IOSCO publishes Sound Practices at Large Intermediaries Relating to the Assessment of Creditworthiness and the Use of External Credit Ratings

The International Organization of Securities Commissions today published the final report on Sound Practices at Large Intermediaries Relating to the Assessment of Creditworthiness and the Use of External Credit Ratings.

The report recommends 12 sound practices that regulators could consider as part of their oversight of market intermediaries.  Large market intermediaries also may find the sound practices useful in the development and implementation of effective alternative methods for the assessment of creditworthiness.  IOSCO believes that identifying sound practices regarding suitable alternatives to credit ratings should reduce the overreliance on credit rating agencies (CRAs) for credit risk assessment. Such a development would help increase investor protection, while contributing to market integrity and financial stability.

CRA ratings can offer investors and lenders an efficient way to label the risks associated with a particular borrowing or lending facility.  But the recent global financial crisis illustrated how reliance on CRA ratings can potentially contribute and exacerbate the fallout on the markets.

In response, numerous international and national bodies have taken measures to address the possible over-reliance of market participants such as broker-dealers on credit ratings. These efforts have mainly focused on two areas:

Ø  requirements for financial firms to undertake their own due diligence and internal risk management instead of relying mechanistically on external CRA ratings, and

Ø  reconsideration of references to ratings in the regulatory framework, in light of their implicit potential to be regarded as public endorsement of CRA ratings, and their potential to negatively influence market behavior.

To identify the sound practices, IOSCO conducted a survey of market intermediaries in IOSCO jurisdictions. Responses were received from 53 market intermediary firms in 14 C3 member jurisdictions. IOSCO also convened two roundtable discussions with intermediary representatives, and published a public Consultation Report in May 2015.

Sound Practices

1.      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.

2.      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. Such involvement would entail oversight of the credit risk assessment process by a dedicated risk management team that reports to high-level management, such as a separate independent credit committee.

3.      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.

4.      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. This may include policy exceptions, limit breaches, stress testing analysis concentrations, watch lists, and top exposures, among other things.

5.      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. This includes having in-house the necessary staff expertise and technological ability to analyze effectively the firm’s portfolio and to stay abreast of market indicators.

6.      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, e.g., structure its portfolios, manage its trading book or whether to take on additional credit exposure.

7.      Incorporate a wide variety of qualitative measures into robust credit assessment processes in addition to quantitative measures. This can provide a more holistic view of creditworthiness than simply relying on quantitative factors alone.

8.      Prescribe internal risk levels and investment appetites for the assessment of creditworthiness that focus on the intrinsic value of the instrument to set limits and risk. These levels might distinguish between various categories, such as industry or on a geographical basis, and be reflected in the policies and procedures that set out the operating standards that must be followed by teams or individuals responsible for the assessment of credit risk.

9.      Subject non-investment grade or unrated financial products to enhanced scrutiny.

10.  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. Carefully consider the effect of using external credit ratings as parameters to assess the creditworthiness of investments or to decide whether to invest or disinvest. Recognize and understand the possible limitations of CRA ratings and become familiar with CRA credit risk assessment methodologies. For example, CRA ratings may be a lagging indicator of more general credit risks and do not always reflect the most recent factors affecting creditworthiness.

11.  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.

12.  Ensure internal audit or another independent party performs regular reviews of credit policies and procedures.

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