In my paper (available here), I discuss the newly approved regulation regarding Credit Rating Agencies (“CRAs”) in Russia and examine, using a comparative analysis, whether the introduced rules match the expectations of the Russian government.
Since the financial crisis of 2008, CRAs have been under scrutiny for their role in the proliferation of structured finance products. It has been questioned whether their methodological tools and evaluations have been up to standard. As is well known, CRAs are multinational enterprises that operate on a global basis. Their evaluations can affect the stability of the international markets. As a legal response to the many concerns raised regarding CRAs, different approaches have been applied to the regulation of the use of credit ratings in the US and EU, although these regimes contain a number of similarities, as discussed further below. Against this backdrop, the government of the Russian Federation recently introduced a new regulation on CRAs drafted along the lines of the EU Regulation. The measures are mainly targeted at managing the conflicts of interest that arise, including by introducing governance reforms, improving the quality of rating methodologies for structured finance, increasing the transparency and disclosure obligations to which CRAs are subject, and introducing direct government oversight to replace self-regulation.
The Russian Regulation on CRAs, in common with those in the US and EU, requires rating agencies to register with a financial supervisor, which in the case of Russia will be the Central Bank of Russia (CBR). The CBR will have to grant every rating agency a judgement of conformity with Russian requirements, and will be involved in the day-to-day supervision of those entities. The Russian Regulation on CRAs lays down the conditions and the procedure for granting, refusing, suspending and withdrawing registration. This licence will hopefully increase the number of players in the industry and therefore, through an increase in competition, reduce the power that CRAs have acquired in recent years. However, as a number of commentators have pointed out, size and market recognition (reputation) may be higher barriers to entry than regulatory status (see eg Frank Partnoy, The Siskel and Ebert of Financial Markets? Two Thumbs Down for the Credit Rating Agencies (1999) 77 Washington University Law Quarterly). An increase in competition without addressing other issues, such as the issuer-pays business model and the rating-based regulation for financial institutions, may result in a trivial exercise. As long as CRAs receive their payments from issuers, a strategy of increasing competition might actually lower the quality of ratings. The reason for this is that new entrants would probably compete by offering higher ratings or by lowering prices. By doing so, both the level of effort in ratings and their reliability would be compromised. Additionally, the reputational incentives of CRAs would be proportionally reduced by the increase of competitors. Finally, it has been noted that a limited number of global CRAs promotes greater consistency and uniformity in ratings across markets, making it easier for investors to compare debt securities issued in different countries. For these reasons, the US Dodd-Frank Act, although affirming that the credit rating market should be competitive, does not make competition a specific objective and it is improbable that the number of authorized credit agencies in the US will increase in the near future.
A large part of all implemented regulations regarding CRAs have been dedicated to reducing the conflicts of interest to which CRAs are subject. To this end, the Russian Regulation imposes several requirements of disclosure on CRAs – described in detail in the article. CRAs will have to comply with rigorous rules to make sure that ratings are not affected by conflicts of interest, that the quality of their rating methodology and their ratings does not deteriorate, and that they act in a transparent manner. For instance, ownership thresholds for certain categories of investors are introduced as well as obligations for CRAs to publish their methodologies and credit rating histories. Furthermore, the Regulation prohibits any clause that links CRAs remuneration to the performance of the credit ratings issued. CRAs are also prohibited from providing their clients with consultancy services.
For the particular task of issuing sovereign ratings, CRAs will have to follow an approved calendar to be agreed with the CBR as appropriate. If the rating is unsolicited, the CRA will have to mention it. In any case, the CBR has the right to add supplementary requirements for the disclosure of certain ratings. These provisions are intended to achieve a compromise between the political interest in ratings of sovereign debt and the maintenance of objectivity and independence in its regulatory regime. The provisions will prevent situations of rating downgrades driven by superficial perceived dangers that do not take into account the country’s economic context and unique features.
As regards governance rules, CRAs will have to set up advisory and executive boards of directors, at least one third of which (or a minimum of two individuals) must be independent non-executive directors, as well as establishing internal controls and compliance functions. All nominations for directorship of a CRA will be proposed by a shareholders’ meeting and by the head of internal audit and accounting and then communicated to the CBR for acceptance. Those nominated must comply with the highest reputational standards for professionals involved in such a business. The law also defines the professional requirements and independence criteria that financial analysts must fulfil in order to become part of CRAs’ rating committees.
Where the Russian approach seems to diverge from that adopted in the US and EU is in relation to the civil liability of CRAs, and the involvement of ratings in banking capital regulation. In the US, section 939G of Dodd-Frank rescinded the exemption from liability under section 11 of the Securities Act of 1933, which rating agencies previously enjoyed under Rule 436(g). After this amendment CRAs became exposed to liability for misconduct in the same way as other gatekeepers such as accounting firms or securities analysts, although only time will tell whether this rule will address CRA failures. A similar approach was taken in Europe where art 35(a) of Regulation 462/2013 established a liability regime for CRAs, especially in circumstances where the absence of a contractual relationship would make it difficult to impose civil liability. Despite these clear examples, the Russian regulator so far has decided not to include any similar provision.
Regarding the problem of rating-based regulation, which is a cause of market over-reliance on CRAs and has facilitated bad practices that have compromised the integrity of their ratings, the US and EU approach diverge. The US Dodd-Frank Act follows the belief that ratings should not be given a “regulatory licence” relative to other forms of financial risk assessment. Accordingly, the objective of the Dodd-Frank Act of 2010 was to remove certified CRAs’ quasi-governmental function and to consider them as exclusively private-sector entities. The same goal is stated in the EU Regulation on CRAs No 462/2013 (CRA III) introduced by art. 5a. However, although the importance of the external assessment (standardised approach) has been reduced it still remains within key EU banking capital regulation (CRR/CRD IV) and is embedded in a certain number of regulatory and contractual provisions. Furthermore, the EU regulation on CRA amended in 2011 (CRA II) included hedge funds among the issuers that are required to use ratings issued by registered or certified rating agencies strengthening the role of CRAs. Recently, the EU Commission released two studies on the ‘State of the Credit Rating Market’ and ‘Feasibility of Alternatives to Credit Ratings’ (December 2015 and January 2016). Both studies demonstrate the importance of CRA ratings for the EU financial market, even when they are used as complementary tools, and the need for increasing competition and reducing conflicts of interest. The Russian regulator has not dealt with this issue yet.
Russia presents a great market for CRAs, which have increased their profits significantly in a very few years. Likewise, the Russian economy needs CRAs in order to raise foreigner funds in order to develop its market. In furtherance of this aim and to banish all doubts as to whether CRAs are driven only by private market forces, Russia recently welcomed a multilateral independent CRA called UCRG (Universal Credit Rating Group) resulting from a partnership between China’s Dagong Global Credit Rating, US-based Egan-Jones Rating Company, and Russia’s RusRating.
Lorenzo Sasso is Associate Professor of International Commercial Law at the National Research University – Higher School of Economics in Moscow and a guest contributor to the Oxford Business Law Blog.