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The report proposes 13 sound practices for large market intermediary firms to consider in the implementation of their internal credit assessment policies and procedures. IOSCO believes that identifying sound practices regarding the suitable alternatives to credit ratings for assessing credit risk should reduce the potential overreliance of large intermediaries on credit rating agencies (CRAs). In turn, this reduction would help increase investor protection, while contributing to market integrity and financial stability.
While CRA ratings can offer investors and lenders an efficient way to label the risks associated with a particular borrowing or lending facility, the recent global financial crisis illustrated how a mechanistic reliance on CRA ratings can contribute to and exacerbate the fallout on the markets.
While CRA ratings can offer investors and lenders an efficient way to label the risks associated with a particular borrowing or lending facility, the recent global financial crisis illustrated how a mechanistic reliance on CRA ratings can contribute to and exacerbate the fallout on the markets.
In response, numerous international and national bodies have taken measures to address the reliance of market participants such as broker-dealers on credit ratings. These efforts have mainly focused on two areas:
- Requirements for financial firms to undertake their own due diligence and internal risk management instead of relying mechanistically on external CRA ratings, and;
- Reconsideration of references to ratings in the regulatory framework, in light of their potential to be regarded as public endorsement of CRA ratings and to negatively influence market behavior.
Regulators could consider these sound practices as part of their oversight of market intermediaries. Large market intermediary firms may find these sound practices useful in the development and implementation of effective alternative methods for the assessment of creditworthiness.
Draft Sound Practices
Establish an independent credit assessment function that is clearly separated from other business units, including the development of appropriate policies and procedures to ensure that decision-making is not unduly affected by operations from other areas of the firm.
Involve senior management in order to ensure the successful implementation of a robust credit assessment process, including promotion of a risk-sensitive culture throughout the organization.
Establish a coherent oversight structure to ensure that the credit assessment process is properly implemented and adhered to, including the establishment of reporting lines and responsibilities that are clearly articulated and followed.
Take steps to ensure that a firm’s governing committee receives an appropriate level of information on the amount of credit risk to which the firm is exposed.
Invest in staff and other resources necessary to develop a robust internal credit assessment management system that appropriately reflects the nature, scale, and complexity of its business. Avoid exposure to particular credit risks whenever the firm does not have the internal capability to independently and adequately assess the exposure.
Take creditworthiness assessment capabilities into account when considering the firm’s business growth plans and deciding how to structure its portfolios or whether to take on additional leverage.
Incorporate a wide variety of qualitative measures into robust credit assessment processes in addition to quantitative measures.
Prescribe risk levels and investment appetites for the assessment of creditworthiness that focus on the fundamental value of the instrument to set limits and risk.
Subject non-investment grade financial products to enhanced scrutiny, including bifurcation of the internal ratings of investment and non-investment grade securities, e.g., a separate review process.
Avoid mechanistically relying on external CRA ratings. View such ratings as only one factor among several that may be used in a comprehensive credit assessment process.
Strive to update and improve continually the firm’s credit risk assessment practices to help ensure that they remain abreast of developments that could have a material adverse effect on the firm’s portfolios and counterparty relationships.
Ensure internal audit or another independent party performs regular reviews of credit policies and procedures.
Comments should be submitted on or before Wednesday 08 July 2015