*FSB for reducing reliance on Credit Rating Agencies*
*Published in SUNS #7029 dated 29 October 2010*
Geneva, 28 Oct (Kanaga Raja) -- The Financial Stability Board (FSB) on Wednesday published a set of principles for reducing reliance on Credit Rating Agency (CRA) ratings.
The goal of the FSB-proposed Principles is to reduce the financial stability-threatening "herding" and "cliff effects" that currently arise from CRA rating thresholds being hard-wired into laws, regulations and market practices.
According to the FSB, the report on the Principles for Reducing Reliance on CRA Ratings issued on Wednesday was endorsed by the G20 finance ministers and central bank governors at their meeting in Gyeongju, Korea on 22-23 October.
The FSB, whose secretariat is hosted by the Bank for International Settlements in Basel, was established to coordinate at the international level the work of national financial authorities and international standard-setting bodies, as well as to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability.
The Board comprises national authorities responsible for financial stability in 24 countries and jurisdictions, international financial institutions, sector-specific international groups of regulators and supervisors, and committees of central bank experts.
According to the FSB, the goal of the principles is to reduce mechanistic reliance on ratings and to incentivise improvements in independent credit risk assessment and due diligence capacity.
Banks, market participants and institutional investors should be expected to make their own credit assessments, and not rely solely or mechanistically on CRA ratings. The design of regulations and other official sector actions should support this, the FSB said.
Accordingly, said FSB, authorities should assess references to CRA ratings in laws and regulations and, wherever possible, remove them or replace them by suitable alternative standards of creditworthiness.
The principles aim to catalyse a significant change in existing practices, and they cover the application of the broad objectives in five areas: prudential supervision of banks; policies of investment managers and institutional investors; central bank operations; private sector margin requirements; and disclosure requirements for issuers of securities.
On the first principle of reducing reliance on CRA ratings in standards, laws and regulations, the FSB said that standard setters and authorities should assess references to credit rating agency ratings in standards, laws and regulations and, wherever possible, remove them or replace them by suitable alternative standards of creditworthiness.
"It is particularly pressing to remove or replace such references where they lead to mechanistic responses by market participants," said the FSB, adding: "Standard setters and authorities should develop alternative definitions of creditworthiness and market participants should enhance their risk management capabilities as appropriate to enable these alternative provisions to be introduced."
"Standard setters and authorities should develop transition plans and timetables to enable the removal or replacement of references to CRA ratings wherever possible and the associated enhancement in risk management capabilities to be safely introduced."
According to the FSB, the "hard wiring" of CRA ratings in standards and regulations contributes significantly to market reliance on ratings.
This in turn is a cause of the "cliff effects" of the sort experienced during the recent crisis, through which CRA rating downgrades can amplify pro-cyclicality and cause systemic disruptions. It can be also one cause of herding in market behaviour, if regulations effectively require or incentivise large numbers of market participants to act in similar fashion.
"But, more widely, official sector uses of ratings that encourage reliance on CRA ratings have reduced banks', institutional investors' and other market participants' own capacity for credit risk assessment in an undesirable way," the FSB added, noting that some jurisdictions have already implemented or are considering actions to remove or replace references to CRA ratings in their laws and regulations.
The second FSB principle on reducing market reliance on CRA ratings states that banks, market participants and institutional investors should be expected to make their own credit assessments, and not rely solely or mechanistically on CRA ratings, and that the design of regulations and other official sector actions should support this principle.
Firms should ensure that they have appropriate expertise and sufficient resources to manage the credit risk that they are exposed to. They may use CRA ratings as an input to their risk managements, but should not mechanistically rely on CRA ratings. Furthermore, they should publicly disclose information about their credit assessment approach and processes, including the extent to which they place any reliance on, or otherwise use, CRA ratings.
"Supervisors and regulators should closely check the adequacy of firms' own credit assessment processes, including guarding against any upward biases in firms' internal ratings."
At the same time, said FSB, CRAs play an important role and their ratings can appropriately be used as an input to firms' own judgement as part of internal credit assessment processes. They can provide economies of scale in analysing credit on behalf of smaller and less sophisticated investors, and can be used as an external comparator by all investors in their own internal assessments.
In general, therefore, principles in this area should recognize these useful functions and should differentiate according to size and sophistication of firm, and according to the asset class of instruments concerned (e. g. sovereign, corporate, or structured) and the materiality of the relevant exposures.
"At the same time, the principles should make clear that any use of CRA ratings by a firm does not lessen its own responsibility to ensure that its credit exposures are based on sound assessments," the FSB stressed.
The FSB also highlighted more specific principles for particular areas of financial market activity. In this context, its third principle covers central bank operations, prudential supervision of banks, internal limits and investment policies of investment managers and institutional investors, private sector margin agreements and disclosures by issuers of securities.
As regards central bank operations, the FSB states that central banks should reach their own credit judgements on the financial instruments that they will accept in market operations, both as collateral and as outright purchases, and their policies should avoid mechanistic approaches that could lead to unnecessarily abrupt and large changes in the eligibility of financial instruments and the level of haircuts that may exacerbate cliff effects.
Central banks should avoid mechanistic use of CRA ratings:
-- except when infeasible, by making independent determinations of whether a financial instrument should be eligible in its operations (both by being prepared to reject assets offered as collateral or for outright purchase despite their external ratings and by assessing whether any external rating change should lead to a change in a financial instrument's eligibility or haircut);
-- by reserving the right to apply risk control measures such as additional haircuts to any individual financial instruments or classes of collateral based on an internal risk assessment; and
-- by reserving the right to apply additional risk control measures such as additional haircuts to any individual financial instrument that has not been subject to an internal risk assessment by the central bank.
According to FSB, this would have a knock-on benefit in reducing the effect of CRA ratings on private sector investment policies, to the extent the policies key off acceptability as central bank collateral (e. g. in regulatory liquidity policies).
At the same time, central banks should conduct their communications and market operations in a way that avoids unnecessary market uncertainty from the use of internal assessments in determining eligibility.
Concerning prudential supervision of banks, the FSB underscored that banks must not mechanistically rely on CRA ratings for assessing the creditworthiness of assets. This implies that banks should have the capability to conduct their own assessment of the creditworthiness of, as well as other risks relating to, the financial instruments they are exposed to and should satisfy supervisors of that capability.
"In order to provide market discipline, banks should publicly disclose information about their credit assessment approach, and the proportion of their portfolio (or of particular asset classes) for which they have not conducted an internal credit assessment. This could be required for instance through Pillar 3 of the Basel II framework."
Banks using the standardised Basel II approach currently have minimum capital requirements based on CRA credit ratings. As long as some banks continue to have capital requirements based on CRA ratings, supervisory processes should be put in place to check the understanding of the appropriate uses and limitations of CRA ratings by these banks' risk managers, said FSB.
Additionally, larger, more sophisticated banks within each jurisdiction should be expected to assess the credit risk of everything they hold (either outright or as collateral), whether it is for investment or for trading purposes.
"Supervisors should incentivise banks to develop internal credit risk assessment capacity, and to increase use of the internal-ratings-based approach under the Basel capital rules. In order to do this, supervisors should enhance their ability to oversee and enforce sound internal credit policies. This may require an increase in resources devoted to bank risk management and supervisory oversight of risk management."
According to the FSB, banks' enhancement of internal credit risk assessment processes could be incentivised through restricting the proportion of the portfolio that is CRA rating-reliant, for example, by: requiring all large exposures (as defined under supervisory rules) to be internally assessed; setting a limit on the share of the overall portfolio or of particular asset types that solely relies on CRA ratings; and raising the capital requirements for investments not internally assessed.
The FSB also pointed to particular restrictions that could be applied to certain types of asset, such as, that large banks could be required to internally assess the creditworthiness of all sovereign and corporate exposures; and use of CRA credit ratings that incorporate an assumption of government support could be particularly tightly restricted.
Noting that the amended Basel II framework, to be implemented from end-2011, already states that securitisations will be deducted from capital if banks do not collect data on the underlying assets to be able to make their own assessment of credit and other risks, the FSB said that further steps could be taken to reduce the reliance on CRA ratings, and the cliff effects resulting from reference to CRA ratings, in the capital requirements for securitisations.
Particular restrictions could also be placed on investments in structured products too complex for banks to be able adequately to internally assess the credit risk.
The FSB stressed that these approaches would require further study of the ways in which they could change banks' incentives. For example, supervisors would need to oversee internal credit modelling carefully to guard against incentives for banks to make internal ratings higher than external ratings.
The Board underlined that while smaller, less sophisticated banks may not have the resources to conduct internal credit assessments for all their investments, they still should not mechanistically rely on CRA ratings and should publicly disclose their credit assessment approach.
"Such banks should understand the credit risks underlying their balance sheet as a whole and, for all exposures that would materially affect the bank's performance, (they) should make a risk assessment commensurate with the complexity and other characteristics of the investment product and the materiality of their holding."
As regards the policies of investment managers and institutional investors, the FSB underscored that investment managers and institutional investors must not mechanistically rely on CRA ratings for assessing the creditworthiness of assets.
"This principle applies across the full range of investment managers and of institutional investors, including money market funds, pension funds, collective investment schemes (such as mutual funds and investment companies), insurance companies and securities firms. It applies to all sizes and levels of sophistication of investment managers and institutional investors."
The Board said that CRA ratings are no substitute for investment managers' and institutional investors' due diligence, including the assessment of credit and other risks.
"While references to CRA ratings in internal limits, credit policies and mandates can sometimes play a useful role as broad benchmarks for transparency of credit policies, they should not substitute for investment managers' own independent credit judgements and that should be clear to the market and customers."
"Investment managers should conduct risk analysis commensurate with the complexity and other characteristics of the investment and the materiality of their exposure, or refrain from such investments. They should publicly disclose information about their risk management approach, including their credit assessment processes," the Board states.
The FSB also stressed that senior management and boards of institutional investors have a responsibility to ensure that internal assessments of credit and other risks associated with their investments are being made, and that the investment managers they use have the skills to understand the instruments that they are investing in and exposures they face, and do not mechanistically rely on CRA ratings.
"Senior management, boards and trustees should ensure adequate public disclosure of how CRA ratings are used in risk assessment processes."
The FSB also said that regulatory regimes should incentivise investment managers and institutional investors to avoid mechanistic use of CRA ratings. "Regulators of investment managers should enhance their ability to oversee and enforce sound internal credit policies."
The FSB pointed to a number of incentives to avoid the mechanistic use of CRA ratings that could include: restricting the proportion of a portfolio that is solely CRA ratings-reliant; supervisory monitoring of credit and other risk assessment processes (in the case of supervised investment managers and institutional investors); and requiring public disclosures of internal due diligence and credit risk assessment processes, including how CRA ratings are or are not used, with the aim of encouraging investment managers to develop more rigorous and individual processes, including in investment mandates, rather than relying on common triggers.
Another incentive is requiring public disclosures of risk assessment policies not only relating to rating thresholds but also according to types of instruments (thus reflecting the different nature of the risks applying to, e. g., structured finance compared with corporate bonds). Such disclosures should be made in a manner consistent with the goal of streamlining disclosures for customers.
With respect to private sector margin agreements, the FSB states that market participants and central counter-parties should not use changes in CRA ratings of counter-parties or of collateral assets as automatic triggers for large, discrete collateral calls in margin agreements on derivatives and securities financing transactions.
While using an external measure such as CRA ratings can be helpful as a third-party reference for setting margin requirements, market participants should use through-the-cycle initial margins and frequent, ideally daily, variation margin payments based on mark-to-market price changes for collateralising bilateral derivatives exposures; and standardized derivatives transactions should be cleared through central counter-parties, with consideration given to using through-the-cycle margins and haircuts, eliminating the need for bilateral margining for these products.
Furthermore, supervisors should review the margining policies of market participants and central counter-parties to guard against undue reliance on CRA ratings. They should not allow CRA rating triggers to be used as a factor that reduces regulatory capital requirements.
On disclosures by issuers of securities, the FSB said: "Issuers of securities should disclose comprehensive, timely information that will enable investors to make their own independent investment judgements and credit risk assessments of those securities. In the case of publicly-traded securities, this should be a public disclosure."
Noting that in some cases, investors have weaker access to issuer information than CRAs thus adding to their reliance on CRA ratings, the FSB underscored that improved disclosure by issuers to investors will facilitate the build-up of capabilities at banks, investment managers and institutional investors to conduct their own assessment of the creditworthiness of the financial products they invest in and thus enhance their ability to avoid mechanistic reliance on CRA ratings.
"Standard setters and authorities should review whether any references to CRA ratings in standards, laws and regulations relating to disclosure requirements are providing unintended incentives for investors to rely excessively on CRA ratings and, if appropriate, remove or amend these requirements."
The FSB has asked standard-setters and regulators to consider the next steps that could be taken to translate the principles into more specific policy actions to reduce reliance on CRA ratings in laws and regulations, taking into account the particular circumstances of products, market participants and jurisdictions. +
