Reform of Credit Rating Agency Regulation in Europe: An End-investor Perspective
by Joanna Cound, Managing Director, and Stephen Fisher, Director, BlackRock
Ratings provide a benchmark or a reference point that investors use to evaluate a security or issuer’s potential eligibility for the inclusion of that investment in a portfolio. Without globally recognised standards for inclusion or exclusion, investor uncertainty about the credit quality of the investment could undermine the confidence of investors.
The financial crisis brought into sharp focus a number of weaknesses in the Credit Rating Agency (CRA) business model. Regulators, globally, have sought to address these weaknesses in the CRA business model and to modify investor behaviour by discouraging an over-reliance on ratings.
In Europe, the third reform of CRA regulation (“CRA3”) since the financial crisis is currently underway. BlackRock supports the rationale behind many of the proposals in the CRA3 package but we are nonetheless concerned that key elements of the package could impair the investment performance and choice of our clients with adverse effects for both European institutional and retail investors including households, pensioners and savers.
This article provides background on the use of ratings in the investment process, establishes the case for further reform of CRAs and the ratings process and summarises concerns expressed by investors with respect to the CRA3 proposal in Europe.
Against this backdrop, we recommend policy makers focus on:
- Analysing the impact of regulation that enshrines the use of ratings in, for example, bank capital and liquidity ratios, and discouraging over-reliance on ratings elsewhere.
- Allowing the market to determine the quality of CRA analysis by increasing transparency, notably by ESMA publishing a matrix establishing CRA’s rating performance.
- Implementing existing CRA regulations to facilitate the effective supervision of CRAs by the European Securities and Markets Authority (ESMA).
How do investors use credit ratings today?
While we believe CRAs provide valuable information to the investment process we would emphasise that we regard it as our fiduciary duty to our clients to perform our own credit research. BlackRock’s active investment philosophy emphasises a commitment to fundamental research and independent credit evaluation. Our research team follows a rigorous process when assessing the creditworthiness of a security. In order to develop a formal view, we conduct both quantitative analyses of corporate capital structures and qualitative assessments of management and industry positioning.
Many clients have investment guidelines which limit their holdings to instruments which carry third party ratings or funds which invest primarily in such instruments. We consider such ratings as a preliminary screen in our own independent credit review; that is, we use the ratings as a ‘starting point’ in our assessment of an investment, formulating our own independent ‘credit opinion’ about an issuer or a specific investment instrument. Our assessment does not end when we purchase a security. Just as each CRA may upgrade or downgrade issues, our credit analysts apply an independent assessment of each security throughout the period that we hold the security in a portfolio which includes monitoring CRA ratings changes.
We believe that this conforms to policy-makers’ expectations of how investors should use credit ratings. ESMA has recently clarified – in respect of its money market fund classification – that “management companies should ensure that they have proper procedures and processes in place to enable them to assess the credit quality of an instrument without relying solely on credit ratings produced by credit rating agencies. In particular, management companies should always conduct an internal assessment of the credit quality as a key element of their decision on whether to invest in that instrument”.
The ESMA money market fund classification also defines minimum credit ratings for the securities held by money market funds. These are A2 for bank and corporate securities and investment grade for sovereign debt. A ratings downgrade could therefore trigger the disposal of downgraded securities. ESMA specifies in this case that “the management company should immediately assess how best to bring the fund back into compliance with its guidelines. It should take remedial action as soon as reasonably practicable, taking into account the best interest of the investors at all times”.