18 May 2011

ESMA issues Guidelines on endorsement and clarifies the use for regulatory purposes of credit ratings issued outside the EU

The Guidelines address how ESMA will implement the 'as stringent as' test for credit ratings produced outside the EU, in what are named third countries. The credit ratings are used by financial institutions to assess the risk of their exposures and in calculating the capital requirements.

The test requires that the credit rating activities performed by Credit Rating Agencies (CRAs) outside the European Union are subject to requirements established by law which are “as stringent as” those key phases concerning the use of non EU credit ratings which are not endorsable.

ESMA’s Guidelines clarify that EU CRAs can continue to issue credit ratings produced outside the EU after the 6 June, at least until the point of registration. If at the point of a CRA’s registration, credit ratings issued outside the EU are not considered endorsable in the European Union, because an appropriate regulatory regime has not entered into force in the relevant third country (or the other necessary conditions as set out in the Regulation are not in place), the use of such credit ratings for regulatory purposes by financial institutions will still be possible for three months from that date.

ESMA will assess whether the use of such credit ratings can continue for another three-month period, in order to avoid the potential for market disruption or financial instability. This would be communicated to the market as soon as the decision is taken. According to Article 40 and Article 24 (2) the possibility to keep using credit ratings issued outside the EU for a period of three months (and potentially for a further 3 months), is embedded in the EU Regulation (please see the ‘notes for editors’ for further details).

Disclosure

After registration, EU CRAs will be asked to indicate to the public those credit ratings issued in third countries which are not endorsable in the EU, and to clarify that these credit ratings can still be used for an initial period of three months. ESMA in turn will disclose relevant information concerning these circumstances to the public.

Implementing the conditions for endorsement

In order to assess whether a third-country regulatory regime has met the conditions for endorsement, ESMA will continue to apply the approach outlined by CESR in June 2010 (Ref. CESR/10-347). This requires a third country to have adopted rules "as stringent as" those provided by the EU CRA legislation. It is a safeguard provided by the Regulation to ensure the quality of ratings used in the European Union.

However, as set out in the Guidelines, there will be flexibility in assessing the requirements applicable in the third country. The wording of the provisions will not need to be identical to those set out in the EU Regulation. ESMA will take a global and holistic view in assessing to what extent the third-country legal framework achieves similar adequate regulatory effects and meets the same objectives as the EU Regulation. Where the EU-Commission has recognised that the regulatory regime of a third country is equivalent to the EU Regulation, it is possible to refer to this decision in respect of the “as stringent as” test set out in Article 4 (3) (b).

In this regard, CESR (as ESMA’s predecessor) has been mandated by the European Commission to review the equivalence of four countries (Australia, Canada, Japan and the US). The Commission has identified Japan’s regulatory regime as equivalent through a formal decision in September 2010. Regarding the US, no formal equivalence decision has yet been taken. However, ESMA is monitoring the improvements to the legislation anticipated by the Dodd-Frank Act, and will be able to continue its assessment as soon as the draft secondary legislation is disclosed by the SEC.

In any event, when ESMA assesses the legal and regulatory framework of a third country and concludes the “as stringent as” test with a positive result, the credit ratings issued in that particular third country are eligible for endorsement also in the absence of a Commission equivalence decision.  ESMA has carried out some work on a number of other jurisdictions in order to assess the requirements of Article 4(3).

© ESMA