Financial services must reduce dependency on credit ratings
The long awaited Capital Requirements Directive (CRD) IV proposals published by the European Commission (EC) on 20 July 2011 require banks to further strengthen their own risk analysis of the assets they hold. European regulators are making a concerted effort to make financial institutions more responsible for their own due diligence and internal risk management obligations and to address the financial sector’s overreliance on external credit ratings.
Michel Barnier, the EU Commissioner responsible for internal market and services, has argued that credit rating agencies’ (CRA) ratings are too embedded in European legislation and must be subjected to enhanced supervision. Barnier has said the CRD IV proposals for banks will be followed by other proposals to limit reliance on external CRA ratings in the insurance, asset management and investment fund sectors by the end of 2011.
The CRD IV proposals will require banks with material credit risk exposures to develop and use internal risk models rather than relying solely on ratings from CRAs. The European Banking Authority (EBA) will monitor banks’ progress against these parameters and will disclose, on an annual basis, information on the steps taken by institutions to reduce their overreliance on external credit ratings and on the degree of supervisory convergence in Europe. The original CRD framework required credit institutions to have their own sound internal risk models. In its 2010 consultation paper on CRAs, the EC said that “basing credit decisions solely on external credit rating agency ratings does not fulfil this requirement under EU-banking legislation”. In the EC’s view, the CRD IV proposals simply reinforce an existing requirement which has failed to effect any meaningful change in how banks assess risk.
In the same speech, Barnier presented proposals to address three broad areas of concern with CRAs:
- Sovereign debt rating: Barnier recommends that CRAs should adopt a specific and rigorous methodology for rating sovereign debt and be subjected to additional transparency and accountability requirements. On the latter point, he believes that governments should be allowed to check the accuracy of the data used by CRA in advance of a downgrading. Barnier also questioned whether it was appropriate to allow sovereign ratings on countries which are part of a monetary union and subjected to internationally agreed aid packages.
- Competition: the EC is currently looking at ways of stimulating competition in the CRA sector, either by supporting the emergence of new external actors or through internal forces creating a new, independent “European rating foundation” and/or establishing a network of smaller European rating agencies.¹
- Responsibility: European regulation could be introduced to enable investors to sue CRAs where they have been negligent or violated applicable rules. Although some jurisdictions already have rules imposing civil liability for CRAs, a common EU framework would result in a much more coherent application of rules.
While these proposals have some merits, they are not without sceptics. On sovereign debt ratings, CRA downgrades usually lag behind market sentiment, in part because the CRAs need more time to carry out detailed analysis. For example, yields on Greece and Irish debt rose long before credit rating agencies downgraded their debt. While CRA’s rating of complex derivatives was exposed as being flawed during the financial crisis, their track record on rating sovereign debt is generally viewed as being stronger.
On competition, in the US similar measures to stimulate external competition under the Credit Rating Agency Reform Act of 2006 failed to break the dominance of the three main players: Moody’s, Standard & Poor’s and Fitch. The proposal on creating a “European rating foundation” is untested with no precedent elsewhere.
Finally on responsibility, rating financial products is a risky business and CRAs ensure that their contracts reflect this fact. Moreover, CRAs negligence is likely to be difficult to prove in court.
With the huge current focus of interest on European sovereign debt and the critical role that ratings play in both the cost of debt for borrowers and perceived health of credit institutions, this remains a key area to watch for further developments.
ESMA outlines its policy thinking on AIFMD
On 13 July, ESMA issued its consultation paper on possible implementing measures of the Alternative Investment Fund Managers Directive (AIFMD). At 438 pages, this paper is the first major foray by ESMA into regulation, outlining its policy thinking in five major areas covered by AIMFD:
- Manager operating requirements - governance, conduct of business, conflicts of interest management, delegation and capital;
- Fund management requirements - calculation of assets under management, controls over leverage, liquidity and processes and requirements around valuation;
- Transparency - detailed proposals around annual reports and other disclosures and periodic reporting to investors and regulators;
- Risk Management organisational requirements to be imposed on managers with regard to the identification, management, measurement and reporting of risks to which their funds and businesses are subject; and
- Depositaries addressing safekeeping, custody of financial and non-financial assets, definitions of when assets are lost, bases for depositary liability, obligations of oversight, delegation of functions, and detailed rules around depositaries’ obligations regarding cash.
The CP does not deal with 3rd country issues, which will be the subject of a separate consultation paper, expected to be issued later in the summer. Other important issues are left unaddressed, for example answers to the question “who is the AIFM?” which will be determined either in ESMA’s technical standards or through national law.
Although not fully comprehensive, this paper gives a sufficient steer for industry participants to prompt them to respond to ESMA. Recognising the clock is now ticking on AIFMD, industry players should be progressing their impact analysis and strategic review of operational structures, as well as relationships with third parties, to position themselves to fully evaluate the AIFMD’s impact and plan for implementation.
The consultation period is open until 13 September 2011. ESMA intends to finalise its advice to the EC in time for submission by 16 November 2011. We encourage industry participants to put forward their views on the critical issues raised in this consultation, as this is likely to effectively be the last chance to influence the EU do so before the work on national implementation begins.
Solvency II impacts fixed incomes investment strategies
Solvency II will result in insurance companies allocating a greater proportion of portfolios towards less risky assets classes and lower capital charges, according to a Bank for International Settlements (BIS) working group report looking at the impact of forthcoming accounting, regulatory and market changes on the insurance industry. BIS concluded that there is no evidence to support an industry-wide flight towards higher risk classes in the short to medium term, despite the pressure to search for higher yields in the current environment of protracted low interest rates.
The BIS working group examined the impact of the new Solvency II rules on the investment strategies for insurance firms with reference to a number of different asset classes. For equities, the report indicates that the charges associated with holding equity instruments will not encourage a broad-based re-entry from these asset classes. The current equity backing ratios for large European insurers is likely to remain constant at only 5-8%.On Government bonds, insurers have a regulatory incentive to increase exposure in European government bonds in domestic currency as these instruments are classified as risk free under Solvency II.
Solvency II will impose capital charges on corporate and covered bonds which did not exist under previous regulations. There will likely be a shift towards short-dated bonds, as the standard formula of Solvency II appears to penalise long-term bonds. Finally, the overall outlook for structured products is generally negative, as both capital requirements and the risk of illiquidity during a crisis are very high.
These findings suggest that Solvency II ‘s main impact will occur on the asset side of insurers’ balance sheets rather than the liability side, which is consistent with the latest quantitative impact study (QIS5) from the European Commission.
Are financial institutions willing to accept more intensive regulation?
Financial institutions are willing to absorb the extra costs associated with regulatory reform agenda, as long as it delivers the promised improvements, according to the Institute of International Finance (IIF), a global association of financial institutions. In a recent report on financial supervision, the IIF recognised that a more effective regulatory framework should be regarded as a “shared endeavour” between firms and regulators.
The IIF is calling for a more challenging, action-focused and, above all, intensive approach to financial supervision. Regulators should be ready to act on an incremental basis and, if necessary, to intervene at an early stage when a firm’s risks and problems are judged to be unacceptable. Action and intervention should focus primarily on making sure that the governance, controls, and risk management of the firm are appropriate to the business and risks undertaken.
Boards need to be more actively engaged in setting risk parameters. Regulatory emphasis needs to make sure that governance structures are operating effectively. Regulators should be more proactive and challenge the Boards more closely on matters such as:
- their business model,
- the quality of market analysis,
- comparative advantage of the firm, and
- the role of the Board.
The IIF believes there is no case for adopting fundamentally different approaches to systemically important financial institutions. Instead, regulators should follow a consistent approach, albeit calibrated to the size, complexity and interconnectedness of the firms concerned.
The contagion effects of rogue firms have been shown to result in greater instability of the system in general. This increases the risk that firms, their customers and their shareholders will have to pick up the cost of failings of other firms. Jurisdictions with insufficient supervisory quality or resources should not be tolerated, and active measures should be taken at the international level to tackle any weaknesses.
The IIF note that sustaining today’s good intentions is vital over the next few years as the financial sector recovers, as memories fade and competitive pressures reassert themselves. Embedding reforms securely for the long term is an essential objective.
¹ see PwC European financial regulation June 20, 2011