Asset managers need to do their homework on credit risk to avoid relying too heavily on credit-rating agencies, says a new report from the International Organization of Securities Commissions (IOSCO) published on Monday.
The IOSCO report sets out best practices for institutional investors to reduce their reliance on credit-rating agencies. The push comes in the wake of the global financial crisis, which revealed that some financial services firms were mechanistically utilizing external ratings to assess credit risk rather than carrying out their own due diligence.
The use of external credit ratings by asset managers is mainly demand-driven, the report says, although it adds that references to external credit ratings may also be built into regulatory requirements or firms’ internal rules. “This may result in mechanistic reliance, which could trigger forced asset sales in the event of downgrades,” it says.
To address these concerns, the IOSCO report recommends that the Financial Stability Board (FSB) consider potential ways to reduce possible overreliance on external ratings that is driven by regulatory requirements, such as those in the global capital rules for banks and insurers. The report also stresses that asset managers should have their own expertise and processes “to assess and manage the credit risk associated with their investment decisions.” Furthermore, the report sets out eight practices that firms can employ when utilizing external ratings.
Those practices follow from a set of principles the FSB developed in 2010 designed to encourage an end to mechanistic reliance on ratings by banks, institutional investors and other market players. The IOSCO report calls on asset managers to avoid investing in products/issuers when they don’t have enough information to perform an appropriate credit risk assessment, among other things.
The report also says that external ratings can constitute one aspect of a credit risk assessment, but they shouldn’t be the only factor, and, that asset sales shouldn’t be triggered automatically by a downgrade.
In addition, asset managers must understand the underlying methodologies, parameters and the basis for the credit-rating agencies’ opinions when external ratings are used, the report stresses. It also calls on asset managers to review the disclosure they provide that details the alternative sources of credit information they use in addition to external ratings.
Finally, the report recommends that firms should not rely solely on ratings to assess the credit quality of counterparties or collateral.