Regulations Depending on Certified Credit Ratings

Credit ratings are used for regulatory purposes both at the international and national level.²⁴⁰ The use of credit ratings in financial market regulations depends on the authorities that establish the regulatory and supervisory frameworks. The most significant uses of credit ratings in regulations stem from US financial market regulations and, on the global scale, from the Basel II Accord. They persist in the Basel III framework.

CRAs that issue the credit ratings relevant for financial market regulations are commonly called certified CRAs. Their credit ratings are labeled certified credit ratings. The specific terminology attributed to this concept depends on the regulators using credit ratings in their regulations. US regulators use the NRSRO concept.²⁴¹ The US knows the most elaborate use of credit ratings for regulatory purposes. Certified CRAs are called NRSROs. Their credit ratings are labeled NRSRO ratings. On the global scale, the Basel Committee on Banking Supervision (BCBS) defines certi-fied CRAs as External Credit Assessment Institutions (ECAIs) in the Basel II and III frameworks.²⁴² National regulators are free to decide whether to implement the Basel II Accord or the newly revised Basel III framework, and use the ECAI terminology in their own financial laws.²⁴³ For instance, the Swiss FINMA is in charge of recognizing CRAs used in Switzerland for regulatory pursposes.²⁴⁴ This supervisory authority publishes a list of certified CRAs and monitors the agencies on its list regularly.²⁴⁵

As long as the application of financial market regulations turns on credit ratings, there is no doubt that a regulatory approval of CRAs is needed.²⁴⁶ A

240 FSF,Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, at 38.

241 ABDELAL, Capital Rules, The Construction of Global Finance, at 168; see also WHITE, Financial Regulation and the Current Crisis: A Guide for the Antitrust Community, at 30.

242 BCBS,International Convergence of Capital Measurement and Capital Standards, A Revised Framework (Basel II), para. 90; BCBS, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems, at 52-53.

243 See IOSCO,Report of the Task Force on the Subprime Crisis, at 23; see EU Regulation (EC) No. 060/2009 of the European Parliament and of the Council on Credit Rating Agencies, art. 2, para. 3 (referring to the ECAI terminology).

244 See, e.g., LOMBARDINI, Droit bancaire suisse, at 146.

245 Swiss FINMA Circular on Recognition of Rating Agencies for the Assessment of Capital Adequacy Requirements, para. 39; see MEIER, Regulierung von Ratingagenturen, Auswirkungen auf die Schweiz, at 946.

246 SCHWARCZ, The Role of Rating Agencies in Global Market Regulation, at 307.

variety of recognition criteria determine the regulatory decisions as to which CRAs deserve to be labeled certified CRAs.²⁴⁷ The most significant criterion relates to CRAs' credibility with international or domestic market participants.²⁴⁸

Credit ratings are generally used by regulators for two main purposes:

determining risk-sensitive capital requirements and defining investment restrictions.²⁴⁹

a. Bank Capital Requirement Regulations

Bank capital requirement regulations are especially used in the banking and securities sectors.²⁵⁰

First, capital requirement regulations consist of the most elaborate incorpo-ration of credit ratings in financial market regulations. On the global scale, the BCBS enacted the Basel II framework in 2004, providing a solution to determine the riskiness of assets based on CRAs’ assessments.²⁵¹ The BCBS proposed to use credit ratings in risk-sensitive bank capital require-ments because credit ratings provide a relatively standardized, harmonized and easy-to-understand measure of credit risk.²⁵² The Basel II framework was heavily criticized in the financial crisis that hit the financial markets in 2007 because of its failure to establish adequate measures to supervise the banking system. Post-crisis reforms were needed. Basel III is considered to be the core regulatory response to problems revealed by the recent financial crisis.²⁵³ Basel III consists of a compilation of reform measures to strength-en the regulation, supervision and risk managemstrength-ent of the banking sector.

Although reducing reliance on credit ratings is portrayed as an area of focus, at this stage Basel III reforms still rely extensively on credit ratings to as-sess bank capital requirements.²⁵⁴ The BCBS has not yet been able to pro-pose any suitable alternative to external credit ratings, i.e. credit ratings continue to play an important role in bank capital requirement regulations.

247 IOSCO,Report on the Activities of Credit Rating Agencies, at 8.

248 Id.

249 THE JOINT FORUM,Stocktaking on the use of credit ratings, at 3-4.

250 See further id. at 4-8.

251 BCBS,International Convergence of Capital Measurement and Capital Standards, A Revised Framework (Basel II), para. 50. The BCBS is an international body that establishes international standards relevant for national regulators and financial institutions such as banks. See, e.g., WEBER & DARBELLAY, The regulatory use of credit ratings in bank capital requirement regulations, at 4; see also ALEXANDER ET AL., Crisis Management, Burden Sharing and Solidarity Mechanisms in the EU, at 12.

252 BCBS, Consultative Document, Strengthening the Resilience of the Banking Sector, at 55.

253 WELLINK, The New Framework for Banking Supervision, at 4.

254 Id.

National regulators implement the Basel II Accord, and subsequently the Basel III framework, on a voluntary basis. In the EU, the EU Capital Re-quirement Directive of 2006 outlined necessary measures with respect to the establishment of capital adequacy requirements applying to investment firms and credit institutions; the Directive implemented Basel II at the EU level.²⁵⁵ In Switzerland, the Federal Council enacted the Swiss Capital Ad-equacy Ordinance of 2006 with a view to partly incorporating the Basel II Accord into Swiss legislation.²⁵⁶ Based on the Ordinance, the Swiss FIN-MA published a circular to define the criteria used in Switzerland to recog-nize CRAs for regulatory purposes.²⁵⁷ The EU and Switzerland are cur-rently assessing proposals to implement Basel III reforms in their financial laws.²⁵⁸ Overall, focus is put on addressing the “too big to fail” problem.²⁵⁹ Neither the EU nor Switzerland have come forward with alternatives to the regulatory use of credit ratings. Nevertheless, the EU is considering reduc-ing over-reliance on credit ratreduc-ings by removreduc-ing regulatory references to credit ratings.²⁶⁰ Switzerland, however, has not yet initiated any steps to move away from credit ratings as highlighted by the recent draft amending the circular on CRAs’ recognition.²⁶¹

b. Regulatory Investment Restrictions

Investment limitations are especially used to supervise institutional inves-tors.

The use of credit ratings for regulatory purposes is generally less extensive in the insurance and pension funds sectors.²⁶² Above all, investment restric-tions are used in the US for institutional investors.²⁶³ In the US, many State

255 EU Capital Requirement Directive of 2006, preamble (5); see CINQUEGRANA, The Reform of the Credit Rating Agencies: A Comparative Perspective, at 5-6.

256 MEIER, Regulierung von Ratingagenturen, Auswirkungen auf die Schweiz, at 946; NOBEL, Schweizerisches Finanzmarktrecht und internationale Standards, at 205.

257 Swiss FINMA Circular on Recognition of Rating Agencies for the Assessment of Capital Adequacy Requirements.

258 See, e.g., Swiss “Too Big Too Fail” Report (Swiss TBTF Report), at 4 (adding that the proposed requirements are more rigorous than the minimum standards of Basel III).

259 KAUFMANN &WEBER, The Role of Transparency in Financial Regulation, at 785.

260 EU Public Consultation on Credit Rating Agencies, at 5.

261 Swiss Amendments to FINMA Circular 2008/26 Rating Agencies, at 8-9.

262 Nevertheless, pension funds and insurance companies may also use credit ratings in their investment guidelines even in jurisdictions in which they are not required by law to do so. For instance, in Switzerland institutional investors tend to turn to credit ratings regardless of any regulatory mandates.

263 See further THE JOINT FORUM, Stocktaking on the use of credit ratings, at 7 (explaining that – with respect to the designation of permitted investments – many jurisdictions reported that credit ratings were used both in the banking and securities sector; the United Kingdom Financial

insurance laws describe permitted investments or concentration limits in terms of credit ratings.²⁶⁴ In the EU, insurance and reinsurance directives do not currently contain any provisions that place reliance on CRAs.²⁶⁵ Broadly speaking, credit ratings used for investment restrictions serve to identify or classify eligible assets, or to define permitted asset concentra-tions.

In this regard, the rule that has the most significant effect on the financial system relates to threshold investment-grade rating. Investment-grade rat-ing is the opposite of speculative-grade ratrat-ing. Constrained investors may be forced to hold assets rated above a certain level deemed prudent. As a consequence, they may have to sell assets if their assets are downgraded below the investment-grade level. Therefore, it is not surprising that there is a large yield discontinuity between investment-grade and below-invest-ment-grade ratings.²⁶⁶ Rating-based regulations in effect influence the availability and cost of capital.

In the banking and securities sectors, investment limitations may be im-posed on specific entities. Investment limitations refer to asset identifica-tion, including – for instance – the designation of permitted investments for mutual funds as well as the establishment of investment concentration lim-its for particular types of assets.²⁶⁷ Moreover, a significant number of juris-dictions use credit ratings for regulatory purposes in the fields of securitiza-tions and covered bond offerings.²⁶⁸ Some regulations require that issuance has to be rated by one or more CRAs prior to being offered to investors.

The breadth of the regulatory use of credit ratings varies, some regulations covering all securitizations and some other covering only certain identified types of securitizations.²⁶⁹

Services Authority (UK FSA), however, noted that credit ratings were not used for asset identification in any of its three financial sectors).

264 Id.

265 Id. at 5.

266 PARTNOY, Overdependence on Credit Ratings was a Primary Cause of the Crisis, at 4.

267 THE JOINT FORUM,Stocktaking on the use of credit ratings, at 7.

268 Id. at 8 (also describing securitizations as the process of pooling assets and issuing securities representing interests in that pool of assets, and describing covered bond offerings as debt securities issued by banks and other credit institutions, repayment being secured by a pool of assets backing the bond).

269 Id. (explaining that, for instance in Italy, credit ratings are required by regulation only when securities are sold to non-professional investors).

3. Distortions of Competition with respect to Rating-Based