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Basel Committee on Banking Supervision, The Joint Forum
Stocktaking on the use of credit ratings - June 2009
Introduction
A. Background
In its report to the
G7 titled Report of the Financial Stability
Forum on Enhancing Market and Institutional Resilience, the
Financial Stability Forum (FSF) requested the Joint Forum to
conduct a stocktaking of the uses of external credit ratings by
its member authorities in the banking, securities and insurance
sectors.
The request also suggested that authorities
review whether their regulations and/or supervisory policies
unintentionally give credit ratings an official seal of approval
that discourages investors from performing their own due
diligence.
To implement the FSF request, the Joint Forum Working Group on
Risk Assessment and Capital (JFRAC) prepared and circulated to
member authorities a questionnaire on the use of credit ratings in
their jurisdictions.
The questionnaire was designed to elicit information regarding
member authorities’ use of credit ratings in legislation
(statutes), regulations (rules), and/or supervisory policies
(guidance) affecting, or generated by, such authorities
(collectively, LRSPs).
he questionnaire requested information on the definitions (either
internal or via crossreference to an external source) of “credit
ratings,” “credit rating agencies,” or any related terms as well
as any references to specific credit rating agencies in LRSPs.
Member authorities were also asked questions regarding the usage
of credit ratings and/or references to credit rating agencies (or,
in either case, related terms) in their LRSPs, including an
explanation of what each LRSP was designed to accomplish and the
purpose of using credit
ratings in the LRSP.
Finally, the questionnaire asked member authorities to describe
their assessments, if any, of unintended implications of such
uses, in particular, 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.
JFRAC received a total of 17 surveys from member authorities,
representing 26 separate agencies from 12 different countries, as
well as five responses describing international frameworks.
This report is intended to serve as a stocktaking of member authorites’ use of credit ratings.
This stocktaking is based entirely on the responses received from
member authorities in response to the questionnaire circulated by
JFRAC and, with the exception of the descriptions of international
frameworks prepared by member authorities, does not address the
use of credit ratings in any other jurisdictions.
The report is not intended to be, and should not be construed as,
an expository discussion of how credit ratings are developed, what
information they are intended to convey, or how and by whom they
are regulated.
Furthermore, the report does not express any
viewpoint regarding the quality, accuracy, or any other subjective
evaluation of credit ratings and does not take any position on the
appropriateness of member authorities’ use of credit ratings.
Pursuant to the FSF mandate, the questionnaire circulated to
member authorities solicited their individual views on potential
unintended consequences of their use of credit ratings in LRSPs (ie,
the appearance of a “seal of approval”).
In preparing their
responses to this portion of the questionnaire, member authorities
were not expected to conduct any independent research on the
issue, but instead simply to convey their broad impressions and
preliminary views.
As such, the summary of these views in this report should not be
construed as a definitive survey of member authorities’ positions;
the report expresses the range of viewpoints expressed by member
authorities on the issue of the unintended consequences of the use
of credit ratings in LRSPs and takes no independent position on
the subject.
Key terms used in this report
Several key terms that are used throughout this report bear
mention.
The two most significant related terms for subsets of “credit
rating agencies” are “nationally recognised statistical rating
organisations” (NRSROs), which are regulated by the United States
Securities and Exchange Commission (US SEC), and
“external credit
assessment institutions” (ECAIs), a term set forth in the Basel II
framework.
The term “NRSRO” is defined in United States (US) legislation and
is limited to credit rating agencies that have applied for and
been granted registration by the US SEC.
This statutory definition of NRSRO is cross-referenced extensively
in US regulations as well as in the Canadian Securities
Administrators’ national instrument relating to the
Multijurisdictional Disclosure System (MJDS).
Almost half of the respondents referenced the term “ECAI,” with
several specifically referencing the Basel II framework and/or the
Committee of European Banking Supervisors (CEBS) “Guidelines on
the recognition of External Credit Assessment Institutions” (CEBS
Guidelines) as the source for that term.
While the amended Basel II framework sets forth criteria to be
used by national supervisors for the “recognition” of ECAIs, it
does not contain a
definition of the term.
Consistent with that framework, the Capital Requirements Directive
(CRD) that implements the Basel II framework in the European
Union (EU) does not define an ECAI, but instead sets forth
criteria for the recognition of eligible ECAIs.
A small minority of respondents indicated that their LRSPs include
an explicit definition of the term “ECAI.”
For instance, under the Australian prudential standards, an ECAI
is defined as “an entity that assigns credit ratings designed to
measure the creditworthiness of a counterparty or certain types of
debt obligations of a counterparty.”
The majority of respondents indicated that their LRSPs reference
specific credit rating agencies.
All but one of those respondents mentioned Moody’s Investors
Service, Standard & Poor’s Ratings Services, and Fitch Ratings.
Several respondents indicated that the individual credit rating
agencies listed in their LRSPs are formally reviewed on a regular
basis, in some cases on a fixed schedule (ie, annually or every
five years).
Several others noted that the Basel II and/or CEBS designation
procedures for ECAIs also applied to the removal of the ECAI
designation.
In addition, a number of respondents indicated that their LRSPs
naming individual credit rating agencies could be amended through
their jurisdiction’s standard legislative or regulatory process.
Finally, the Markets in Financial Instruments Directive (MiFID),
an EU law designed to provide a harmonised regulatory regime for
investment services, defines the term “competent rating agency”
for that specific purpose as an entity that “issues credit ratings
in respect of money market funds regularly and on a professional
basis and is an eligible ECAI within the meaning of Article 81(1)
of Directive 2006/48/EC.”
Basel Framework
Basel II serves as the foundation for the use of credit ratings in
a significant number of member jurisdictions.
These jurisdictions have implemented the Basel II framework into
their domestic LRSPs to varying degrees, with most appearing to
have incorporated the substantial elements of the framework into
their domestic LRSPs.
As alluded to above, the EU implemented Basel II via the CRD,
which applies to both banks and investment firms.
Uses of credit ratings
As described in greater detail below, credit ratings are generally
used in member jurisdictions for five key purposes:
(a) determining capital requirements;
(b) identifying or classifying assets, usually in the context of
eligible investments or permissible asset concentrations;
(c) providing a credible evaluation of the credit risk associated
with assets purchased as part of a securitisation offering or a
covered bond offering;
(d) determining disclosure requirements;
and (e) determining prospectus eligibility.
In general, the member authorities that responded to the survey
reported a greater use of credit ratings in their LRSPs covering
the banking and
securities sectors than in their LRSPs for the insurance sector.
A. Capital
1. Banking and securities sectors
This category features the broadest application of the use of
credit ratings.
Member authorities from every jurisdiction submitting responses
indicated that their LRSPs contained provisions using credit
ratings for the purpose of determining net or regulatory capital,
and more LRSPs are applied to capital requirements than to any
other category of use.
Credit ratings were generally used in those LRSPs as a means of
mapping credit risks to capital charges or risk weights.
A related use for ratings in LRSPs is the determination of margin
rates; for example, certain sovereign bonds and debentures may be
subject to lower margin rates as a result of receiving investment
grade ratings.
In the Basel II framework, external ratings are used for the
purpose of enhancing the risk sensitivity of the framework, for
example, by being incorporated into assessments of the credit
quality of an exposure or creditworthiness of a counterparty – and
thus the imposition of capital requirements.
External ratings are primarily used under the standardised
approach for credit risk,10 but also to risk-weight
securitisations exposures.
The different uses of external ratings generally correspond to
probability of default treatments under the standardised
approaches, and to situations where the use of internally
generated ratings is impossible or difficult given, for instance,
the lack of statistical data for securitised products.
In most cases, for member jurisdictions that have incorporated the
Basel II framework, the external ratings that can be used for the
purpose of determining regulatory capital are limited to those
provided by rating agencies recognised by national supervisors as
ECAIs.
Supervisors assess whether these criteria are fulfilled and aim at
identifying rating agencies that issue ratings that are
sufficiently sound and robust to warrant using them to determine
the appropriate regulatory capital levels. Supervisors are also in
charge of articulating the
conditions and details for the use of ratings (eg, in the EU, for
the mapping of external ratings to the regulatory risk-weights or
credit quality steps).
All members of the EU have implemented the CRD, which implements
the Basel II framework for both banks and investment firms.
Within the EU, the decision as to whether or not to recognise an ECAI is within each member’s discretion, although the “joint
assessment
process” set forth in the CEBS Guidelines is designed to achieve a
consistent approach among EU member states.
In Australian LRSPs for authorised deposit-taking institutions,
mappings of credit ratings are used to calculate regulatory
capital risk weights for certain credit risk and securitisation
exposures, as set out in the Basel II framework.
In Canada, all banks have implemented the Basel II framework and
hence external ratings are used to assess the credit risk of an
exposure.
In Japan, credit ratings issued by Designated Rating Agencies (DRA)
are used to estimate market risks and counterparty risks for the
purpose of calculating the capital adequacy ratios for securities
companies.
Japan also noted that for calculating the capital adequacy ratios
for banks and other deposit-taking institutions, credit ratings
issued by ECAIs are used subject to the Financial Services Agency
(JFSA) ordinance under the Banking Act.
In the United States, which features the most widespread use of
credit ratings in LRSPs that establish capital requirements in the
securities and banking sectors, the use of credit ratings for
capital purposes is almost exclusively restricted to those issued
by credit rating agencies
designated as NRSROs through the US SEC’s registration process.
2. Insurance Sector
In the European Union, the existing insurance and reinsurance
directives do not contain any provisions that place reliance on
credit rating agencies.
There is no explicit credit risk charge for the solvency margin in
the Solvency I framework.
The solvency margin in the Solvency I framework is not the sum of
different capital charges related to different risks, but a single
capital charge calibrated to reflect all the risks an insurance
company faces.
Nevertheless, the importance of credit quality is taken into
account in the rules applying to asset allocation; but they are
not based on the use of credit ratings.
For instance, Article 24 of Directive 2002/83/EC establishes rules
for investment diversification without any reference to credit
ratings.
An insurance company must diversify the assets that cover its
liabilities towards policyholders and limit its investments in
certain asset classes as a percentage of total liabililties.
However, a number of member jurisdictions’ national laws
implementing the investment rules of the current Solvency I
Directives do refer to, or place reliance on, ratings in order
to determine whether a certain asset is authorised or eligible to
cover technical provisions.
Moreover, in a number of member jurisdictions, (re)insurance
undertakings are required, as part of their internal reinsurance
policy, to pay special attention to the financial strength of
their reinsurers, using ratings as a proxy.
For example, in the Netherlands, when pension funds reinsure their
assets, they must maintain buffers to cover the risk of the
reinsurance company defaulting on its obligations.
The size of these buffers depends on the credit spread of the
reinsurance company.
As a gesture to the sector, on its website, De Nederlandsche Bank
publishes credit spreads that (smaller) pension funds can use when
they cannot obtain market data.
In the United Kingdom, the Insurance Prudential Sourcebook
provides a table with “listed rating agencies” (A.M. Best Company,
Fitch Ratings, Moody’s Investor Service, Standard & Poor’s Ratings
Services), including credit rating descriptions and “spread
factors.”
With regard to insurance capital resources requirements,
credit ratings from these firms are used in determining assumed
spread stresses.
In the United States, insurance regulators require bonds and
preferred stocks to be reported in statutory financial statements
in one of six National Association of Insurance Commissioners (NAIC)
designations categories that denote credit quality.
If an accepted rating organisation (ARO) has rated the security,
the security is not required to be filed with the NAIC’s
Securities Valuation Office (SVO).
Rather, the ARO rating is used to map the security to one of the
six NAIC designation categories.
The NAIC designations are primarily designed to assist regulators
(as opposed to investors) to monitor the financial condition of
their insurers.
Finally, in light of the impact that the credit market crisis had
on the credit ratings of the financial guarantors and the bonds
they insure, the NAIC announced that the SVO will be issuing
“substitute” ratings for some municipal bonds. In doing so, the
NAIC will be assessing the creditworthiness of the municipality
that issued the debt.
These credit ratings will be used to determine the risk based
capital charge for the security.
The insurance regulators indicated that the proposal will
“decouple” the NAIC rating from the rating agency process.
In Canada, a significant portion of an insurer’s capital
requirement (especially for a life insurer) arises from its
exposure to credit risk.
This component of the overall insurer capital requirement is
determined using asset default factors.
For rated short term securities, bonds, loans and private
placements, these factors are based on the rating agency grade.
In its life insurer capital guideline, the Office of the
Superintendent of Financial Institutions (OSFI) states that:
“A company must consistently follow the latest ratings from a
recognized, widely followed credit rating agency.
Only where that rating agency does not rate a particular
instrument, the rating of another recognized, widely followed
credit rating agency may
be used.
However, if the Office believes that the results are
inappropriate, a higher capital charge would be required.”
Further, in Canada, asset default factors for preferred shares,
where rated, are based on the rating agency grade.
For financial leases where rated, and the lease is also secured by
the general credit of the lessee, the asset default factor is
based on the rating agency grade.
Other examples of the use of credit ratings in LRSPs governing
capital requirements are found in Japan, where credit ratings
issued by DRAs are used to calculate the solvency margin ratios
regarding estimating credit risks for insurance companies, and
Australia, where prudential standards for both general insurers
and life insurers use credit ratings to assign counterparty grades
used in regulatory capital requirements.
Go to
Stocktaking on the use of credit ratings - June 2009 Part 2
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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