On 27 October 2010, the FSB released at a global level its principles for reducing reliance on credit rating agency (CRA) ratings. The European Commission published in turn a new consultation on the issue of overreliance on CRAs on 5 November 2010. The consultation, which came to an end on 7 January 2011, aimed at promoting better due diligence and considering internal risk management models. It also called for changing the role of ratings in the current regulatory policy in light of their potential impact on investors’ behaviours.
The main themes of the Commission consultation paper are:
- Reducing overreliance on external credit ratings (by suggesting the use of internal credit risk assessment process and of a mix of alternative measures, either in the case of capital requirement calculation than investment policy decisions and risk management purposes);
- Enhancing sovereign debt ratings (among others, one of the proposals is to reduce the assessment time period from one year to six months and increase the number of documentation disclosed by rating agencies );
- Enhancing competition in the credit rating industry (by encouraging the ECB to issue ratings);
- Proposing civil liability of CRAs; and
- Elimination of potential conflict of interest due to the “Issuer-Pays” Model
The AMIC is of the view that reforms, while desirable, need to be well conceived in order to maintain the public-good aspects of credit ratings and to avoid unintended consequences such as increased costs and reduced access to capital markets. Credit rating agencies provide an assessment of the creditworthiness of a corporation or security, based on the issuer's quality of assets, existing liabilities, borrowing history, and overall business performance. Credit rating agencies offer the issuing company the opportunity to use and communicate non-public information externally, without disclosing its precise content. This is a critical aspect of a functioning international capital market.
The current regulatory framework is so reliant on ratings that significant changes can only be conceived to take place over time. Mandates to use ratings have become part of the fabric of financial markets, and cannot be unwoven instantaneously. Many institutional investors are legally obliged to hold only securities of some minimum rating, or may have to hold larger reserves when investing in bonds of lower ratings. Ratings are also used in private contracts, for example to define the investment objectives of bond mutual funds. Accordingly the AMIC believes that regulatory use of ratings has exacerbated pro-cyclicality in the financial system as a whole. However, in order to reduce private reliance on ratings, credible alternatives or substitutes should be developed, particularly for institutions that lack resources to assess independently the number of available fixed income instruments.