In October 2022, the FCA issued a Dear CEO letter in relation to its thematic findings on the effectiveness of governance in credit rating agencies (CRAs). It is sending this letter to all UK-registered credit rating agencies.
In February 2022, the FCA sent a letter to credit rating agencies outlining its view of risks in the areas of ratings process and methodologies, governance and oversight, market and perimeter risks, and operational resilience and resourcing. This is available at https://www.fca.org.uk/publication/correspondence/portfolio-letter-credit-rating-agencies.pdf.
Since then and as part of its ongoing review of governance as a key driver of culture, it has reviewed the Board structures and documentation of all the registered CRAs within the portfolio. Further, for a selection of agencies, it has met Board members, which included senior executives and independent non-executive directors (INEDs), and has observed Board meetings.
The letter provides feedback on common findings from these reviews and the FCA’s wider supervisory work across the portfolio. Overall, it was clear to the FCA that some CRAs can do more to benefit from the value that a well-functioning Board can bring to the strategic direction and oversight of an organisation. This issue is heightened by the global nature of many CRAs, which often leads to an inadequate level of consideration and control being given to the UK Board. The FCA believes that strong Board governance, clear Board-level accountability, and independent challenge are essential to ensure organisations deliver independent ratings free from conflicts of interest and that there are gaps in this respect at some CRAs.
The FCA expects firms’ senior leadership and Boards to consider the risks outlined below, how they monitor these risks and whether they have appropriate strategies in place to address them.
Purpose of the Board
The FCA expects firms to meet the CRA Regulation both in principle and practice. This means that the Board should ensure meaningful oversight of the independence of UK credit rating activities, management of conflicts of interest, and compliance with the CRA Regulation.
Many CRAs operate as part of global structures, and the FCA expects the UK Board to have a clear role and purpose in overseeing the credit rating activities of UK-regulated entities. This encompasses the firm’s strategy as well as its operational performance. The FCA is concerned that the UK Board may play a diminished role where there is a global group structure as more focus may be given to the parent Board. It expects the UK Board to meet the requirements of the CRA Regulation and to operate with a clear purpose and understanding of the UK market.
It has seen instances where senior management considered the meeting of the UK Board as a regulatory formality. This was reflected in the lack of senior management participation in Board meetings, information requests of INEDs not being addressed, and decision-making related to UK credit rating activities being taken without the knowledge or consent of the UK Board. Firms should assess the role of the UK Board, the responsibility it is given, and where there are shortfalls, make any necessary adjustments to give it appropriate and meaningful control of UK activities.
Composition of the Board
The CRA Regulation states that at least one-third, but no less than two, of the members of the Board, must be independent members who are not involved in credit rating activities. For CRAs that issue credit ratings on securitisation instruments, at least one INED and one other member of the Board should have in-depth knowledge and experience in structured finance. Overall, senior management on the Board should ensure the sound and prudent management of the CRA.
A well-performing Board consists of individuals with a diverse mix of skills, experience, and industry knowledge relative to the needs of the business. The FCA expects Board members to be capable of providing input on the strategy of the firm and key risks associated with the delivery of independent ratings. This includes the management of conflicts of interest, internal quality controls, and processes for compliance and governance. When the risks facing the firm are well understood by the Board, this leads to better oversight.
Where the Chair is also the Chief Executive, extra care is required to maintain a division of roles and objectivity and to ensure open discussion and active encouragement to share views.
The FCA saw failures to meet the basic Board composition requirements for a number of INEDs. While there is no requirement in the CRA Regulation on the number of directors serving on the Board (apart from the requirement for at least two INEDs), membership should take into account the range of skills necessary to operate a CRA and succession planning – too few directors may lead to gaps in skills. An imbalance in the ratio of executives to non-executives may compromise the role of the independent members.
The FCA noted inconsistencies in Board members’ understandings of the key risks of a CRA, which may imply the absence of a risk framework, inadequate Board level discussions, and/or insufficient knowledge at the Board level. Firms should assess their Board’s structure and skills to ensure that it has sufficient expertise to conduct its responsibilities.
Role of Independent NEDs
The role of the INED is to provide independent oversight and challenge. INEDs for CRA Boards have the specific task of monitoring the development of credit rating policy and methodologies but should not be involved in credit rating activities. The FCA expects INEDs to be professionally selected through a robust process, to have the range of skills required to oversee the CRA, and to undergo a thorough induction process that provides access to individuals across the organisation.
INEDs should demonstrate an understanding of their responsibility and their remit, which involves achieving an appropriate balance in their involvement with the business. Some CRAs are not taking the necessary steps to maintain independence of the INEDs. This may be through a lack of an objective recruitment process or due to INEDs potentially being involved in credit rating activities
The FCA has seen varying levels of INED challenge at Board meetings and, where the challenge is made, differing degrees of acceptance by senior management to address issues and requests for information. Firms should review their INED recruitment process for objectivity and their induction process for continuity. They should identify the appropriate INED skills and background for their business and verify whether the current INEDs are able to assess the key risks in their firms; their senior management should consider their responsiveness to challenges by INEDs and monitor how any issues raised are addressed.
How the Board operates
The FCA expects the relationship between Board members to be challenging and supportive during and between Board meetings. It considers that Board meetings should be held with appropriate frequency, be of an appropriate length to enable proper consideration of issues, and be conducted in an open manner that supports critical thinking and discussion of difficult issues. Information flow to Board members should be timely and of sufficient clarity and detail to facilitate informed discussion and decisions. There should be adequate follow-up on matters raised, evidenced in accurate and detailed minutes.
The FCA has seen differing levels of consideration at Board meetings, ranging from in-depth to superficial, and instances where Board members participated fully and actively while in others, it saw members leaving meetings before the conclusion of material discussions. While Board meeting papers for certain firms were comprehensive in nature with transparent documentation of the next steps, others failed to present key details or did not reflect the reality of the business. The FCA saw instances where the use of data, key risk indicators, and management information systems to monitor risks was not apparent or was inadequate.
Next steps
The FCA expects all CRAs to consider the findings in the Dear CEO letter and any work they may need to do to rectify any issues. It expects firms’ action plans to be strategic, appropriately resourced, and address the root causes of the issues.
It has asked CRAs to provide a Board-approved summary of their firm’s assessment of key risks relating to governance and the details of their action plans, including timescales, by 30 January 2023. Firms must also identify the member of their senior management team who will oversee the provision of this and the implementation of their action plans and notify the FCA of this contact person by 11 November 2022.
As part of its ongoing supervisory focus on CRA governance and oversight, the FCA will continue to engage with firms, and, where individual firms fall short of expectations, fail to consider FCA feedback, or are making insufficient progress, the FCA will consider the full range of supervisory responses and enforcement powers at its disposal.
If you’d like to know more about how we can help you with your credit rating agency governance arrangements, or any other regulatory compliance issues, our specialist team is here to help.
Contact us today on 0207 436 0630 or email info@thistleinitiatives.co.uk.