The Treasury Select Committee (TSC) has taken evidence from expert witnesses Steven Maijoor, Chair, European Securities and Markets Association; Verena Ross, Executive Director, European Securities and Markets Authority; and David Lawton, Acting Director, Markets, Financial Services Authority, on the effects of the EU's proposed "CRA3" regulation of credit ratings agencies. While erroneously high ratings of structured finance products by credit ratings agencies were thought to be one of the causes of the financial crisis, it is unclear whether the EU's proposed regulation of them will be helpful or harmful for the users of ratings information. Today's TSC hearing aimed to gain expert input into the issue, and David questioned the witnesses on the content of the proposed regulation. The full transcript of the exchange is below:

Q101 Mr Ruffley: Ms Ross, on CRA3, as we know there is a proposal to introduce liability on ratings agencies where investors can demonstrate loss. Her Majesty's Treasury have said that placing unlimited liability on rating agencies, "could drive CRAs to limit their liability through withdrawing certain ratings or issue more conservative ratings or seek to limit their liability in other ways". What is the answer to that objection?

Verena Ross: It is absolutely a valid risk to identify. It is quite hard to know exactly how a market will react to the introduction of a liabilities regime.

Q102 Mr Ruffley: Do other jurisdictions have a similar law making CRAs liable for economic loss or is this just a European idea?

Verena Ross: I do not know exactly what the liability regimes are like in other countries outside Europe. I think the aim is clearly to try to improve the quality of the ratings that are produced, and by putting a more direct link between the credit rating agencies needing to be standing up for their rating-

Q103 Mr Ruffley: I think we all understand that, but the Treasury have said, in terms, that the CRAs might try to limit their liability by withdrawing certain ratings. So that is not going to help anyone, is it, if they just withdraw from the difficult areas where they think there might be a risk and they might cause loss if they get it wrong? It seems to be pretty much a knock-down argument, doesn't it?

Verena Ross: There could be a problem with introducing a liabilities regime. On the other hand, it is very hard to judge. It might not happen. They might not withdraw from key ratings. I just do not know the answer.

Q104 Mr Ruffley: We understand that the Treasury argument here is that a minimum of six CRAs may be required by 2015 to meet the demand of large issuers of structured products. Do you think six is a realistic figure or do you think the Treasury is wrong on that?

Verena Ross: There are certain rotation proposals, obviously, in CRA3 in terms of the timing, and it will depend a lot on how many structured ratings are issued how quickly that rotation would kick in. Also, in the structured finance area, there is a proposal in CRA3 that there would be more information about the underlying asset pools made available to the general public and to any rating agencies that would rate. In that context, the issue that David raised in terms of having sufficient background and information to do the next rating might be slightly ameliorated.

Q105 Mr Ruffley: The Treasury put it more bluntly, don't they? If it is going to be a minimum of six and, therefore, implicitly, perhaps more than six, they say, "In the absence of any eligibility performance criteria, CRAs would be assured of a market share, irrespective of the quality of their rating, perhaps resulting in a deterioration of ratings quality". Again, this could be quite a flaw in the CRA3 regime, don't you think?

Verena Ross: I think I said earlier that the rotation policy has at least that risk-that there could be deterioration in the quality of the ratings.

Q106 Mr Ruffley: You are going to have to implement some new regulatory standards. The Treasury also raise questions about this, for instance, in relation to the establishment of EURIX, based on a harmonised rating scale. That is an example of a proposal that would in their words "pose significant technical challenges, in respect of both Information Technology infrastructure and expertise in credit risk modelling". Do you think you have sufficient resources at your disposal at ESMA, as the prime regulator here, to manage those challenges? What is your budget?

Verena Ross: We currently have a budget of about ?16 million and staff of around 70 people. Clearly, for CRA3 we would require additional resource to fulfil the requirements in CRA3.

Q107 Mr Ruffley: Could you give us an order of magnitude? Twice your current budget or-

Verena Ross: As ESMA we have broader responsibilities than just CRA supervision and regulation. Currently we have about 15 staff working on CRA matters, mainly supervision, some on policy issues, and we think if CRA came into place, the way it is currently proposed, we would probably need an additional 20 to 25 people to fulfil those requirements-obviously, as you rightly say, also some IT budget to actually build the type of systems that are envisaged.

Q108 Mr Ruffley: That is very helpful. Perhaps Mr Lawton might want to also answer this question, but Ms Ross, could you tell us what further opportunities you see the UK having to influence the final shape of CRA3? What stage are we at in the negotiations and what scope does Britain have to press home, and I am presuming will be pressing home, some of the Treasury objections that I have just been reading out?

Verena Ross: I will leave the question on what the UK will do to David, but where we are in the process at the moment is that the proposals have been put forward by the Commission and are currently in the negotiation phase between the European Parliament and the Council. Basically they are both looking at the proposal, proposing revisions to those proposals, and ultimately will vote respectively on their preferred scenario. Then that will come together in the so-called trialogue.

Q109 Mr Ruffley: Mr Lawton, does the British Parliament have any say on this?

David Lawton: Of course, the Treasury is participating in the negotiations in the Council, as it would for any European regulation, but this will be a co-decision between the Council and the European Parliament. It is at a relatively early stage. There have been three Council working groups and the European Parliament have just produced a first draft report. My sense is that a number of other member states around Europe share some of the concerns that we have been discussing this afternoon.

Q110 Mr Ruffley: What is the timescale, in terms of months-this year, next year?

David Lawton: That would, in part, depend on the ambition of the respective presidencies, but I think that the aim is that this is something to be completed within the course of the next 12 months.

Q111 Mr Ruffley: Just one final question. Issuers rated by two rating agencies under CRA3 may retain one agency for six years-am I right in that?-but the other must be dropped after a three-year period. Is that correct?

David Lawton: Is that for structured finance products?

Mr Ruffley: Generally under CRA3, as I understand it. Can you help me here, Ms Ross?

Verena Ross: There is certainly a distinction. If you just have one credit rating agency or if you have already two rating you then there is a different rotation policy, but I have to admit I cannot exactly remember the dates now.

Q112 Chair: Can you remember the rotation policy?

David Lawton: No.

Q113 Chair: We have three regulators here who are not sure what the rotation policy proposal is.

David Lawton: The basic rotation policy is rotation after three years or after you have rated 10 instruments.

Q114 Mr Ruffley: Yes, we have that here. Is that all?

Chair: Is that for structured products?

David Lawton: No. That is for all products.

Chair: All products?

David Lawton: Yes.

Q115 Mr Ruffley: That is for everything, and then one rating agency may be retained for six years. What happens to the other one?

David Lawton: I can't quite remember the rotation periods for structured products, but for structured products the proposal is that you must have more than one rating.

Q116 Mr Ruffley: But one agency can be retained for six years, yes?

David Lawton: I am sorry. I am afraid I can't remember whether that is the precise proposal.

Q117 Mr Ruffley: There is some confusion on your part, so it is not surprising that we are confused. But the suggestion seems to be that whatever the rotation policy and whatever the specifics, it could entrench the established rating agencies in their dominance. Do you think that is correct or not?

David Lawton: As you were questioning a few moments ago, I think the challenges with rotation are two or threefold. The first is, will it increase competition? It is not clear that rotation among the big three would increase competition, for precisely your point: it would tend to give you a minimum market share come what may. Secondly, in respect of those niche agencies that specialise in particular sectors, there is a limit to what you can be rotated into. If you specialise in insurance companies, being rotated into structured finance or sovereigns is not ideal from a business model point of view. The third challenge is the point about capacity, because if the goal is that rotation generates more credit rating agencies, but the rotation periods are set very short and those agencies do not appear by the relevant dates, the market comes to a complete standstill. I think the Commission, in making the proposal, to my view, have not completely convinced on those three points.

Q118 Chair: Judging by some of the things you have said, "has not completely convinced" is one of the great understatements, isn't it, Mr Lawton?

David Lawton: I am a regulator, I am afraid. I don't do overstatement.

Q119 Chair: You do understatement. Okay, so we should aim off for these statements. If you do not think that competition is going to be increased, we are going to find the risk of greater reliance on rating agencies, because they have an endorsement from regulators, with no offsetting competition benefit. Correct?

David Lawton: Through rotation or just generally?

Chair: Generally; rotation and generally.

David Lawton: The public policy challenge to focus on is to work to reduce the mechanistic reliance on ratings in the regulatory system.

Q120 Chair: So we need to downplay the importance of these things?

David Lawton: We need to downplay the mechanistic reliance. It is unlikely we will ever get to a situation where they play no role, but they need to be just one of a number of indicators of creditworthiness that we need to rely on.