ESMA issues first report card on CRAs
The European Securities and Markets Authority (ESMA) has carried out its first onsite- examination of the three largest credit rating agencies (CRA) to assess compliance with the new EU-wide CRA Regulation (Regulation No 1060/2009), with mixed results.
Generally, Fitch, Moody’s and Standard & Poors made good progress during the registration process last year on putting in place rigorous policies and procedures, clearly allocating detailed roles and responsibility to their staff, and formalising their activities to fully comply with the new regime.
However, ESMA noted that certain ‘core elements’ of their rating processes were not ‘appropriately or systemically’ documented, in particular the outcome of voting within the rating committee (RC) and the reasons considered to support or depart from the initial proposals presented by the analyst. Having records that reflect these decisions is important because without appropriate records, the regulator will find it difficult to conclude that the RC’s decision has been taken in compliance with the Regulation.
In addition, ESMA is concerned by the short length of time given to RC members to review the documentation which would be discussed at the meeting. The regulator also flagged high staff turnover within these committees and amongst analysts as a significant concern, particularly given the peculiarities of specific asset classes and the need for specialist skills. ESMA believes that if CRAs have limited time for assessments and impaired resources it will reduce the quality of ratings.
In at least one case, ESMA asked the independent directors of the CRA to continue to develop their involvement in CRAs’ activities and interactions with internal control functions.
For users of credit ratings to make informed decisions, they need to understand how CRAs form and build their opinions. The CRA Regulation explicitly requires rating agencies to be transparent with users on the criteria they use, and the models they follow, to develop their opinions. While only sophisticated investors and financial institutions are likely to fully understand the mathematical equations underpinning these models, ESMA is probably expecting their analysis to percolate down to retail investors as well, who in many cases are advised by experts before making investment decisions.
ESMA found that CRAs’ disclosures were generally good but not user friendly. However, the regulator did identify instances where the methodologies underlying credit rating decisions were contained in multiple documents published at different times, and so were not easy to identify on the CRAs’ websites.
ESMA identified a number of potential weaknesses on the firms’ IT systems (e.g. reliance on outsource providers, fragmentation of systems) which may impede their efforts to improve the communication and accuracy of records. The regulator also cited common pitfalls in migrating to new systems as a source of potential concern, especially in terms of the ‘appropriateness and soundness of the transitional phase’.
ESMA has urged the CRAs to put in place a number of measures to address the weakness it observed. ESMA has not determined whether or not any of these weaknesses constitutes a breach of the Regulation, but will follow-up on the observations with the individual CRAs this summer.
Firms should welcome the regulators early push towards raising standards in this market: it is a good sign of ESMA’s ongoing ability to oversee this industry effectively. Better-run CRAs should produce better ratings. As Moody’s, Fitch and Standard & Poors control the lion share of ratings in the EU (95%), regulators want to stimulate competition in the market but this is proving difficult, see our 20 June 2011 article
). The drive to reduce reliance on credit ratings for regulatory purposes (see last week’s article
), will not reduce the value of credit ratings as an important benchmark. So, supplementing these initiatives with efforts to improve the quality of credit ratings is good news.
EC release working paper on retail bank accounts
Retail bank structures across the EU differ considerably and, consequently, are highly fragmented along national lines. The European Commission (EC) has identified a number of obstacles to customer choice and mobility in the financial services in the single market. According to the EC and backed-up by a number of studies (e.g. the Monti Report
), the most pressing obstacles are the lack of transparency of fees linked to bank accounts; high switching costs (both in terms of money and time required); and the lack of universal access to basic banking services. The EC believes that about 30 million EU citizens don’t have bank accounts.
In the past, the ‘minimum harmonisation’ approach in EU regulation has resulted in a ‘patchwork of rules and codes of conduct’ which renders pan-European mobility more difficult. The EC is keen to take action in this area, for the sake of retail clients but, perhaps more importantly at this stage, to facilitate cross border business, particularly SME business within the Single Market. On 20 March, it released a consultation paper to canvass opinion on what additional measures are required at EU-level to promote greater bank account mobility.
In July 2011, the EC released a Recommendation outlining EU- principles for a basic payment account which should give customers the right to open and use a bank account with a number of basic features, such as the ability to withdraw and lodge money and execute payment transactions. This Recommendation addressed a fundamental need of EU citizens, and the Commission is reviewing the efficacy of measures taken by Member States in response to it, which were voluntary rather than mandated.
The EC is now looking to improve customer choice in service providers by seeking feedback on additional measures needed. To promote customer choice, it is seeking comments on what measures should be introduced to improve the level of information on bank fees and the way banks present fee information to customers. The measures proposed include standardised lists of fees, comparison tools and personalised cost simulations. Back in 2010, the EC requested the European Banking Industry Committee (EBIC) to develop solutions to assist consumers on bank account fees. However, the EC noted that (as at the end of 2011) this self-regulatory initiative hadn’t worked.
The EC is also seeking views on how to make it easier for consumers to switch bank accounts. In particular, the EC is consulting on the efficacy of the common principles for bank account switching published by EBIC in December 2008.
The consultation closes on 12 June 2012. It remains to be seen how effective greater transparency, lower switching costs and universal access, will be in increasing choice, and what the resulting impact on competition (and possibly lower fees) will be. At the national level, studies have shown that customers show a general inertia towards switching bank accounts. On a cross-border basis, additional difficulties, such as language barriers present themselves. But also – and probably more importantly – local regulators impose different national rules for accepting new customers. It is not clear how harmonising the elements examined by the EC in the current consultation will smooth the path to bank account mobility across borders – perhaps the solutions to achieving that lie elsewhere.
Regulating the proxy advisory industry
More and more institutional investors (asset managers, mutual and pension funds) rely on the services of the proxy advisory industry across Europe. Proxy advisors analyse the resolutions presented at the general meetings of public companies and advise investors on voting and other actions. While the European market for these services is relatively small compared to the United States, it has been growing significantly in recent years.
Following fact-finding work in 2011, ESMA published a discussion paper on 22 March, which focuses on the following key issues:
- factors influencing the accuracy, independence and reliability of the proxy advice, such as the potential for conflicts of interest to arise, proxy advisors’ methodology and their dialogue with issuers
- the degree of transparency on how proxy advisors manage conflicts of interest, dialogue they have with issuers, how they develop voting recommendations, etc.
ESMA suggests a range of policy options which could be considered, and seeks further input from market participants. These options include: taking no action at the EU-level; encouraging Member States or industry to develop standards; or implanting binding EU legislation.
Does a clear rationale exist for regulating proxy advisors? The proxy advisor market has not yet displayed any signs of market failure (i.e. monopoly power, asymmetries of information, etc.) or been shown to be a source of potential risks to financial stability or market integrity. While proxy advisors aren’t directly regulated, various other regulations exist which may already be sufficient to keep the market in check (e.g. for UCITS management companies when exercising voting rights). In addition, many countries have formal rules and well-recognised corporate governance standards that apply to publicly listed issuers at a national level (sometimes based on the ‘comply or explain’ approach), which go some way to address the same issue.
The consultation period closes on 25 June 2012. ESMA expects to publish a feedback statement at the end of the year which will summarise the responses received and set-out ESMA’s view on whether policy action is needed in this area.
Joint Committee of ESAs publish medium term strategy
The Joint Committee of the European Supervisory Authorities (ESAs) published its medium term strategy in March―setting its planned deliverables for the next few years. Under the aegis of the three ESAs, he Joint Committee focuses on issues which are relevant across the financial services sector, with the remit to promote cross-sectoral consistency among the three authorities.
The Committee’s medium term strategy will focus on the following five areas over the next few years:
- consumer protection: considering appropriate measures in the light of the Commission’s legislative proposals on packaged retail investment products (PRIPs), and its likely interaction with MiFID II and the Insurance Mediation Directive regime.
- regulatory work: developing technical standards and guidelines for legislative proposals that have cross-sectoral implications, such as the Financial Conglomerates Directive (2002/87/EC) (FICOD), the proposed Regulation on OTC derivatives, central counterparties and trade repositories (EMIR) and the Third Money Laundering Directive.
- risk assessment: promoting ‘cross-sectoral co-ordination, monitoring and assessment of the ESAs’ work on systemic risk’.
- supervisory practice: establishing guidelines on convergence of supervisory practices relating to mixed financial holding companies, third country equivalence and supervisory co-ordination arrangements under FICOD. It will also look at anti-money laundering supervisory practices with a view to producing an AML supervisory tool kit.
- common processes and procedures: promoting the development common and consistent policies and procedures for key ESA processes and procedures.
The timeline for most of these deliverables is 2012 to 2013, with the exception of common processes and procedures, where the deadline is the end of this year.
The Joint Committee does not have legal personality and powers in the same way as the ESAs themselves. However, its work going forward will be increasingly important in ensuring cross-sectoral consistency of financial services regulation, so that regulatory reforms in one financial sector do not result in distortions in regulatory regimes that apply to different financial sectors. The Joint Committee will also have a role in monitoring the interconnectivity of the sectors, supporting the European Systemic Risk Board.