IOSCO Recommends Practices for Reducing Reliance on Credit Rating Agencies in Asset Management (with Lofchie Comment)

IOSCO published its final report outlining eight good practices for reducing overreliance on external credit rating agencies ("CRAs") in the asset management industry.

In the report, IOSCO explained that the use of CRAs is driven primarily by demand, and stated that references to external credit ratings may derive from regulatory requirements or an investor's internal rules. IOSCO cautioned that the use of CRAs could result in "mechanistic reliance," and speculated that CRAs could trigger forced asset sales in the event of downgrades.

IOSCO outlined eight recommendations that investors can use to reduce reliance on CRAs, including:

• asset managers should make their own determinations as to the credit quality of a financial instrument before investing and throughout the holding period;
• asset managers should have the appropriate expertise and processes in place to perform credit risk assessment appropriate to the nature, scale and complexity of any investment strategy they implement and the type and proportion of debt instruments they invest in. Asset managers should refrain from investing in products/issuers when they do not have enough information to perform an appropriate credit risk assessment;
• external credit ratings should not constitute the sole factor supporting the credit analysis;
• the manager’s internal assessment process should be regularly updated and applied consistently.
• where external credit ratings are used, asset managers should understand the methodologies, parameters and the basis on which the opinion of a CRA was produced, and have adequate means and expertise to identify the limitations of the methodology and assumptions used to form that opinion;
• asset managers should review their disclosures describing alternative sources of credit information in addition to external credit ratings and make available to investors, as appropriate, a brief summary description of their internal credit assessment process, including how external credit ratings may be used to complement or as part of the manager’s own internal credit assessment method;
• when assessing the credit quality of their counterparties or collateral, asset managers should not rely solely on external credit ratings and consider alternative quality parameters (e.g., liquidity, valuation, correlation, etc.); and
• where external credit ratings are used, a downgrade should not automatically trigger the immediate sale of the asset. Should the manager/board decide to divest, the transaction is conducted within a timeframe that is in the best interests of the investors.

IOSCO also stressed the importance of asset managers having the appropriate expertise and processes in place to assess and manage the credit risk associated with their investment decisions.

Lofchie Comment: While the Credit Rating Agency model is obviously flawed, it came into existence for a reason; i.e., it is difficult and largely non-economic for lenders to make a credit assessment of borrowers on an individualized basis. An injunction not to rely on credit rating agencies thus raises difficult questions for investors in debt securities: do they concentrate their investments in a smaller number of issuers to reduce the degree of required credit analysis? Do they lend more to larger borrowers on the theory that they are more likely to be protected by a market consensus as to value? The very low interest rate environment will exacerbate the difficulty that lenders face in making money while performing individualized credit analyses, particularly for smaller loans.

See: IOSCO Final Report: Good Practices on Reducing Reliance on CRAs in Asset Management.