notes. These measures are temporal, until the breach of the CRAR is ended.111

Furthermore, under Article 36a of the CRAR, ESMA can impose a fine if it considers the breach to be committed intentionally. The amount of the fine is limited depending on which requirement of Annex III is breached.112_{An infringement by a CRA is considered to have}

been committed intentionally if ESMA ‘finds objective factors which demonstrate that the credit rating agency or its senior management acted deliberately to commit the infringement’.113_{This action is subject to the jurisdiction of the European Court of Justice.}114

Hence, if CRAs do not comply with the CRAR, refuse to disclose requested information or tocooperate with an investigation, ESMA can take action accordingly.

§3. Intervention in the Rating Process

This section scrutinises the substantive requirements that CRAs have to fulfil pursuant to the CRAR. Whether they meet these requirements is examined by ESMA upon registration and, in case ESMA suspects breaching of the CRAR by a registered CRA, this CRA will be forced to allow ESMA to conduct a research on the workings of its firm. In case an infringement is proved, ESMA will enforce compliance as described in the previous section. The conduct of a CRA is subject to substantive requirements that aim to reduce conflicts of interest, to empower investors and to restructure the market.

Pursuant to the CRAR, CRAs shall take the necessary steps to ensure their ratings are not affected by any conflict of interest.115_{The regulation focusses on prevention, identification,}

elimination and disclosure of conflicts of interest. Annex I CRAR therefore stipulates both organisational and operational requirements regarding the avoidance of conflicts of interest.

111_{Art. 24 (1) CRAR.} 112_{Art. 36a (2) CRAR.} 113_{Art. 36a (1) CRAR.} 114_{Art. 36e CRAR.} 115_{Art. 6 (1) CRAR.}

(22)

The organisational requirements include the obligation to install a supervisory board that ensures the independence of the rating process and manages conflicts of interest.116_{At least}

three independent members are to be installed for a maximum of five years and one third of these members shall not engage in rating activities.117_{Dismissal is allowed only in case of}

misconduct. Members of the board will be responsible for the monitoring of internal quality programs and the development of policies on avoiding, managing and the disclosure of conflicts of interests.118_{Their opinions are to be made available to the competent authorities}

and ESMA upon request.119_{Additionally, CRAs should install an independent compliance}

department that reports to ESMA on the compliance of the CRA with the CRAR.120

Secondly, the Annex provides operational requirements. These include that a CRA is bound to disclose the names of rated third parties from which they draw over 5% of its annual revenue.121_{Additionally, when an analyst is linked to the rated entity, through control,}

ownership, or by holding an administrative, management or supervisory position, the CRA shall not issue a rating or can be forced to withdraw the rating.122_{Moreover, a CRA can no}

longer provide consultation and advisory services in that case.123_{This means that no advice}

regarding legal structure, liabilities, and no recommendations or proposals prior to the rating of the product, formal or informal, are allowed.

Furthermore, the CRAR introduces a rotation mechanism that provides that no employee will work for the same client for over four years, unless the agency does not employ over fifty people.124_{In addition, pursuant to CRA III, shareholders holding 5% in one CRA cannot, at}

the same time, hold over 5% in either capital or voting rights in another CRA. Nor can they have a dominant influence on another CRA or be a member of a board in another CRA.125

116_{Annex I, Section A (1) CRAR.} 117_{Annex I, Section A (2) CRAR.} 118_{Annex I, section A (1) CRAR.} 119_{Annex I, section A (2) CRAR.} 120_{Annex I, section A (5) CRAR.} 121_{Annex I, section B (2) CRAR.} 122_{Annex I, section B (3) CRAR.} 123_{Annex I, section B (4) CRAR.}

124_{Art. 7 (4) CRAR; Annex I, Section C (1) CRAR.} 125_{Art. 6a (d) CRAR.}

(23)

The CRAR introduced a rotation mechanism for transactions involving re-securitisations. Directive (EU) No. 2006/48/EC relating to the taking up and pursuit of the business of credit institutions126_{(Capitial Requirements Directive, CRD) Recital 40a defines ‘re-securitisation’}

as ‘a securitisation where one or more of the underlying exposures meet the definition of a securitisation position’.127_{In other words, re-securitisation differs from straight securitisation}

in the sense that securitisations are secured by loan portfolios, whereas with re-securitisations the collateral consists of securitisations.128_{Collateralised Debt Obligations (CDOs) are an}

example of re-securitisations covered by the CRAR.129

CDOs are based on ordinary securitisations but collateralised in the sense that the notes issued by the SPV are divided into several tranches.130_{These tranches offer different degrees of risk}

and various degrees of return in correlation with the risks.131_{CRAs have an important role in}

this process as they advise on the quality of the product, the estimated loss distribution and how to acquire the desired structure of the CDO.132

The CRAR rotation system entails that, upon entering into a contract with the requesting issuer of the re-securitisation, a CRA cannot agree to rate re-securitisations that involve underlying assets from the same originator for over four years.133_{Additionally, after the}

contract expires, the CRA cannot enter into a new contract for rating the product in which the underlying assets belong to the same originator, for a period equal to the duration of the contract.134

§4. Restructuring the Market

Chapter 2.4 introduced the following market failures: (1) a lack of competition; (2) over-reliance on ratings by investors and legislators and; (3) a lack of supervision. This section of

126_{[2006] OJ L 77, 30.6.2006.} 127_{Art. 4 (40a) CRD.}

128_{EC 2009, p. 6; Wibier 2011, p. 85.} 129_{EC 2009, p. 5.}

130_{Wibier 2011, p. 6.}

131_{Blommestein, Keskinler & Lucas 2011, p. 18.} 132_{Ashcraft 2008, p. 7.}

133_{Art. 6b (1) CRAR.} 134_{Art. 6b (3) CRAR.}

(24)

the thesis aims to describe the endeavours of the CRAR to reduce over-reliance and increase competition.

4.1 Empowering Investors

The CRAR aims to empower investors in three ways: (1) reducing the references to ratings of financial institutions and obligating them to make their own assessment of the financial products` credit worthiness; (2) requiring CRAs to disclose information that potentially influences the quality of their ratings to stimulate investors to find alternative methods of risk assessment; (3) it introduces a liability regime.

The CRAR endeavours to reduce reliance in two ways. First, by reducing reliance of financial institutions, the European Supervisory Authorities (ESA), the European Systemic Risk Board (ESRB) and Union law in general. Second, increasing awareness among investors regarding conflicts of interest will incentivise them to assess the credibility of ratings, rather than relying on them. Provisions on disclosure should move investors to critically assess the value of ratings.

4.1.1 References to ratings

Pursuant to art. 5a CRAR, financial institutions such as investment firms, insurance undertakings, reinsurance undertakings, institutions for occupational retirement provision and management companies shall make their own credit risk assessment and may no longer rely solely on credit ratings.135_{The competent authorities of the Member States are in charge of}

supervising these entities. They must monitor the adequacy of their credit risk assessment processes, which include the use of contractual references to credit ratings. In case the competent authorities detect excessive use of references to ratings, they shall encourage the entity in question to mitigate the impact of such references.136_{Furthermore, art. 5b CRAR}

obliges the European Supervisory Authorities, such as ESMA, not to refer to credit ratings in their guidelines, recommendations and draft technical standards if these references have the potential to trigger ‘sole and mechanistic’ reliance on ratings.137_{Art. 5c CRAR aims to reduce}

over-reliance on credit ratings in Union law in general. It obligates the European Commission to review whether references to credit ratings in Union law trigger reliance on ratings by

135_{Art 5a (1) CRAR io. 4 (1) CRAR.} 136_{Art. 5a (2) CRAR.}

(25)

financial market participants. Ultimately, by 2020, all references to ratings that trigger sole and mechanistic reliance on ratings should be removed from EU legislation.138

For some financial institutions, the requirements to reduce reliance on ratings are specified in Directive (EU) No. 2013/14/EU amending Directive 2003/41/EC on the activities and supervision of institutions for occupational retirement provision, Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) and Directive 2011/61/EU on Alternative Investment Funds Managers in respect of over-reliance on credit ratings (ORD).139_{The objective of this Directive is to contribute to the reduction of the over-reliance}

of Institutions for Occupational Retirement Provision (IORPs), Undertakings for the Collective Investment in Transferable Securities (UCITS ) and Alternative Investment Funds (AIFs) on credit ratings when making their investments.140_{The Directive is meant to be}

complementary to provisions in the CRAR.141

Member States are to ensure that the adequacy of the pension funds’ credit assessment processes are monitored and, where appropriate, that they are encouraged to mitigate the impact of references to ratings.142_{Regarding UCITS, an investment company shall employ a}

risk-management process which enables it to monitor the risk of the positions and their contribution to the overall risk profile of the portfolio of a UCITs for assessing the creditworthiness of the UCITS’ assets.143_{Competent authorities monitor the adequacy of the}

companies’ credit assessment process, and assess the use of references to credit ratings. Pursuant to article 3, AIF managers shall implement adequate risk-management systems in order to identify, measure, manage and monitor appropriately all risks relevant to each AIF investment strategy and to which each AIF is or may be exposed.144_{Additionally, the risk}

management shall aim to no longer rely solely and mechanically on credit ratings.

138_{Art. 5c CRAR.} 139_{[2013] OJ L 145, 31.5.2013.} 140_{Recital (5) ORD.} 141_{Recital (4) ORD.} 142_{Art. 1 ORD.} 143_{Art. 2 (1) ORD.} 144_{Art. 3 ORD.}

(26)

4.1.2 Disclosures

The second measure taken by the EU, was to increase transparency. This should move investors to gauge the value of ratings.145 _{Pursuant to Annex I section E, CRAs are to disclose}

all information considered to influence their ratings, such as potential conflicts of interest146_,

ancillary services147_{and compensation structures.}148_{Additionally, a CRA should disclose its}

methodologies, descriptions of models and key rating assumptions used in its credit rating activities.149_{Once every six months, a CRA is required to disclose data about the historical}

default rates of its rating categories and whether the default rates of these categories have changed over time.150_{Lastly, CRAs should be able to present annual reports including, inter}

alia, detailed information on legal structure and ownership of the credit rating agency151_{, a}

description of the internal control mechanisms ensuring quality of its credit rating activities;

152_{the outcome of the annual internal review of their independent compliance functions}153_and

financial information on the revenue of the CRAs.154

4.1.3 Liability

A third way to empower investors is to allow them to bring civil enforcement actions against CRAs. Article 35a CRAR allows investors to sue CRAs in case they commit any of the infringements listed in Annex III CRAR. It has to have been committed intentionally or with gross negligence and has to have had an impact on the rating, as a result of which the investor suffered damage. Hereby, the investor has to prove his reasonable reliance on the rating and that he has taken due care in assessing the creditworthiness of the financial product.155

145_{Rousseau 2009, p. 39.}

146_{Annex I, section E, I (1) CRAR.} 147_{Annex I, section E, I (2) CRAR.} 148_{Annex I, section E, I (4) CRAR.} 149_{Annex I, section E, I (5) CRAR.} 150_{Annex I, section E, II (1) CRAR.} 151_{Annex I, section E, III (1) CRAR.} 152_{Annex I, section E, III (2) CRAR.} 153_{Annex I, section E, III (5) CRAR.} 154_{Annex I, section E, III (7) CRAR.} 155_{Art. 35a (1) CRAR.}

(27)

The infringements are formulated quite broadly. Examples are: not ensuring analysts have the appropriate experience and knowledge for their assigned tasks156 _{or not adopting,}

implementing and enforcing rules to ensure rating outlooks are based on a thorough analysis of all the available information.157_{In addition to proving the infringement occurred, investors}

will also have to prove that the infringement had an impact on the rating.158_{As many}

infringements concern procedural requirements, such as the installation of an independent supervisory board, the causal link between infringement and rating may be hard to prove.159

There are two infringements that are most likely to serve as a foundation for a liability claim.160_{The first is the CRA’s failure to use all available information that is relevant}

according to its own rating methodology.161_{The second is the failure to use rigorous,}

systematic, continuous methodologies that are subject to validation based on historical experience, including back-testing.162_{Proving the causal link can be challenging, particularly}

when a rating was correct at the moment it was first issued, yet the CRA failed to properly monitor it afterwards.163_{Terms such as ‘damage’ and ‘gross negligence’ are not defined in the}

CRAR and should be interpreted in accordance with the applicable national law as determined by the relevant rules of private international law.164

4.2 Competition

In order to lower the access barriers for smaller agencies, the regulation provides an exemption to the rotation rule that applies to re-securitisations. The rotation rule does not apply to agencies that employ less than fifty people.165_{Additionally, in case an issuer intends}

to appoint more than one CRA to provide a rating, they are obliged to consider one CRA with less than 10% market share.166_{ESMA shall publish a list of registered credit rating agencies}

156_{Annex I, I (27) CRAR.} 157_{Annex I, I (42) CRAR.} 158_{Art. 35a (2) CRAR.} 159_{Lehmann 2014, p. 16.} 160_Idem.

161_{Annex III, I (42) CRAR.} 162_{Annex III, I (43) CRAR.} 163_{Verbruggen 2013, p. 7.} 164_{Art. 35a (4) CRAR .} 165_{Art. 6b (5) CRAR.} 166_{Art 8d (1) CRAR.}

(28)

annually. This list should contain information on the total market share and the types of credit ratings issued by a CRA. The list can be used by the issuer as a starting point for its decision on what agency to hire.167_{This should allow the smaller CRAs to get a foothold in the field.}

Thereby, competition will increase.

§5. Conclusion

The Regulation and subsequent amendments brought about a significant change regarding the supervision of CRAs. The lack of integrity is managed by the CRAs themselves under supervision of ESMA. Additionally, disclosure of the names of influential clients should provide investors with the opportunity to re-assess the value of the ratings and CRAs are no longer authorised to give advice prior to issuing a rating. In order to lower entrance barriers to the oligopolistic rating market, the CRAR enhances transparency by requiring issuers to disclose the information they shared with the rating CRA, also to other CRAs, thus allowing for unsolicited ratings. Protecting investors from a ‘mechanistic reliance’ on ratings is an aim of the EU. Removing all CRA references from legislation indicates that the government itself no longer trusts the opinions of CRA. Moreover, this may stimulate investors to follow the government’s lead. The introduction of tortious liability provides an important tool for investors to claim damages in cases of CRAs` misconduct. However, the EU has not addressed all the problems associated with CRAs and several provisions in the CRAR are controversial.

Chapter 4 Omissions and Side Effects

The question as to how reforms of the credit rating market should be shaped, is not one to which an unequivocal response has been found. What measures should be taken is interrelated with the belief of what the primary causes of the problems with CRAs are. Even though these causes have been thoroughly researched, there is no consensus on the key causes. The ‘gatekeeper’ perspective advocates to aim reforms at reducing conflicts of interest, whereas the ‘regulatory licence’ perspective favours deregulation or enhancing market discipline.168

The EU does not explicitly embrace one of these perspectives and acknowledges the relevance of both. This view can be traced to its regulatory choices as they pursue both to

167_{Art. 8d (2) CRAR.} 168_{OECD 2010, p. 39.}

(29)

decrease the influence of conflicts of interest and, at the same time, to reduce the regulatory use of ratings. As the regulatory framework in the EU pursues both simultaneously, some measures may be counterproductive or conflicting. Additionally, several subjects remain untouched. This chapter describes these issues.

Firstly, the EU adopted measures to reduce the influence of conflicts of interest that CRAs face. These measures, however, are primarily aimed at revising the internal business structure of CRAs, but the issuer-pays model, strongly related to conflicts of interests, remains unaffected by the CRAR. Several alternative models of remuneration are proposed, including an investor-paid CRA and a platform-paid CRA. Secondly, the regulation is also to some extent based on the hypothesis that increasing competition will improve the quality of ratings. This view is challenged. Finally, the tenability of the supervisory system is discussed, with an emphasis on the possibility of creating an unwarranted sense of security for investors, thus increasing over-reliance on ratings.

§2. Conflicts of Interest

Increasing integrity by reducing and managing conflicts of interest is an important aspect of the CRAR. However, the prime cause of conflicts of interest is the issuer-pays model. The European Commission even identifies conflicts of interest as being ‘inherent’ to this remuneration model.169_{This argument is supported in legal and economic literature.}170_In

2010, the European Commission assessed the possibility of changing the remuneration model by means of a ‘consultation paper’.171_{This has hitherto not led to any actual changes. The}

considered alternatives include a subscriber-pays model, a platform-pays model, and a payment-upon-result model.

2.1 Subscriber Pays Model

Firstly, in the previously mentioned consultation paper, the European Commission considered the subscriber-pays model. This model was used by CRAs until the mid-1970s. It could effectively prevent CRAs from inflating ratings on behalf of issuers as a result of a conflict of interest.172_{In this model, investors request the ratings and CRAs earn revenue from the users}

169_{EC 2010b, p. 26.}

170_{See: Chapter 2 §3 of this thesis.} 171_{EC 2010b, p. 1-32.}

(30)

of ratings. Since CRAs would not work for the issuers of the rated instruments, they would not be influenced to either inflate or deflate the ratings to please the issuers of the instruments. The question remains what would happen to the advisory services that CRAs offer. Research suggests that these services negatively influence the quality of ratings if the same rating agency provides both the advise and the rating.173_{This argument is attenuated when a CRA}

would first provide an advice on the structure of a product for the benefit of the issuer and consequently rate it for the benefit of the investor. The incentive to inflate ratings will be mitigated, as the CRAs would also earn revenue from investors.

Pagano & Volpin (2009) consider switching to subscriber-paid ratings indispensable to effectively address the problem of conflicts of interest. In addition, they argue that investors and CRAs should be given free and complete access to all information about the portfolios underlying structured debt securities.174

Despite the obvious problems with an issuer-pays model, two points have thus far prevented governments from seeking to eliminate it in favour of a subscriber-pays variant: (1) the subscriber-pays model would facilitate that ratings could also be used by non-subscribers, without the CRA being compensated and; (2) investors have biases that can create conflicts for CRAs as much as issuers have.175

The first problem associated with the subscriber-pays model is that the subscriber could easily share the information it paid for, without the CRAs being compensated. This is referred to as the free-rider problem.176_{In economics in general, this problem describes the situation where}

some individuals in a population pay less than their fair share of the cost for the use of a common resource. In the context of the subscriber-pays model, the free-rider problem indicates that ratings would become a common resource. Once it is published, it could be made available to other people than the subscriber. As a result, free-riders will acquire and rely on the information without compensating the CRA.177_{This was the reason the CRAs}

abolished the system in the first place.178

173_{Boersma 2010, p. 12.}

174_{Pagano & Volpin 2010, p. 404.} 175_{Coffee 2010, p. 255.}

176_{EC 2010a, p. 26.}

177_{OECD 2010, p. 53; Amtenbrink & Heine 2012, p. 5; Hill 2004, p. 50.} 178_{Miglionico 2012, p. 31 note 88.}

(31)

Secondly, the assertion that investors have biases of their own is also invoked by CRAs in defence of their remuneration models.179_{The subscriber-pays model enables investors to put}

pressure on CRAs to inflate ratings, as high and stable ratings would allow them to hold risky securities, or deflate ratings as the securities would become cheaper.180_{Additionally, since}

avoiding the free-rider problem could require ratings to remain secret, the model would not allow for broad market scrutiny.181_{This would impair quality control.}

Coffee argues that, in spite of these problems, adjusting the remuneration model is a necessity.182_{In his opinion, meaningful reform must encourage a subscriber-pays model that}

can compete with the current issuer-pays model. This change of remuneration model will have to be attained via regulatory intervention, due to the informational goods nature of financial information.183

2.2 Platform Pays Model

Secondly, in order to avoid the above-mentioned problems with the subscriber-pays model, Mathis (2009) suggest the introduction of a rating platform. This platform would take the form of clearing house for ratings, complemented by prudential oversight of ratings quality to control for maintaining integrity.184_{The idea is to cut any direct commercial links between}

issuers and CRAs. The issuer would pay an issue fee to the central platform, upon request of the rating. The central platform would then organize the rating of the pool of loans by one or several CRAs. The rating fees would be paid by the platform to the CRAs. These fees would be independent of the outcome of the rating process.

The European Commission considered a variation of this model, referred to as the government-as-hiring-agent model, in a public consultation.185 _{The platform would be}

composed of an independent ‘CRA Board’ consisting of supervisors, representatives of issuers

179_{Sharma 2009, p. 9.} 180_{Coffee 2010, p. 234.} 181_{CRS 2009, p. 3.} 182_{Coffee 2010, p. 278.} 183_Idem. 184_{Mathis 2009, p. 657-674.} 185_{EC 2010b, p. 28.}

(32)

and subscribers/investors. The different backgrounds of the board members will ensure the impartiality of their choices, as they all have different interests. The selection of a CRA would be undertaken by this board. They could be empowered to select a CRA either at random or on the basis of objectively defined criteria to rate an issuer’s structured finance instruments.186

The problem with this model, however, is its governance, which will need to be watertight as it appears to be vulnerable to bribery by the issuers.187_{Issuers may be inclined to approach}

members of the platform and obtain a favourable rating through a form of side-contracting. The platform-pays model needs therefore to be complemented with strong cost-effective oversight.188_{The outcome of the public consultation conducted by the EC also indicates that}

respondents considered this model to have negative implications for the integrity of the rating system.189

§3. Competition

The EC considers the improvement of the conditions for effective competition in the concentrated rating market a key objective.190_{Nonetheless, research suggests that more}

competition does not necessarily improve rating standards, on the contrary.191_{In order to}

attract business, ratings may become inflated and issuer-friendly.192_{Research conducted by}

Becker and Milbourn (2009) suggests that increasing competition has a negative effect on the quality of ratings.193

Becker and Milbourn researched the entry of a third rating agency (Fitch) to the competitive landscape that was before that dominated by Moody’s and S&P. This offered a unique experiment to empirically examine how in fact increased competition affects the credit ratings market. Fitch was founded in 1913, yet it initially remained a relatively small player. As a result of a series of mergers it acquired a substantial market share after 2000, Fitch’s monthly share of U.S. credit ratings increased from a low of 20% in 2000 to a peak of 45% in 2006. This provided a unique opportunity to research the effects of this expansion on the duopoly of

186_Idem.

187_{OECD 2010, p. 54.} 188_{Ponce 2010, p. 22.} 189_{EC 2011a, p. 4.} 190_{EC 2014, p. 2.}

191_{Becker & Milbourn 2009, p. 9; Jaakke 2012, p. 54; Camanho, Deb and Liu 2009, p. 27.} 192_{Lannoo 2010, p. 5.}

The legal framework applicable to Credit Rating Agencies in the EU