The presidency of the EU Council (Council) moves to Vilnius next month, as the Lithuanians get their first taste of running one half of the EU legislature. It shouldn’t be a total baptism of fire, thanks to good progress made by the Irish Presidency on key dossiers. However, we are at a crucial stage in the legislative process of some big ticket reforms in Europe and there is every possibility of being blown-off course in the coming months as politicians back track on implementing tough reforms.
The European Parliamentary election next year heaps added pressure to reaching political agreement on proposals already on the table within the life span of the current European Parliament (Parliament). It will take months for newly elected parliamentarians to get up-to-speed with current debates. It is also not clear what form and construct the new Parliament will take and where its priorities will lie.
While the forthcoming Presidency hasn’t laid out its strategy on regulatory reform just yet, we will take you through the main reform areas, providing you with our best guess of what’s going to happen:
Single rule book
This summarises what is actually on the table so far. But Michel Barnier, speaking to the European Parliament on the 27 May, outlined further proposals due to be tabled before the end of the year:
In his comments to the European Parliament, Commissioner Barnier also flagged upcoming proposals on financial benchmarks and money market funds, without indicating precise timing for these proposals.
But that’s not all. Having made progress in all the above areas, the Commission intends to turn its attention to means designed to ‘base the EU economy on productive capital rather than financial capital’, as outlined in its Green Paper issued on 25 March. Clearly, we will not see any relaxation, in the short-term, of the legislative onslaught. The Lithuanian Presidency comes as a crucial juncture overall, given the Parliamentary and Commission elections next year, and the challenges it will face are significant, not least juggling the priorities. Progress in the coming six months will depend on sustained political good will and energy amongst EU legislators. But there are already clear indications that not all of the stuffed legislative agenda will be finalised before the end of the year or progressed sufficiently for the next holders of the Presidency (the Greeks) to finalise them. The question is which ones will slip through the cracks.
The third iteration of the Credit Rating Agencies Regulation (CRA III) was published in the Official Journal on 31 May 2013. Financial institutions will have until 20 June 2013 to improve their own credit risk assessment capabilities to ensure they no longer have to rely solely or mechanically on ratings from third parties.
National supervisors will be mandated to monitor the adequacy of firms’ internal credit risk procedures (based on the proportionality principle), assess the use of contractual references to credit ratings and, where appropriate, encourage them to mitigate the impact of such references. Firms should also empower customers to undertake their own due diligence before making investment decisions.
Migrating from relying solely on credit ratings is an arduous, but necessary, task. Clearly, financial firms placed too much reliance on credit ratings, in the run up to the crisis, that were evidently flawed. But regulators (and regulatory regimes) and central banks were also overly dependent on the work of credit rating agencies. Like firms, regulators and central banks will need to start using their own judgement when determining what financial instruments they will accept for regulatory purposes. Given limited resources, they are also going to have to begin to rely again on the judgements on credit risks made by the firms they regulate.
Regulators have already started preparing for the latter by strengthening firms’ internal credit risk assessment processes. Along with CRA III, a Directive amending UCITS IV and the Alternative Investment Fund Managers Directive was also published in the Official Journal on 31 May 2013. The changes are aimed at limiting the reliance on external ratings by fund managers subject to those directives.
The Capital Requirements Directive (CRD) IV requires banks to further strengthen their own risk analysis of the assets they hold. CRD IV 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.
While the original CRD framework required banks and large investment firms to have their own sound internal risk models, the Commission believes that “basing credit decisions solely on external credit rating agency ratings does not fulfil this requirement under EU-banking legislation”. In the Commission’s view, the CRD IV rules in this regard simply reinforce an existing requirement which failed to effect any meaningful change in how banks assess risk.
In the insurance space, EU commissioner Michel Barnier, said that the Commission intends to include measures relating to reliance on credit ratings in the delegated acts for Solvency II in the coming months.
CRA III focuses on other issues beyond reducing over dependence of credit ratings. CRAs are required to adopt a specific and rigorous methodology for rating sovereign debt and be subjected to additional transparency and accountability requirements. Some are sceptical about these requirements, claiming that CRA importance in respect of sovereign ratings is overblown. 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 stronger.
The Regulation also attempts to spur competition in the highly concentrated CRA market by encouraging the use of smaller rating providers. Where issuers are seeking credit ratings from two or more CRA’s, the issuer “should consider appointing at least one credit rating agency which does not have more than 10% market share” according to the Regulation. Moreover, the Regulation mandates a regular rotation of CRAs issuing credit ratings on re-securitisations. Multiple and different views, perspectives and methodologies applied by CRAs should produce more diverse credit ratings and ultimately improve the assessment of the creditworthiness of re-securitisations.
Finally, politicians want to make CRAs more liable and accountable for the ratings they issue. Where a CRA has committed, intentionally or through gross negligence, any of the infringements that have an impact on a credit rating, an investor or issuer may claim damages from that CRA. However, rating financial products is a risky business and CRAs ensure that their contracts reflect this fact and limit liability. Moreover, CRAs negligence is likely to be difficult to prove in court.
The EBA published a raft of consultations on draft regulatory technical standards (RTS) and implementing technical standards (ITS) on CRD IV last month as we gear-up to a potential start date of 1 January 2014 for the new prudential regime. We expect two dozen further CRD IV consultations from the EBA this year as the final t’s are crossed and the i’s dotted.
The RTS and ITS are narrow in focus and technical in nature, but important nonetheless:
In May the EBA also published draft guidelines on capital measures for foreign currency lending to unhedged borrowers under the Supervisory Review and Evaluation Process (SREP) on 23 May 2013, following a recommendation from the European Systemic Risk Board. The guidelines will form a part of the suite of EBA guidelines setting out common procedures and methodologies for the SREP being developed under Article 102(3) of CRD IV. They are subject to the finalisation of the SREP guidelines and may therefore be revised in due course.