ECB criteria risk closed shop for raters
The European Central Bank's role in capital markets financing has never been more important, with Covid-19 prompting an increase in purchase and repo operations, and for securitisation in particular banks have accessed central bank funding in preference to their asset-backed programmes, where spreads remain well wide of pre-pandemic levels.
Eligibility for eurosystem programmes such as the various long-term refinancing operations – or LTROs – depends in part on ratings but the ECB only recognises ratings from four firms: Moody's, S&P, Fitch and DBRS.
Not being on that list can put other ratings agencies at a huge commercial disadvantage, with few issuers willing to pay for a rating that doesn't confer ECB eligibility.
"It's an oligopoly – the central bank is actively closing down competition," says Mauricio Noe, head of Europe at Kroll Bond Rating Agency.
"The last LTRO was for €1.3trn and every one of those securities has to be rated by one or more of those four firms. This means a closed shop, which improves their profitability to the detriment of anyone trying to compete with them," Noe said.
Raters in Europe are supervised by the European Securities and Markets Authority, which has registered dozens of rating firms and whose mandate includes fostering competition in the sector as well as maintaining stringent standards.
CATCH-22
For the ECB, though, a green light from ESMA is not enough. The central bank also requires rating agencies to demonstrate broad market coverage for a minimum of three years before it will consider adding them to its list.
But that creates a Catch-22 situation that some say would force new rating agencies seeking ECB recognition to spend years giving ratings away for free. To satisfy the ECB a rating agency would have first to rate a large number of issuers, but few companies are willing to pay for a rating that doesn't confer ECB approval.
"The fact it’s only the four agencies with ECB recognition is just a monumental impediment to new agencies establishing," said Dave King, chief executive officer at ARC Ratings.
"For now we have decided we will focus on niche markets – we are locked out of the biggest market by far."
KBRA has a similar strategy. "We are competing head-to-head on CMBS, CLOs and on esoteric assets, which are not eligible for the ECB, but when assets are eligible it becomes nigh-on impossible,” said Noe.
Unlike ARC and KBRA, Scope Ratings made the decision to try to get onto the ECB's list and invested around €80m to ramp up its coverage.
It says it hit that coverage target at the end of 2018, so should be able to apply for ECB recognition by the end of 2021.
Guillaume Jolivet, managing director at Scope, acknowledged the difficulties in charging issuers for ratings without that ECB recognition and said the firm used a different business model in order to build coverage.
"The additional coverage comes from ratings that are not public but are only available to our subscribers – and those ratings are solicited by our subscribers, whether they are investors, intermediaries, issuers and so on," Jolivet said.
"There is a lot of appetite for an alternative view – for a European view," he added. Scope is based in Germany, while the four incumbents are all headquartered in North America.
ECB RATIONALE
Although the ECB's additional criteria put it at odds with ESMA, the central bank is forced to take rating agencies more seriously than a typical asset manager.
That's because if a security meets its criteria, including a minimum rating from an approved agency, it is then required to buy or repo that security.
By contrast an investor – in theory at least – would use a rating just as a starting-point before going on to make their own credit decision.
In a 2018 letter to MEPs, the ECB's then president Mario Draghi said the minimum coverage requirements were designed to demonstrate an agency's ratings have market acceptance, and broad credit risk expertise – the latter particularly important for complex products such as structured finance where the various counterparties in a transaction will also need a credit assessment.
The requirements are also designed to ensure ratings are comparable and mutually consistent between countries, asset classes and issuers, Draghi said.
Securitisation market participants themselves have in the past been worried that too many rating agencies fighting over the same business could potentially lead to lower standards, or so-called ratings shopping among issuers.
"It's good to have a level playing-field but you also have to make sure you are comparing apples with apples – you have to be confident that a Triple A from one agency is as consistent as that from one of the others," said one ABS syndicate banker.