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Basel Committee on Banking Supervision, The Joint Forum
Stocktaking on the use of credit ratings - June 2009
III. Member assessments and initiatives
As noted in the introduction, the questionnaire submitted to
member authorities requested a description of their assessments,
if any, of unintended implications of the use of credit ratings in
LRSPs.
The questionnaire included specific questions as to whether the
use of credit ratings has had the effect of implying an
endorsement of such ratings and/or rating agencies or discouraging
investors from performing their own due diligence.
In addition to answering these questions, members provided the
working group with information concerning a number of initiatives
relevant to both such an assessment and the future use of credit
ratings in LRSPs.
A. Assessments on the impact of the use of credit ratings in LRSPs
No respondent reported that it had conducted a comprehensive,
formal assessment of the impact of the use of credit ratings in
LRSPs on investor behavior.
Nonetheless, many offered their views on the question.
In general, respondents were split as to whether their use of
credit ratings and/or reference to credit rating agencies has had
the effect of implying an endorsement of such ratings and/or
agencies, although a slight majority answered in the affirmative.
Respondents answering in the affirmative were generally cautious
in their analysis with only a small minority providing an
unconditional affirmative response.
Several respondents whose LRSPs use the term ECAI noted that
while Basel II�s introduction of the term
was merely meant to be in line with market practice concerning the
use of credit ratings issued by major credit rating agencies, the
designation of those agencies as ECAIs may have reinforced the
tendency of the marketplace to rely on the ratings excessively.
In addition, a small number of respondents noted that the
eagerness of some smaller credit rating agencies to obtain the
ECAI designation implied a perception that the designation carried
an endorsement effect.
Several respondents indicated some additional possible unintended
consequences of the use of credit ratings in LRSPs.
Some respondents noted that the use of credit ratings in LRSPs
could lead to increased demand for highly rated instruments issued
by off-balance sheet entities, as the use of credit ratings in
LRSPs may have �officialised� credit ratings for those instruments
and therefore made such highly rated investments more desirable.
One respondent suggested that the use of credit ratings in LRSPs
may have led to increased barriers to entry for the credit rating
industry, as the possible endorsement effect of designating
certain credit rating agencies in LRSPs could have negative
business effects on agencies not so designated.
Another respondent noted that the use of credit ratings in LRSPs
may have resulted in an amplified perception of credit risk as
predominant, resulting in reduced attention to other kinds of
risk, in particular liquidity and market
risks.
Finally, one respondent suggested a possible �relaxing effect� on
financial institutions� internal assessment procedures, as firms
may have placed too much reliance on external ratings in lieu of
performing their own thorough due diligence of investment
opportunitites.
Respondents expressing a belief that their
use of credit ratings and/or reference to credit rating agencies
in LRSPs has not had any untended �endorsement� effects, generally
stressed the purely technical nature of their LRSPs� use of credit
ratings.
Several respondents indicated that their ECAI
recognition/designation process was based purely on the
verification of a credit rating agency�s compliance with published
criteria and thus did not imply any endorsement.
In addition, a majority of respondents
expressed their belief that their use of credit ratings and/or
reference to credit rating agencies did not discourage investors
from performing their own due diligence.
Several respondents indicated that while there may have been
investor over-reliance on credit ratings, it was not clear whether
the use of credit ratings in LRSPs played a material part in such
over-reliance.
B. New Initiatives relating to credit ratings
1. Banking and securities sector
The US SEC noted that it has issued proposed rule amendments that
would eliminate references to NRSROs and their ratings from most
of its LRSPs, stating that by doing so, it would �remove any
appearance that the Commission has placed its imprimatur on
certain ratings.�
The OSC indicated that it was in the process of considering
replacing the word �approved� in its LRSPs employing credit
ratings with the word �designated� in order to �avoid
misconceptions regarding regulatory endorsement of credit ratings
or credit rating agencies.�
The OSC also noted that the Canadian Securities Administrators
have published a paper for consultation (until February 2009) that
seeks to reduce reliance on credit ratings in Canadian securities
legislation by considering possible alternatives to the use of
credit ratings or removing the references to credit ratings.
On July 31, 2008, the European Commission (EC) published two
working documents for consultative purposes.
The first document sought public views on a draft proposal for a
regulation with respect to the authorisation, operation and
supervision of credit rating agencies.
Following the public consultation, the EC adopted the proposal on
November 12, 2008, in the hope that the Council of the European
Union and the European Parliament would adopt the final proposal
before the next European Parliament elections in June 2009.
The main objective of the EC proposal is to
ensure that ratings are reliable and accurate pieces of
information for investors.
Credit rating agencies will be required to
deal with conflicts of interest, have sound rating methodologies
and increase the transparency of their rating activities.
The proposal also introduces a registration and surveillance
procedure for credit rating agencies whose ratings are used by
credit institutions, investment firms, insurance, assurance and
reinsurance undertakings, collective investment schemes and
pension funds within the EU.
The second document, of particular relevance to the Joint Forum�s
project, identifies in broad terms the references made to ratings
in the existing EU legislation and looks at possible approaches to
the potential problem of excessive reliance on ratings.
The EC proposed three possible (but not
mutually exclusive) approaches:
(1) require regulated and sophisticated investors to rely more on
their own risk analysis, especially for (relatively) large
investments;
(2) require that all published ratings include �health-warnings�
informing of the specific risks associated with investments in
these assets; and/or
(3) examine the regulatory references to credit ratings and
revisit them as necessary.
In August 2008, the JFSA added new supervisory �checkpoints� for
financial institutions in order to avoid uncritical reliance on
credit ratings when contemplating investment in structured
products.
The checkpoints seek to encourage an understanding of rating
methodologies and relevance (eg, what does the rating really mean
for purposes of the investment?) as well as establishing better
risk management functions within the organisations.
Since April 2008, in order to meet the checkpoint for the sales of
securitisation products, the JFSA ensures that distributing
institutions are effectively carrying out the collection, risk
valuation and disclosure of the underlying securitised assets, as
well as assessing the risk factors associated with securitised
products without relying solely on credit ratings.
The JFSA�s Financial System Council
has pointed out the necessity to review the use of DRA credit
ratings for the purpose of the reference system and the shelf
registration system for public offerings of corporate bonds.
In December 2008, the JFSA�s Financial System Council has also
reported that credit rating agencies should be regulated under the
framework of the registration system.
2. Insurance sector
Under current LRSPs, US insurers ceding to
reinsurers must obtain collateral from non-US licensed reinsurers
in order to reflect the statutory accounting credit for
reinsurance, but no collateral is required when ceding to US
licensed reinsurers.
Florida recently promulgated rules allowing ceding insurers to
take full credit for reinsurance with reduced collateral for
reinsurance placed with financially strong foreign reinsurers from
qualifying jurisdictions.
In this rule, a preliminary filter, not an
absolute criterion, is based on acceptable ratings from recognized
rating agencies.
New York is finalizing a similar
rule.
Within the frameworks, the reinsurer�s credit ratings serve as a
maximum cap on the amount of collateral reduction that is
available; further analysis and due diligence can, for a given
rating for a specific reinsurer, increase the amount of required
collateral.
On a broader scale in the United States, a
new Reinsurance Regulatory Modernisation Framework has been
adopted by the NAIC�s Reinsurance Task Force.
This framework, which is subject to ratification by the
NAIC, would change the manner and
extent to which US ceding companies can reflect offsets in their
statutory financial statements for reinsurance ceded.
Under the proposed framework, reinsurers (both US and non-US) will
be assigned to one of five rating categories determined by US
insurance regulators based on a number of factors, similar to the
New York and Florida frameworks.
Importantly, one of those factors is the reinsurer�s financial
strength rating provided from a recognized credit rating agency.
In particular, the lowest rating received by the rating agencies
will be used by the regulators to establish the maximum rating of
a reinsurer (eg, the maximum amount of collateral reduction).
The assigned rating category determines the extent to which the
reinsurer is required to collateralise its obligations in order
for US cedants to take credit for that reinsurance.
In July 2007, the EC proposed a revision of EU insurance law that
would replace 14 existing directives with a single directive
designed to improve consumer protection, modernise supervision,
deepen market integration and increase the international
competitiveness of European insurers.
Under the new system, known as Solvency II,
insurers would be required to take account of all types of risk to
which they are exposed and to manage those risks more effectively.
In addition, insurance groups would have a
dedicated �group supervisor� that would enable better monitoring
of the group as a whole.
In February 2008, the EC published an
amended proposal.
The EC�s goal is to have the new system in
operation by 2012.
Currently, there are no references to
external credit ratings or ECAIs in the latest Directive proposal.
The most recent (fourth) draft Quantitative Impact Study (QIS4),
however, would use credit ratings as a proxy for financial
strength.
As this remains a work in progress, however,
it is unclear what the final capital requirements will be.
The precise design of capital requirements in Solvency II,
including the possible counterparty default risk capital charge,
will be set out in the future level 2 implementing measures to be
developed by end 2010.
Go to
Stocktaking on the use of credit ratings - June 2009 Part 4
Basel Committee on Banking Supervision, The Joint Forum
Stocktaking on the use of credit ratings - June 2009 Part 1
Stocktaking on the use of credit ratings - June 2009 Part 2
Stocktaking on the use of credit ratings - June 2009 Part 3
Stocktaking on the use of credit ratings - June 2009 Part 4
Stocktaking on the use of credit ratings - June 2009 Part 5
Stocktaking on the use of credit ratings - June 2009 Part 6
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