Mandatory rotation of rating agencies as set out in regulation proposed by the European Commission in November would be disruptive and damaging, according to industry representatives – who plan to lay out their opposition shortly – and the dominant rating agencies in Europe, although DBRS is in favour of it.

The commission in November issued a draft regulation and directive that amends the existing framework regulating credit rating agencies (CRAs), with a rotation rule set to have the most “striking” impact on the covered bond market, according to Jan King, senior covered bond analyst at RBS. Other measures included in the draft revised framework relate to the independence of CRAs, civil liability for breaches of European Union (EU) rules, and the frequency of updates of EU sovereign ratings. The law is expected to come into force by the end of 2012, said King.

Under the rotation rule, issuers would be subject to restrictions on the duration of contractual relationships with individual rating agencies for rating them or their securities. Included in the rotation proposals, according to RBS’s King, are a rule that issuers generally have to change the agency rating them every three years, with the same rule normally applying to ratings of individual debt instruments, and a cap of six years on the length of a contractual relationship between an issuer and a rating agency. Additionally, once a rating agency has rated 10 consecutive debt instruments of the same issuer it should stop assigning new ratings or may continue up to the end of a maximum period of only 12 months in total, and a cooling off period of four years must pass before a rating agency can restart coverage after being dropped.

“This effectively raises the need for additional rating agencies being widely accepted and well established in the covered bond market,” said King, “unless issuers opt to be rated by only one rating agency at a time on a rolling basis every three years between S&P, Fitch and Moody’s.” (See table below.)

The proposal has raised concerns among covered bond market participants, according to bankers working with members of the European Covered Bond Council (ECBC), which together with the European Mortgage Federation (EMF) is due to publish a formal position paper on the regulation in the coming days.

Boudewijn Dierick, head of structured covered bonds at BNP Paribas and chair of the ECBC rating agency approaches working group, opposes obligatory rotation of rating agencies, saying that the EC proposal is unworkable and could have negative implications, such as increased ratings volatility and reduced rating quality.

In an article for an EMF newsletter co-authored with Frank Will, head of covered bond and supra/agency research at RBS and chairman of the ECBC EU legislation working group, Dierick said that the ECBC rating agency approaches working group has over recent months been collecting feedback from all covered bond jurisdictions and actively liaising with the commission and European Securities & Markets Authority (ESMA).

“The working group has established a constructive dialogue between the European Institutions/Authorities and the market stakeholders, which has allowed the covered bond community to raise its concerns and to highlight the market implications of the CRA III Proposal,” wrote Dierick and Will.

The Covered Bond Report understands that the ECBC is keen for the rotation rules in their current form to be removed from the final regulation.

The dominant rating agencies in the European covered bond market have come out against the rotation proposals, with Fitch, for example, referring to them as “likely to be the most detrimental to European companies’ ability to compete for European and foreign capital and investors’ ability to use ratings as useful tools”.

The rating agency said that the proposals are likely to worsen, rather than improve, the quality of ratings and their usefulness as tools for financial investors.

A Moody’s spokesperson said that forced rotation “is an experiment that will lead to standardisation and reduced offering of opinions”.

“It will remove incentives to improve ratings quality and long term performance,” she said.

Standard & Poor’s also has concerns about the rotation proposals. Martin Winn, European head of communications at S&P, told The CBR that the rating agency is in favour of competition, but that this should not be forced.

“Issuers and investors should be free to choose whether and which ratings to use, rather than having the choice dictated by regulation,” he said.

S&P believes that mandatory rotation as proposed by the commission would be very disruptive and lead to greater rating instability, said Winn, with covered bond issuers most severely affected. This is because of the frequency with which they come to market and the requirement, under the prevailing EC proposal, that once a rating agency has rated 10 consecutive debt instruments of the same issuer it should stop assigning new issue ratings, or may continue up to the end of a maximum period of only 12 months in total.

“This means that after a relatively short time period an issuer would be stripped of its ability to use globally recognised ratings,” said Winn.

Disagreements over the impact of the rotation proposals revolve in part around their implications for competition in the rating industry and consequently for the quality of ratings.

DBRS, for example, considers that the rotation proposals would help pave the way for greater competition, which would be a positive development.

Alan Reid, managing director at DBRS, told The CBR that the rating agency is in favour of the concept of rotation of rating agencies and that it considers the commission’s proposal to be the first meaningful step to address a lack of competition, although it recognises that some changes may be made to the existing proposal to encourage a broader use of rating agencies.

“The barriers to entry in the rating industry are very high,” he said. “Without some form of rotation competition will be suppressed, which is bad for investors and issuers.

“The more rating opinions are available there is less rating volatility and reliance on household raters.”

He highlighted, for example, that where an issuer chooses four rating agencies the rotation requirements would be minimal.

Dierick, however, disagreed that rotation would increase competition and therefore boost the quality of ratings.

“History shows that isn’t the case,” he said. “When a third rating agency entered the industry in the US, results were worse.”

He favours a greater role for supervision of rating agencies’ track record and the quality of their records rather than mandatory rotation.

ESMA on 2 February launched a database (Central Rating Repository, CEREP) , which it said will allow investors for the first time to assess on a single platform the performance and reliability of credit ratings on different types of ratings, asset classes, and geographical regions over a time period of choice.

Fitch said that many aspects of the proposals will stifle rather than encourage meaningful competition, and may encourage rating shopping, with potential also for ratings inflation.

DBRS’s Reid disagreed that rotation could, via a chain of effects, undermine the quality of ratings.

“Given that the rating agencies are subject to the same regulation by ESMA and went through the same highly detailed registration process to be registered in Europe it would be erroneous to say that ratings will be compromised,” he said.

RBS’s King said that the entry into the market of more rating agencies in addition to the established three is unlikely to lead to a significant increase in rating agency fees, with any drop in revenues potentially negatively impacting the quality of ratings analysis.

Reid acknowledged that greater competition in an industry impacts pricing, but said that this “should be a benefit to issuers because competition should result in shrinking fees”, and that a reduction in the overall cost of ratings as a result should not compromise the quality of rating agencies’ analysis given that the rating agencies are now subject to regulation.

Source: EMF, RBS

According to Will and Dierick, if high frequency covered bond issuers (more than 10 issues per year) want to maintain issue ratings by three rating agencies, then eight rating agencies would be needed to enable issuers to comply with the proposed rotation rule. Volume-weighted Bloomberg data, according to the bankers, shows that 38% of covered bonds have three ratings and another 41% have two, with around 20% of covered bonds featuring one.