Credit rating agencies (CRAs) play a prominent role in the global financial markets. CRAs provide external credit ratings of individual financial instruments and issuers that express a view on the instrument or entity’s overall creditworthiness. The role of CRAs has come under regulatory scrutiny, both in the EU and globally, partly as a result of the over-reliance placed by some market participants, including some asset managers and institutional investors, on CRA ratings in their assessments of both financial instruments and issuers in the run-up to the 2007-2008 financial crisis. For example, ESMA revised its guidelines on a common definition of European money market funds with a view to preventing sole or mechanistic reliance on credit ratings when an investment manager is assessing the credit quality of money market instruments.
The latest development in this context is the recent publication by IOSCO of a set of good practices for consideration by market participants and regulators in relation to the use of CRA ratings in the asset management industry. The set of good practices is addressed to national regulators, asset managers and investors, where applicable, and suggests specific practices that asset managers could undertake to reduce any potential over-reliance on external credit ratings in the asset management space.
The good practices issued by IOSCO are set out in full below:
- Asset managers make their own determinations as to the credit quality of a financial instrument before investing and throughout the holding period.
- Asset managers 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, and should refrain from investing in products / issuers when they do not have enough information to perform an appropriate credit risk assessment.
- External credit ratings may form one element, among others, of the internal assessment process but do not constitute the sole factor supporting the credit analysis.
- The manager’s internal assessment process is regularly updated and applied consistently.
- Where external credit ratings are used, asset managers understand the methodologies, parameters and the basis on which the assessment of a CRA was produced, and have adequate means and expertise to identify the limitations of the methodology and assumptions used to form that assessment.
- Asset managers 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 methods.
- When assessing the credit quality of their counterparties or collateral, asset managers do not rely solely on external credit ratings and consider alternative quality parameters (e.g., liquidity, valuation, correlation, etc.).
- Where external credit ratings are used, a downgrade does 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.