Shadow Ratings Investigation Pits Banks in Nordics Against ESMA

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.

“If you want a vibrant corporate bond market, also for mid-sized and smaller companies, this is not helpful at all,” said Michael Sandfort, senior portfolio manager at Sparinvest, which holds about 45 million euros ($51 million) in bonds that have been vetted by banks, rather than ratings companies. That’s about 4 percent of the total bond portfolio. “It will become more difficult for non-rated issuers to sell to us.”

Bank guides to credit risk have emerged over the past decade 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 could 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.”

ESMA spokeswoman Catherine Sutcliffe said the Paris-based agency doesn’t comment “on any on-going supervisory activities.”

Banks including Swedbank and Nordea Bank AB offer the service, generally for free, to their investment clients, while businesses routinely have it included in issuance programs, rather than spending more on ratings by Moody’s and S&P. More than half of the 80-plus companies on which SEB AB offers research are unrated, according to the bank’s website.

The system has a “checkered history,” after banks were caught pumping up companies whose bonds they were poised to sell, according to Sindre Stoeer, managing director of the Norwegian Securities Dealers Association. But “that is in the past,” stopped by the raft of rules imposed since the financial crisis and industry efforts to police itself, Stoeer said.

The shadow ratings are trustworthy, according to Martin Lundby, head of finance at Hafslund ASA. The Norwegian energy company is “quite dependent” on the grades it gets from the six major Nordic banks, he said. “For market transparency and liquidity, shadow ratings are important,” he said. “Many Nordic issuers are too small to obtain official ratings.”

Swedbank applies its own methodology to the same data that ratings companies use, 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 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.

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,” Busch said. Lenders can come up with alternatives -- Swedbank is working on it -- and some businesses can get bank loans. But since the financial crisis, focus has been on spreading risk, and “you can’t syndicate a loan as widely as you can a bond,” he said.

According to Sandfort, the ones to benefit from an ESMA ban would be the large ratings companies. “They couldn’t have come up with something better for themselves,” he said.

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