Article Preview – “Artificially Increasing Competition in the Credit Rating Industry: The ESMA Meets an Immovable Object” – European Company Law

Today’s post previews a forthcoming article by this author, entitled ‘Artificially Increasing Competition in the Credit Rating Industry: The ESMA Meets an Immovable Object’, which will be published in the European Company Law Journal (available here in a pre-published form). The paper is concerned with the recent push by the European Securities and Markets Authority (ESMA) to enforce an increase in competition within the credit rating industry, particularly with regards to the rating of structured products. However, even though the rules that dictate that regional authorities must endeavour to enforce this new regulatory drive are clear, an analysis of the reality of the situation reveals that the only actor that can realistically dictate the movement of the industry, with regards to its output and internal competition, are the investors who use the ratings of the largest agencies.

The article begins by looking at the regulatory and legislative attempts from both the U.S. and the E.U. in response to the rating agencies’ complicity in developing the financial crisis, with the Dodd-Frank Act of 2010 and the three E.U. regulations seemingly aiming for two important supporting aspects of the agencies’ modern position: regulatory reliance and a lack of competition. Regulatory reliance has been tackled by removing reference to credit ratings in official documents and guidance, but this has had a limited effect due to the protections appropriated by the agencies. With regards to the issue of competition, the E.U., via the ESMA, is attempting to put an enforcement strategy in place regarding competitive issues in the form of enforcing the usage of smaller agencies by issuers who are issuing debt that requires two or more credit ratings. Yet, as Partnoy notes regarding the regulatory reliance issue, the same fundamental problem persists with regards to competition, and that is that investors are at the heart of determining change in this particular industry.

The E.U. has dictated that, based on the legislative orders found in CRA III – the third in a series of credit rating agency-focused regulations – ‘measures should be taken to encourage the use of smaller credit rating agencies [by way of] where two or more credit ratings are sought, the issuer or a related third party should consider appointing at least one credit rating agency which does not have more than 10% of the total market share’. The article, having positioned this approach, then seeks to assess the reality of the situation, and ultimately finds that there is little substance to the move. For example, where the issuer does not select the smaller agency to rate its issuance, the issuer must only document that they did not do so and detail some reasons why. The paper takes issue with this suggestive stance by detailing that were there are gaps in the regulation, financial entities will almost always exploit them. The obvious circumvention for issuers is to claim that the smaller agencies, who are incredibly small and under-resourced when compared to the Big Three, simply do not have the expertise nor resources to adequately rate the issuances at hand; whilst this is not really true because a number of smaller agencies have a high degree of accuracy when it comes to rating, the rationale in that defence has two important connotations. Firstly, the claim by issuers regarding size allows them to circumvent the regulations that have been put in place. Secondly, the basis of the claim reveals that the driving force in this arena are investors, as the reputation of the smaller agencies is what is actually the sticking point for issuers – investors simply do not allow for the smaller agencies to be selected as it increases, theoretically, the borrowing costs for the issuer via a less reputable credit rating source. Whatever the rationale, the paper finds that the regulations are simply not being adhered to, with the ESMA admitting that ‘unfortunately, successful implementation of these Articles has been hindered by a lack of clarity in a number of key areas’.

However, the actual response by ESMA to this obvious outcome is rather disheartening. Firstly, it suggests that all Sectoral Competent Authorities – the nominated financial authorities from each region in the E.U. – should converge to enforce the ruling. Secondly, ESMA reiterates the rules that were originally posed in the aftermath of the Crisis. That is it. The dejected tone in the supervisory briefing falls in line with the academic tone that has revolved around the industry for years: rating agencies do not act within the law, and the interested parties i.e. issuers and investors, perpetuate this phenomenon. Yet, the paper suggests that the proposed aims of the regulations are not wrong, but simply misguided. In order to demonstrate this point, the paper proposes that the concept of ‘position’ be applied to the industry and its connected parties, after which a clearer understanding can be establish. For example, on a number of occasions here in Financial Regulation Matters we have discussed the divergence between the reality of the situation and what is desired by outside parties, and ESMA has unfortunately fallen foul of this divergence like many before it. To explain, it is almost impossible under the current confines of the rating industry to enforce increased competitive pressures upon the Big Three because, quite simply, the natural oligopolistic structure of the industry dictates that it cannot. It is a natural oligopoly because investors, who are either a. retail investors who have a need for quick decipherable information or b. sophisticated investors who represent, usually, a large group of dispersed investors who again rely upon easily decipherable information, perpetuate the use of ratings simply because of their ease. If we align the fact that, traditionally, the corporate ratings of the agencies have been incredibly accurate, then the reputable basis that understanding develops means that investors will continue to rely upon what is seemingly easily decipherable and relatively accurate guidance. Arguably, what is required on the back of that understanding is an increased awareness of the differentiation in the rating agencies’ outputs, and the historical accuracy of each stream; whilst corporate ratings have been accurate (as it is easier to obtain necessary information and rate it accordingly for a corporate body), the same cannot be said for structured product ratings, which have been incredibly inaccurate due to the propensity of the agencies to reduce their analytical thoroughness for increased fees, whilst it also true that rating structured finance products – which may contain ‘pools’ of products like mortgages that can rank in the thousands in any given structured finance issuance – is tremendously difficult, time consuming, and resource intensive. Investors then are left with a simple choice between agencies who do not, potentially, have the resources to conduct such intensive investigations but have cleaner reputations, and agencies who do have the resources to conduct investigations, but who have traditionally not done so and who have incredibly poor reputations in the markets within which they are investing – quite a dilemma that only has one realistic outcome. In making this point as its conclusion, the paper proclaims that until regulators start to act on this differentiations and look at the roles the interested parties actually play, then there can be no development in this particular field.