Shadow ratings investigation pits banks in Nordics against ESMA

[COPENHAGEN] Nordic banks, brokers and businesses are warning that a ban by European regulators on so-called shadow ratings would destroy a cornerstone of the region's corporate bond market.

The industry's internal guides to credit risk have emerged as an essential element for ensuring liquid markets in the Nordic region, especially for investors without pockets deep enough to conduct their own research and for smaller businesses that issue securities.

But the European Securities and Markets Authority is now investigating those guidelines amid concern they effectively amount to ratings, which it says can only be offered by registered rating companies.

The probe could end in a ban, according to the Swedish Securities Dealers Association. That has the potential to hurt liquidity, increase systemic risk and disrupt the entire market, said Mikael Busch, head of credit research at Swedbank AB.

"It's not something that's going to affect only banks as intermediaries," Busch said. "It affects issuers and it affects investors."

Banks including Swedbank and Nordea Bank AB offer shadow ratings, generally for free, as a service to their investment clients, while businesses routinely use them in issuance programs, rather than spending more on assessments by Moody's and S&P.

The shadow ratings have "high credibility," according to Martin Lundby, head of finance at Hafslund ASA. The Norwegian energy company is "quite dependent" on the credit grades it gets from the six major Nordic banks, he said.

"For market transparency and liquidity, shadow ratings are important. Many Nordic issuers are too small to obtain official ratings," Mr Lundby said. "Most corporations and most investors have quite a high trust in these shadow ratings, and it has been working very well in the Nordics."

Swedbank applies its own methodology to the same data that ratings companies use, Mr Busch said. The bank's selling point comes in large part from its analysts, who in some cases have "grown up with the businesses," he said. "They've done case studies when they were in university and continue to cover them in a professional capacity."

The Swedish association told the industry of the probe last week after being alerted by members. Kerstin Hermansson, the group's head, said it took the step to begin broad discussions over how to proceed.

While the Credit Rating Agency Regulation only allows registered companies to hand out ratings, members contend they have been operating legally under an exemption for investment research, Hermansson said.

ESMA spokeswoman Catherine Sutcliffe said the Paris-based agency doesn't comment "on any on-going supervisory activities." The Nordic corporate bond market is already struggling. Researchers in the Swedish central bank's Financial Stability Department said in a May report that liquidity has fallen since the financial crisis.

So far, the decline has had limited effects, but the report's authors warned that monitoring is important because markets change rapidly.

Research by Nordea shows liquidity costs are increasing, according to a June 10 note. At the same time, issuance looks set to fall for the fourth straight year amid weakening investor confidence and smaller funding needs, Moody's said in an April report.

To be sure, "it is not an end-of-the-world day if ESMA were to decide, effective immediately, that from now on banks need to stop," Mr Busch said. Banks can probably come up with some alternative - Swedbank is working on it already - and some businesses can get bank loans, he said.

But since the financial crisis, focus has been on spreading risk "as broadly as possible so that you don't have large risks concentrated in certain pockets," Busch said. "You can't syndicate a loan as widely as you can a bond.

BLOOMBERG