Credit Rating Agency:

Functioning of credit rating agencies

The main activity of credit rating agencies is to issue opinions on the creditworthiness of
a particular issuer or financial instrument, or the likelihood that it will honour its financial
obligations. Credit ratings are divided up into categories, going from low-risk or
investment grade to high-risk or speculative grade. They are based on the revenue stream
and balance sheet of the issuer being rated, as well as past financial performance.
Many credit rating agencies provide other financial services as well, such as investment
advice.
Impact on the financial markets
Credit ratings carry considerable weight in financial markets, both in terms of business
practice and regulatory requirements. The Commission notes that the credit rating
agencies generally play a very positive role in the markets for both investors and issuers.
Issues of concern
In its Resolution of February 2004, the European Parliament underlined how important it
was that the credit rating agencies exercise their functions responsibly. It noted four main
issues of concern:

the quality of the ratings;

the agencies' independence and objectivity;
transparent credit rating methods;
a high degree of concentration in credit rating activities and its possible
anticompetitive effects.

EU legislation
Three Directives relating to the Commission's Financial Services Action Plan (FSAP) are
relevant to credit rating agencies:

the Market Abuse Directive (MAD) and its implementing Regulation and
Directives;
the Capital Requirements Directive (CRD);
the Markets in Financial Instruments Directive (MiFID).

The Market Abuse Directive tackles insider dealing and market manipulation, which
prevent full market transparency. In general, agencies must follow internal policies and
procedures designed to ensure objective, independent and accurate credit ratings. This
Directive prohibits:

the use of inside information to acquire or dispose of financial instruments to

which that information relates;
the disclosure of inside information to anyone else except in the normal course of
employment, profession or duties.

The CRD Directive (1993/6/EC) introduces a new capital requirements framework for
banks and investment firms.
The use of credit assessments by External Credit Assessment Institutions (ECAI) is
considered essential to the determination of risk weights and consequential capital
requirements applied to a bank or investment firm's exposures. The CRD sets out the
main reliability and quality requirements the credit rating agencies must meet in order to
be recognised as ECAI.
Finally, the Markets in Financial Instruments Directive (MiFID) is applicable only to
credit rating agencies undertaking investment services and activities over and above their
regular credit rating activity. It imposes a number of rules concerning organisational
structure and conduct of business.
This comprehensive legal framework has to be transposed into national legislation. The
Commission monitors this transposition process very closely and may initiate
infringement procedures against a Member State if it does not fulfil its obligations.
However, the Commission does not share the European Parliament's concerns about the
degree of market concentration in the credit rating industry.
The IOSCO Code of Conduct
In September 2003, the International Organisation of Securities Commissions (IOSCO)
published its Statement of Principles Regarding the Activities of Credit Rating Agencies
(PDF ). This document is aimed at reinforcing investor protection, market fairness,
efficiency and transparency and reducing the systemic risk. It subsequently led to the
creation of the IOSCO Code of Conduct.
Whereas EU legislation applies only within the EU, the IOSCO Code of Conduct applies
to credit rating agencies operating worldwide. Agencies are required to fully incorporate
the Code into their procedures. The Commission will request the Committee of European
Securities Regulators (CESR) to monitor compliance with the IOSCO Code and to report
back to it on an annual basis.
Background
Credit rating agencies are crucial to the functioning of the financial markets. Following
the Enron and Parmalat fraud scandals and the European Parliament's Resolution of
February 2004, the Commission has looked into the way these agencies function. The
conclusion was that credit rating agencies are sufficiently covered by three Directives
relating to the Commission's Financial Services Action Plan (FASP) and by the IOSCO
Code of Conduct, and that therefore there currently is no need for new legislation.