The European Securities and Markets Authorities (ESMA) has published a report on its general investigation in the way credit rating agencies (CRAs) conduct surveillance of structured finance credit ratings, as indicated in ESMA’s Credit Rating Agencies Annual Report 20131. The investigation took place between October 2013 and September 2014 and involved the four largest CRAs providing credit ratings on structured finance instruments in the EU, namely DBRS Ratings (DBRS), Fitch Ratings (Fitch), Moody’s Investors Service (MIS) and Standard & Poor’s (S&P).
Outcome and findings of the investigation
ESMA’s interest in the structured finance credit ratings is consequent to the relevance of structured finance, and more generally securitisation, in the financial industry as an important alternative funding source and risk-transfer tool. Despite the reduced issuance of structured finance instruments following the financial crisis, outstanding volumes remain high, and signs of renewed support for securitisation in Europe may lead to future growth in this area.
During its investigation, ESMA identified shortcomings and weaknesses, as well as examples of good practices, in several areas affecting the surveillance of structured finance ratings for each CRA investigated. As the shortcomings identified may jeopardise the quality of credit ratings, ESMA expects CRAs to enhance their practices in various areas highlighted by the investigation. Moreover, ESMA identified shortcomings on the level of disclosure and transparency which could be detrimental to investor protection. The outcome of the investigation is of particular relevance given that the four CRAs involved account for almost 100% of the total outstanding credit ratings of EU structured finance instruments.
Critical issues identified
Critical issues that ESMA identified in one or more of the CRAs include:
- the lack of quality controls over information used and received from data providers;
- incomplete application of the full methodology during the rating monitoring process aggravated by insufficient disclosure of the different analytical frameworks used;
- delays in the completion of the annual review of ratings;
- need to strengthen the role of the internal review function and the activities it performs during the review of methodologies, models and key rating assumptions applied to structured finance ratings in order to ensure effective independence from the business lines responsible for credit rating activities.
ESMA requests and further monitoring
Not surprisingly, “ESMA has requested that individual CRAs put in place remedial action plans to resolve the individual concerns identified. In some instances the CRA involved has already taken remedial steps to address the issues identified.”
ESMA continued, “The findings and considerations contained in this report are general in nature and so are likely to be applicable to a variety of ratings issued by CRAs, not just the RMBS ratings which were the subject of this investigation. All registered CRAs should therefore take note of the issues identified in this report to ensure that they properly incorporate the requirements and the objectives of the Regulation into their working practices and remove any practices and procedures which conflict with these.”
ESMA plan to follow up with each of the four CRAs, and will also montor other registered CRAs.
Finally, ESMA warn that they could look at other potential infringements of the CRA Regulation.
CTMfile take: This breakdown in the performance of the CRAs is serious as they are critical to the stability of the financial system. ESMA is quite rightly playing hardball.
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