Description
Credit rating agencies (CRAs) play a prominent role in today's global financial markets. Although approaches may differ across jurisdictions, investment managers often use the services of CRAs to form an opinion on the creditworthiness of a particular issuer before purchasing securities, selecting counterparties, or choosing the best collateral to secure transactions.
Good Practices on Reducing Reliance on CRAs in
asset management
Consultation Report
THE BOARD OF THE
INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS
CR04/14 JUNE 2014
This paper is for public consultation purposes only. It has not been approved for any other
purpose by the Board of IOSCO or any of its members.
ii
Copies of publications are available from:
The International Organization of Securities Commissions website www.iosco.org
©International Organization of Securities Commissions 2014. All rights reserved. Brief
excerpts may be reproduced or translated provided the source is stated.
iii
Foreword
The Board of the International Organization of Securities Commissions (IOSCO) has published
this Consultation Report.
This Consultation Report is prepared by the IOSCO Committee 5 on Investment Management
(C5). IOSCO seeks the views of stakeholders on the questions posed in this report to inform its
final Good Practices on Reducing Reliance on CRAs in asset management. Investment managers,
institutional investors and credit rating agencies are the main stakeholders targeted by this
Consultation Report.
How to Submit Comments
Comments may be submitted by one of the three following methods on or before Friday 5
September 2014. To help us process and review your comments more efficiently, please use
only one method.
Important: All comments will be made available publicly, unless anonymity is specifically
requested. Comments will be converted to PDF format and posted on the IOSCO website.
Personal identifying information will not be edited from submissions.
1. Email
• Send comments to [email protected]
• The subject line of your message must indicate [Good Practices on Reducing
Reliance on CRAs in asset management]
• If you attach a document, indicate the software used (e.g., WordPerfect, Microsoft
WORD, ASCII text, etc.) to create the attachment.
• Do not submit attachments as HTML, PDF, GIFG, TIFF, PIF, ZIP or EXE files.
2. Facsimile Transmission
Send by facsimile transmission using the following fax number: +34 (91) 555 93 68.
3. Paper
Send three (3) copies of your paper comment letter to:
Mr Mohamed Ben Salem
General Secretariat
International Organization of Securities Commissions (IOSCO)
Calle Oquendo 12
28006 Madrid
Spain
Your comment letter should indicate prominently that it is a “Public Comment on Good
Practices on Reducing Reliance on CRAs in asset management”.
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Contents
Introduction .......................................................................................................................................... 1
Chapter 1 – Scope ................................................................................................................................ 5
Chapter 2 – Internal credit assessment .............................................................................................. 9
Chapter 3 – Uses of external credit ratings by investment managers ........................................... 13
3.1 Asset selection ............................................................................................................. 13
3.1.1 References to external ratings in fund disclosures ...................................... 13
3.1.2 References to external ratings in individual investment mandates ........... 13
3.1.3. Investment managers’ access to underlying credit rating information .... 15
3.1.4 Investment managers’ disclosures on uses of external credit ratings ....... 16
3.1.5 Uses of external ratings to determine the quality of an asset’s guarantor
or of a fund’s sponsor ..................................................................................... 16
3.2 Quality of counterparties and collateral .................................................................. 18
3.3 Investment managers soliciting fund ratings ........................................................... 20
3.4 Managing external credit rating changes ................................................................ 23
Appendix A – List of Possible Good Practices ................................................................................ 25
Appendix B – List of Questions for consultation ............................................................................ 26
1
Introduction
Credit rating agencies (CRAs) play a prominent role in today’s global financial markets.
Although approaches may differ across jurisdictions, investment managers often use the services
of CRAs to form an opinion on the creditworthiness of a particular issuer before purchasing
securities, selecting counterparties, or choosing the best collateral to secure transactions. On their
part, investors often refer to CRA ratings to determine their investment universe before buying
shares of a fund
1
, or when guiding investment managers on the basis of a tailored investment
mandate.
The role of CRAs has come under regulatory scrutiny, mainly as a result of the over-reliance
placed by market participants, including investment 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.
To tackle this concern, in October 2010, the Financial Stability Board (FSB) published its report
on Principles for Reducing Reliance on CRA Ratings (“FSB 2010 Principles”)
2
. The goal of the
Principles is to end mechanistic reliance on ratings by banks, institutional investors, and other
market participants, thereby reducing the financial stability-threatening herding and cliff effects
that could arise from CRA rating thresholds being hard-wired into laws, regulations, and market
practices. The FSB 2010 Principles contain a number of important recommendations.
The relevant FSB Principles for investment managers in detail
Principles I and II provide the general framework requiring that standard setters, authorities
and market participants consider ways to reduce overreliance to CRA ratings.
Principle I. Reducing reliance on CRA ratings in standards, laws and regulations
Standard setters and authorities should assess references to credit rating agency (CRA)
ratings in standards, laws and regulations and, wherever possible, remove them or replace
them by suitable alternative standards of creditworthiness.
Principle II. Reducing market reliance on CRA ratings
Banks, market participants and institutional investors should be expected to make their own
credit assessments, and not rely solely or mechanistically on CRA ratings.
Of particular relevance for investment managers is Principle III.3 thereof:
Investment managers and institutional investors must not mechanistically rely on CRA
ratings for assessing the creditworthiness of assets. This principle applies across the full
range of investment managers and of institutional investors, including money market funds,
pension funds, collective investment schemes (such as mutual funds and investment
companies), insurance companies and securities firms. It applies to all sizes and levels of
1
For the purpose of this consultation report, the term “fund” is understood broadly to include both registered
(e.g., collective investment schemes - CIS) and non-registered (e.g. private funds) collective investment
vehicles across different jurisdictions.
2
Available at: http://www.financialstabilityboard.org/publications/r_101027.pdf.
2
sophistication of investment managers and institutional investors.
Principle III.3.b adds that senior management and boards of institutional investors have a
responsibility to ensure that internal assessments of credit and other risks associated with
their investment are being made, and that the investment managers they use have the skills to
understand the instruments they are investing in and exposures they face, and do not
mechanistically rely on CRA ratings
3
, In addition, senior management, boards and trustees
should ensure adequate public disclosure of how CRA ratings are used in risk assessment
processes.
Principle III.3.c suggests a list of measures that regulators could adopt to avoid the
mechanistic reliance on ratings. These are inter alia:
• Restricting the proportion of a portfolio that is solely CRA ratings-reliant;
• Supervisory monitoring of credit and other risk assessment processes (in the case of
supervised investment managers and institutional investors);
• Requiring the boards, trustees or other governing bodies of investment managers and
institutional investors to regularly review any use of CRA ratings in their investment
guidelines and mandates and for risk management and valuation;
• Requiring public disclosures of internal due diligence and credit risk assessment
processes, including how CRA ratings are or are not used, with the aim of
encouraging investment managers to develop more rigorous and individual processes
included in investment mandates, rather than relying on common triggers;
• Requiring public disclosures of risk assessment policies related not solely to specific
rating thresholds, but also accounting for the types of instruments (thus reflecting the
different nature of the risks applying to, for instance, structured finance products
compared with corporate bonds). Such disclosures should be made in a manner
consistent with the goal of streamlining disclosures for customers.
Finally, Principle III.5.a proposes that standard setters and authorities should review
whether any references to CRA ratings in standards, laws and regulations relating to
disclosure requirements are providing unintended incentives for investors to rely excessively
on CRA ratings and, if appropriate, remove or amend these requirements.
The FSB 2010 Principles concluded with an exhortation for standard setters – including IOSCO -
and regulators to consider steps for translating the principles into more specific policy actions
4
. In
3
In the text accompanying the Principle III.3.b, the FSB report adds that the case of smaller, less
sophisticated investors (who do not have the resources to conduct internal credit assessments for all their
investments or who may outsource all or part of their investment management), this could be carried out
through the trustees or others responsible for directing the investment strategy, ensuring that they
understand the risks implied by the strategy they are following, as well as the appropriate uses and
limitations of CRA ratings.
4
IOSCO has already addressed these issues in a J uly 2009 report on Good Practices in Relation to
Investment Managers´ Due Diligence When Investing in Structured Finance Instruments. Although the
mandate focussed on due diligence when investing in structured finance products, the report recognized that
many of the principles and themes discussed therein could be applied regardless of the type of product. This
3
line with the FSB approach, IOSCO’s Policy Committee on Investment Management (C5)
launched a first mapping exercise in March 2011 to better understand the extent of its Member
jurisdictions’ reliance on regulations explicitly referencing CRA ratings for investment managers
and identify gaps between existing domestic regulations and the FSB 2010 Principles
5
.
As a follow-up to its 2010 Principles, in November 2012, the FSB published its so-called
"Roadmap"
6
, highlighting the short- to medium-term milestones for progress towards lessening
the continued over-reliance on CRAs and for strengthening financial firms’ own risk assessments.
Both the Principles and the Roadmap adopt a dual-track approach, in which the removal of the
“hard-wiring” of references to CRA ratings in standards, laws and regulations is to be
accompanied by promoting incentives for the private sector to develop its own internal credit risk
assessment processes. In this respect, the FSB has conducted a thematic peer review of progress
made in member jurisdictions in implementing the 2010 Principles. The peer review’s main
objective is to assist national jurisdictions in fulfilling their commitments under the Roadmap
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.
In view of the need to provide guidance to its Member jurisdictions (and indirectly to market
participants to develop alternative credit assessment procedures), IOSCO has launched a series of
new mandates among its policy committees aimed at complementing the on-going FSB peer
review process.
In this light, C5 carried out a second mapping exercise in October 2012. The results of this
second exercise have revealed further progress in reducing the over-reliance on CRAs in national
regulations applicable to investment management in line with the 2010 FSB Principles. In order
to address the outstanding concerns, C5 Members obtained the approval of a mandate under
which C5 could respond, inter alia, to the following objectives
8
.
1. Identify Good Practices by analyzing the type of alternatives to CRA ratings envisaged in
the various C5 jurisdictions and where appropriate build on the previous IOSCO Good
Practices in Relation to Investment Managers´ Due Diligence When Investing in
Structured Finance Instruments of 2009 (“IOSCO 2009 Good Practices”) when investing
in structured finance products;
2. Consider the issue of the ratings of investment funds, or of other collective investment
schemes (CIS), with a view to determine what policy tools could be explored;
3. Monitor the FSB work to ensure the specificities of the investment management industry
are appropriately taken into account.
would concern, in particular, certain good practices related to the use of third parties, including CRAs, in
the due diligence process.
5
Results demonstrated that several jurisdictions had undertaken important steps in amending their relevant
regulations to discourage over-reliance, while identifying areas that had not yet been fully addressed.
6
Available at: http://www.financialstabilityboard.org/publications/r_121105b.pdf
7
The final report on its main findings was published in May 2014 and is available at:
http://www.financialstabilityboard.org/publications/r_140512.pdf
8
For this purpose, a working group within C5 was established. It is co-Chaired by the French AMF and the
U.S. SEC, and is comprised of the following additional regulators: the Australian ASIC, Brazilian CVM,
the J apanese FSA, the Mexican CNBV and the Québec AMF.
4
The present consultation report is designed to gather the views of industry (investment managers
and their representative trade bodies, institutional investors and their associations, including any
interested party, and CRAs) and draw on their practices for the purpose of developing and
finalizing a set of Good Practices in 2014. These will be addressed to national regulators,
investment managers, and investors, where applicable, and will suggest specific practices to
reduce over-reliance on external credit ratings in the asset management space. It should also be
noted that IOSCO’s Policy Committee for the Regulation of Market Intermediaries has launched
a project to identify “good practices” currently in place at intermediaries with regard to the use of
alternatives to credit ratings to assess creditworthiness.
5
Chapter 1 – Scope
Different notions of external rating
This consultation report distinguishes between external ratings of individual financial
instruments, of issuers, and of certain types of pooled investment vehicles (e.g., money market,
structured finance vehicles) that express a view on the overall creditworthiness (hereafter “credit
ratings”) from those that on the other hand emphasize other, non-credit and qualitative aspects of
a selected issuer, such as managerial talent, the effectiveness of a particular strategy in meeting
the desired returns, the quality of internal operations and controls, etc.
9
. It is specifically with
regard to credit ratings that, when used for regulatory purposes or when included in private
investment agreements, concerns arise regarding over-reliance because of the potential “cliff
effects” resulting from a ratings downgrade
10
.
Notwithstanding these concerns, it is widely accepted that credit ratings act as useful, and at
times necessary, benchmarks against which investment managers and investors may wish to
compare their own internal credit analysis when available. Credit ratings rely on a blend of both
quantitative (e.g., the systematic assessment of financial data, the calculation of ratios, running of
models, etc.) and qualitative indicators (e.g., business risks, the impact of regulatory change, the
quality of management, the implied future industry outlook, etc.) to objectively assess the
9
An example of this second category is provided by Morningstar’s methodology for rating funds, split
between the Star Ratings, that are backward-looking, strictly quantitative, assessing a fund’s past
performance in terms of returns adjusted for risk/volatility, of performance vis-à-vis competitors in the same
category, and of value generated for investors over specified periods; and the more recent Analyst Rating
system, where more qualitative and “subjective” factors are taken into account to express a forward-looking
opinion on the people (a fund’s managers), the process (i.e., how a fund’s proclaimed strategy is translated
into a portfolio), the parent (i.e., what are the managing company’s priorities), the performance (i.e., why
did a fund behave in a certain way in certain markets and probability of the same repeating in the future),
and the price (i.e., is a fund a good value proposition for investors compared to peers). The Analyst Rating
system methodology factsheet is available at:
http://corporate.morningstar.com/US/documents/MethodologyDocuments/FactSheets/AnalystRatingforFun
dsFactSheet.pdf.
For further information, please refer to the Morningstar Equity Research Methodology of J anuary 2012,
available at: http://news.morningstar.com/pdfs/Equity_Research_Methodology_010512.pdf.
See also Fitch Ratings with regard to the fund quality ratings criteria: Assessing Funds’ Investment
Processes and Operational Attributes, available at:
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=552845.
The Fitch Quality Ratings have three pillars: (1) an assessment of the investment process, its resources and
the management company; (2) an operational “pass/fail” analysis; and (3) a ‘reality check’ of the qualitative
assessment against the manager’s historical risk-adjusted performance.
10
In the October 2010 Principles for Reducing Reliance on CRA Ratings, the FSB acknowledges that the
hard-wiring of CRA ratings thresholds into laws, regulations and market practices causes financial stability-
threatening herding and cliff effects where the downgrade of a security under a specific threshold may lead
to sudden disproportionate cascading effect.
6
probability of default (PD) or expected loss (EL)
11
.
The present report deals exclusively with this category of credit ratings, as it is with reference to
them that over-reliance raises concern
12
. To the extent that ratings assigned to certain types of
funds by CRAs are based on the analysis of the creditworthiness of the underlying portfolio, the
present report also discusses potential issues with the use of such ratings.
For the purpose of this consultation report only external credit ratings, which express a
predominant and clear outlook on the creditworthiness (i.e., in particular the implied probability
of default) of a particular instrument and/or entity, will be considered.
Uses of external credit ratings by investment managers
Investment managers may refer to external credit ratings to different degrees in the construction
and management of their portfolios. Given the diversity of asset classes and breadth of different
investment vehicles, each following an investment strategy that is set to meet different investor
needs, there is no single way that investment managers use external credit ratings.
According to the results of the mapping exercises conducted among C5 Member jurisdictions
over 2011-2012, investment managers use external ratings predominantly:
• To guide asset selection in the construction and optimization of an investment portfolio;
• To guide the selection of eligible collateral received or posted from/to different
counterparties;
• To assess a counterparty’s overall financial health and ability to uphold its obligations vis-à-
vis one or more funds, as well as to determine the credit quality of certain guarantors or of
sponsors that may provide support to certain pooled investment vehicles (e.g., money market
funds or structured finance vehicles)
13
.
External credit ratings may also be an element that is accounted for in estimating and managing
portfolio risk subject to the methods or metrics used. Depending on the standard industry models
11
Examples of credit ratings are those assigned to individual financial instruments and issuers by the large and
more established CRAs like Standard & Poor’s, Moody’s and Fitch. By definition their ratings are opinions
on the general creditworthiness of an obligor (issuer), or of its creditworthiness in relation to a particular
security or financial obligation, taking into account the foreseeable future events. See Moody’s Investor
Service, Ratings Symbols and Definitions (April 2014) at 4; Standard & Poor’s, About Credit Ratings
(2012), available at:
http://www.standardandpoors.com/aboutcreditratings/RatingsManual_PrintGuide.html; FitchRatings,
Definitions of Ratings and other Forms of Opinion (J an. 2014) at 4
12
Under the IOSCO CRA Code of Conduct in 2008, a credit rating is defined as “an opinion regarding the
creditworthiness of an entity, a credit commitment, a debt or debt-like security or an issuer of such
obligations, expressed using an established and defined ranking system.”
13
In general, a guarantor of a debt security has an unconditional obligation to pay the guarantee holder the
principal amount of the underlying security plus accrued interest upon default. A sponsor of a structured
finance vehicle or MMF on the other hand is not legally obligated to provide support to the entity, but some
sponsors have done so, including in 2008. See Money Market Fund Reform; Investment Company Act
Release No. 28807 (June 30, 2009) at n.54 and accompanying text (available at
http://www.sec.gov/rules/proposed/2009/ic-28807.pdf)
7
used and on prevailing industry practices, C5 Members would like to understand more about how
external ratings are used in this regard, i.e., what effects downgrades may or may not have on the
average risk of the collective portfolio that is evaluated using these methods or metrics.
Uses of external ratings by investors
Investors may consider external credit ratings before investing and throughout the life of their
investments to define the range of assets in which they choose to invest. They may often establish
investment guidelines to direct investment managers as to the types of instruments that investors
wish their fund or managed account to be invested in. As such, external credit ratings represent a
“common language” used by parties to an investment management agreement. In the absence of
external credit ratings provided by CRAs, many investors would need to rely almost exclusively
on the investment manager in determining whether a security is of investment grade or of high
credit quality. As such, references to CRA ratings, even when embedded in investment contracts,
may prove beneficial to investors by offering them alternative information points from a third
party, while establishing that certain expectations as to how the fund should be managed are to be
taken into account by the investment manager. Investors also may rely on credit ratings, among
other factors, when choosing to invest (or remain invested) in a particular investment vehicle
14
.
Questions for consultation:
1. Do you agree with the above categorization of uses by investment managers of
external credit ratings? Are there other ways in which investment managers use
external credit ratings? Can you point to situations where you would consider there
is no alternative to external credit ratings?
2. What benefits do you as an investment manager see in the use of external credit
ratings? How does your particular size, resources, capabilities, etc., affect the
benefits you perceive?
3. How do investment managers adjust their internal portfolio risk models (e.g.,
diversification parameters, liquidity profile, VaR, etc.) to account for external credit
rating changes to their portfolio securities? Among other risk factors (e.g., currency
and interest rate changes), how relevant are external ratings in determining the
ultimate risk level of a specific portfolio? Where possible, please suggest some
examples as to why rating changes to the underlying securities may or may not be
relevant.
4. As investors, depending on the type of investment vehicle and on your own capacity
to carry out your own internal credit analysis, to what extent is the credit rating of a
fund’s portfolio holdings or of the fund itself, a determining factor in making your
investment decision? Do you require the investment manager to reference one or
more CRA ratings? If yes, is this your own choice or is it required by your specific
institution?
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For example, some investors will only invest in money market funds that have received the highest rating
8
5. Before investing, do you as an investor verify that an investment manager has
procedures in place to perform its own credit analysis? Please elaborate on whether
the approaches differ depending on the type of investment vehicle (e.g. a money
market fund (“MMF”) vis-à-vis a high yield bond fund).
6. Do you as an investor have the capabilities to monitor the credit quality of portfolio
securities and/or follow-up on changes to external ratings that affect the portfolio
securities or the fund in which you are invested? Could you briefly describe your
procedures?
9
Chapter 2 – Internal credit assessment
As set out in the FSB 2010 Principles for reducing reliance on CRA ratings, a key measure to
reduce market reliance on external credit ratings is for investment managers to conduct their own
credit assessments. The FSB 2010 Principles state that investment managers should be able to
make their own determinations of the credit quality of the assets they intend to acquire or have
acquired without mechanistically relying on credit ratings, and should publicly disclose
information about their credit assessment processes. Pursuant to FSB Principles, several
jurisdictions have introduced a requirement for investment managers to conduct their own credit
assessment or due diligence before investing in fixed-income products (e.g., Brazil, EU, South
Africa).
IOSCO’s 2009 Good Practices highlighted certain good practices in relation to investment
managers’ due diligence when investing in structured finance instruments. Among these, the
following still hold true for investment managers for the present report:
• Understanding the methodology, parameters and the basis on which the opinion of a CRA
was produced, and having the adequate means and expertise to question that methodology
and the parameters, notably to identify their limits.
• Understanding how the opinion of the CRA was formed without relying excessively or solely
on it to form an opinion of the assets invested in. External credit ratings do not substitute for a
manager’s due diligence: they may be the beginning of due diligence, but not the end
15
.
The overarching principle is that, while CRA ratings may be used as an input by investment
managers, a manager should have appropriate controls and procedures in place internally to
assess and manage on an on-going basis the credit risk associated with its investment decisions.
A manager has fiduciary duties to its clients, which would encompass an understanding of the
material credit risks of any investments that the investment manager makes or recommends and
that they are appropriate for the client’s risk profile and investment objectives.
For an investment manager, developing its own in-house credit assessment expertise is an
essential added value provided to clients and represents one of the key factors managers use to
differentiate themselves from one another. However, although the approaches adopted by
investment managers to assess credit risk may substantially differ from one another, investment
managers generally should disclose in an understandable way to their investors the approach they
follow.
IOSCO understands that in general two internal models exist for assessing creditworthiness. In
the first model the same person performs both portfolio management and credit assessment tasks;
in the second model, credit research is carried out by a separate team of professionals. As a
general rule, managers should disclose to their investors the internal model used.
a) Depending on the size and resources available to them, some investment management
companies may entrust the credit assessment to the same person in charge of making
investment decisions. Typically, smaller investment management businesses lack the
resources to constitute teams of dedicated credit analysts to cover the whole spectrum of
15
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD300.pdf.
10
their investments. These businesses may be specialized investment firms that focus on
fewer asset categories and allow the managers to develop their own views – more or less
formalised – on the credit quality of the entities they choose to invest in on behalf of their
clients.
The risk of this form of organization lies in the inherent conflict of interest between the
desired “objectivity” of a manager’s credit assessment and the manager’s interest in
pursuing higher returns through less creditworthy investments. Such conflicts are
generally managed and mitigated through internal policies, procedures and controls;
b) Other investment management companies that have ample resources can maintain internal
dedicated teams of analysts to assess and monitor the credit quality of their portfolio
investments. Within such firms, so as to avoid conflicts of interests, the credit analysis
functions are deliberately segregated from those of asset management. The risk
assessment may also be conducted on an intra-group level or outsourced externally to an
independent third party. Furthermore, the function of risk management plays an important
role in ensuring that risk is managed in line with the funds’ investment objectives.
Asset managers willing to invest in fixed-income products should have the appropriate expertise
and processes in place to perform credit risk analysis in line with their investment policy. In
jurisdictions where applicable, regulators may check as part of the authorization process the
adequacy, means and expertise that asset managers put forward to pursue the investment policy.
However, these standard setters and regulators should be wary of imposing regulations relating to
standards for in-house credit assessment, in particular to the extent that it might reintroduce other
types of overreliance and potential trigger effects stemming from an excessive homogeneity of
practices that may result from overly prescriptive rules. In particular, standard-setters and
regulators should take into account the nature, scale and complexity of the activities carried out
by the management company when monitoring the adequacy of its credit assessment process.
While encouraging the development of internal credit assessment procedures, IOSCO recognizes
that external credit ratings can play an important role in providing investment managers with
useful inputs before investing and while managing a portfolio. Noting that the use of external
credit ratings and in-house credit research are not mutually exclusive, it is suggested that the
former may be used as an input for the latter. In this regard, IOSCO acknowledges that its
recommendations should allow for external credit ratings to continue to be used as benchmarks,
among other purposes, complementing a manager’s internal credit analysis and providing an
independent opinion as to the quality of the portfolio constituents.
Possible good practice
Investment managers make their own determinations as to the credit quality of a
financial instrument before investing and throughout the holding period.
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.
Investment managers could consider credit assessment procedures that include some or all of the
following criteria, as appropriate:
11
• Performing the assessment on the basis of an internal assessment scale and through the
application of a rigorous methodology validated by the management board;
• Basing such methodology on all the relevant information available as appropriate to the
type of instruments the funds may invest in or the adviser may recommend;
• Ensuring that information used for the assessment is of sufficient quality, updated
regularly and from trusted sources;
• Reviewing the assignment of internal credit assessments on an on-going basis and
regularly assessing the impact of external events likely to alter the credit quality of an
individual entity (e.g., events in the broader financial market, or specific to the entity such
as a corporate event, a change in the relative external credit rating, etc.);
• Regularly reviewing the assessment procedure so that when there are changes in a fund’s
objectives and financial market conditions, or in case of material change affecting its
parameters the assessment procedure can be updated accordingly;
• Documenting, where relevant, the assessment procedure and the meaning of each internal
assessment so as to provide the rationale underlying specific assessments, including a
description of parameters, data sources, assessment models and their underlying
assumptions, ratings’ assignment processes, and events likely to trigger changes in the
assessments;
• Specifying if, how, and the extent to which external ratings are taken into consideration
and clarifying in the procedure the type of measures the investment manager would put in
place in the event of a downgrade by a CRA where external ratings are used as inputs in
the internal process;
• Making available to investors, for instance, through a link on the investment manager’s
website or in the annual reports of the funds, a brief summary description of these internal
assessment procedures focusing on salient information.
It should also be noted that external credit ratings may be used as an indicator of liquidity, in
particular in periods of market stress where it may be seen as a quality seal, this being
particularly true for structured finance instruments. In periods of stress, managers may be more
prone to sell downgraded assets not only because of a change in the CRA’s credit quality
assessment, but also as managers fear the assets become illiquid. In such situations, internal credit
assessment models may need to take into account other market indicators to evaluate the liquidity
of a finance instrument.
Possible good practice
An internal assessment process that is commensurate with the type and proportion of
debt instruments the investment manager may invest in, and a brief summary
description of which is made available to investors, as appropriate.
An internal assessment process that is regularly updated and applied consistently.
12
Questions for consultation:
7. Is the above description of the two models of internal analysis of credit quality within
investment management firms accurate?
8. What factors would be effective in mitigating the conflict described in letter a)?
9. Do investment management companies adopt different internal assessment models
depending on the type of investment management vehicle (e.g., MMFs, equity or
bond funds, alternative or structured investment vehicles, etc.) they manage?
10. How do smaller investment managers use external credit ratings? What methods of
credit assessment do small and medium managers use in addition to review of credit
ratings?
11. Do you agree with some or all of the internal credit assessment procedures described
above? Are there other procedures you use or would recommend?
12. To the extent that you have internalized your credit analysis, for what sort of
instruments/issuers are you better able to perform it? If external credit ratings remain
as a point of reference, how are these accounted for in the internal analysis and what
is their relative value in determining and monitoring the creditworthiness of an
instrument or issuer?
13. In periods of market stress, are credit ratings considered as one indicator of liquidity
to be taken into account in the procedures of liquidity risk management, and if so
how?
13
Chapter 3 – Uses of external credit ratings by investment managers
3.1 Asset selection
The following sub-sections address concerns regarding the way investment managers use external
credit ratings for asset selection, how credit ratings may influence the relative weight of certain
securities in an investment portfolio and investment managers’ access to the information
underlying the credit ratings.
3.1.1 References to external ratings in fund disclosures
Despite the long standing efforts to reduce mechanistic reliance on CRAs ratings, external credit
ratings continue to be used by investment managers to communicate the level of credit risk of a
given portfolio and by investors when selecting the risk profile of a fund. It remains common
practice to describe in a fund’s disclosures the investment universe of a specific fixed income
fund by referring to a minimum external credit rating that limits the securities in which the fund
can invest.
Acknowledging that there is to date no fully satisfactory alternative to external credit ratings,
IOSCO could encourage investment managers to review their disclosures and consider providing
a description of the targeted level of credit risk that does not refer solely to external credit ratings.
External credit ratings could remain as an illustration.
Possible good practice
Regulators could encourage investment managers to review their disclosures describing
alternative sources of credit information in addition to external credit ratings.
3.1.2 References to external ratings in individual investment mandates
External ratings can be viewed as a “common language”, used by the parties to an investment
management agreement to better identify the desired level of credit risk underlying the portfolio.
It is worth noting that a manager’s asset selection may often be conditioned by the internal risk
guidelines imposed by the manager’s investor. Such may be the case for instance if the investor
imposes strict investment restrictions that are derived from regulatory requirements or the
investor’s internal rules. For instance, an investor that is a bank or an insurance company subject
to the Basel framework or in Europe the Solvency regime may determine its investment universe
based on the capital cost incurred for specific instruments. Apart from these international
standards, some investors may still be subject to national laws and regulations that incorporate
CRA ratings in prescribing investments for those entities. For instance, in some jurisdictions
retirement plans may be required by law to define their investment universe according to CRA
ratings.
In such circumstances, managers may establish privately managed accounts that are tailored to
the specific profile and needs of the investor (e.g., a large pension or insurance fund). The
investment manager would exercise its discretion within specific bounds by purchasing only
those securities rated at or above a minimum external credit rating in conformity with the
guidelines established by the investor. The following box illustrates this with examples of the sort
of language that has been used by (i) a large pension fund, client to a large global manager, in an
14
excerpt taken from the relevant investment guidelines; by (ii) and (iii) with excerpts taken from
the investment guidelines relative to a managed account run by another large global manager in
the interest of institutional clients; and by (iv) in a national self-regulatory organization (SRO)
regulation concerning certain complementary pension schemes with regard to asset eligibility
rules.
Box I - Examples of references to external credit ratings in fund investment mandates
or in national SRO standards
According to (i), “Fixed income securities shall not be rated less than Baa3 or its
equivalent.” […] “All securities must be rated by either Moody’s or Standard & Poor’s.”
According to (ii), “Securities must be rated either by S&P or Moody’s. […] Securities rated
equal to or lower than BBB+/Baa1 must have no more than 50% of the Fund’s total NAV. In
case of a downgrade, the Investment Manager can hold securities rated equal to or lower
than BB+/Ba1 but must be no more than 10% of the Fund’s total NAV.”
According to (iii), the following table illustrates the relative weight of government and
corporate bonds as a percentage of the account’s portfolio relative to their long-term rating
issued by S&P
16
:
Long-term grade
at time of
purchase
Bonds issued (or
guaranteed) by a
sovereign with a
minimum rating of
A-
Other bonds
(corporates) with a
rating between
AAA and AA-
Other bonds
(corporates) with a
rating between A+
and A-
Other bonds
(corporates) with a
rating of BBB+or
lower
Max. portfolio
weight per issuer
35% 5% 3% 1%
According to (iv) “Bonds and other types of debt instruments comprising the minimum 60%
quota of a portfolio must obtain an (external) rating above or equal to A- or equivalent
(where no rating is available, the rating of the issuer may be referred to). Nevertheless, in
the case of a managed account or of a dedicated investment fund mandate, securities rated
below A- or above or equal BBB- are allowed to be invested in up to a limit of 5% of a
portfolio on condition that those rated at least A- represent at least 60% of the portfolio.”
In this regard, a privately managed account can offer the investor a greater degree of flexibility in
negotiating a mandate, including the desired minimum credit quality of the individual assets to
constitute the portfolio.
The degree of CRA rating reliance largely depends on the sort of investment vehicle, on the
investment purpose this serves, and on the degree to which the investment manager must observe
minimum external credit ratings under private agreement with the investor. References to
external credit ratings may trigger mechanistic reliance if embedded in trigger clauses;
16
The mandate further admits that the comparable ratings of Moody’s and Fitch are also taken into account
and where “split ratings” occur, the lowest of among three CRAs shall be considered.
15
conversely, if used for reaching a consensus between client and agent for defining the investment
criteria, these references may be less problematic.
As a general principle, for the purpose of reducing over-reliance on external credit ratings,
regulators could encourage investment managers, as applicable, to include in investment mandate
agreements references to alternative credit information sources
17
. For example, the external credit
rating could be reviewed internally by the manager using an appropriate internal credit
assessment procedure and the results of that procedure approved by a board of the management
company.
Possible good practice
Regulators could encourage investment managers– as represented collectively through
trade associations and/or SROs – to include in their credit assessments alternative
(internal) sources of credit information in addition to external credit ratings.
3.1.3. Investment managers’ access to underlying credit rating information
When referring to external credit ratings to guide asset selection, managers should be able to
form an opinion on the methodologies that the chosen CRAs have used to determine their credit
ratings. In this respect, an investment manager would benefit from an adequate level of
disclosure, accompanied by inquiries, when appropriate, for the chosen CRAs about rating
methodologies, credit outlooks, as well as broader market events or factors likely to affect the
average credit quality of the invested portfolios. Such disclosures are also in line with IOSCO’s
planned revision of the 2008 Code of Conduct Fundamentals for CRAs concerning the important
role that transparency can play by allowing investment managers to understand and compare the
processes of various CRAs
18
, to identify, where necessary, the limitations of the CRAs’
methodologies, models and key parameters, as well as to develop their own internal credit
assessments, which may incorporate data disclosed by CRAs
19
.
Possible good practice
Where external credit ratings are used, investment managers understand the
methodologies, parameters and the basis on which the opinion of a CRA was produced,
and have adequate means and expertise to identify the limitations of the methodology
and assumptions used to form that opinion.
17
IOSCO also could encourage investors (represented collectively by their trade associations and self-
regulatory organizations - SROs), but recognizes that such investors may be outside of the scope of
securities regulation.
18
Please refer to the letter from IOSCO Board Chairman, Greg Medcraft, to the Finance Ministers and Central
Bank Governors of the G20 of 15 April 2013; Available at:
http://www.iosco.org/library/briefing_notes/pdf/IOSCOBN01-13.pdf
19
In this regard, especially for certain types of structured products, investment managers could decide to
exercise their own due diligence in conformity with the IOSCO 2009 Good Practices, which notes that a
good practice for the investment manager is to understand the methodology, parameters and the basis on
which the opinion of the third party (e.g., the CRA) was produced, and to have the adequate means and
expertise to challenge that methodology and the parameters (notably, to identify their limits).
16
3.1.4 Investment managers’ disclosures on uses of external credit ratings
The C5 2011-2012 mapping exercises have shown that requirements for investment managers to
disclose their use of external credit ratings vary among jurisdictions, as well as across asset
classes, or types of investment contract (e.g., discretionary investment contracts or not). In some
jurisdictions, disclosures remain at the discretion of the manager or depend on the significance
that external credit ratings may have in determining the risk profile of a fund portfolio
20
.
In light of the above and given the importance of fostering greater transparency for investors,
investment managers could be encouraged to make available their policies with regard to the use
of external credit ratings, for example, in prospectuses and/or in the relevant sales documents.
Information could contain some or all of the following elements, as appropriate:
• The sensitivity of the invested portfolio to changes in the assigned credit ratings,
downgrades on the return/risk profile
21
and redemptions from the fund. Such description
could include the likely effects resulting from changes in the external credit quality of
collateral or of a counterparty, or where appropriate, of a guarantor or sponsor where this
could have a material impact on the portfolio;
• A description (or reference to public availability) of the methodology underlying any
CRA ratings on which the manager relies, with the main assumptions;
• Where the investment manager performs its own internal assessment, a general
description of its methodology, including its underlying assumptions, including, if
appropriate, the use of external credit ratings.
Possible good practice
Regulators could encourage investment managers to disclose the use of external credit
ratings and describe in an understandable way how these complement or are used with
the manager’s own internal credit assessment methods.
3.1.5 Uses of external ratings to determine the quality of an asset’s guarantor
or of a fund’s sponsor
Credit ratings also may be used to assess guarantors and other potential providers of credit
support for certain assets. In the context of structured finance vehicles, external credit ratings
may be considered where an evaluation of securities issued by the vehicle may include
consideration of the credit quality of a guarantor or explicit support provider
22
. In case of MMFs,
20
For instance, in one jurisdiction only if instruments subject to credit risk form a “significant” part of the
portfolio, and where CRA ratings are given significant weighting by the manager in making credit
assessments, would they be required to be disclosed. Furthermore, such disclosure is required only where
investment is sought from investors who are neither professional nor sophisticated.
21
In this regard, please also refer to the IOSCO 2009 Good Practices.
22
For example, CRAs may consider the rating of the guarantor or support provider when rating securities
issued by a structured finance vehicle. Please refer to Moody’s Approach to Rating Asset-Backed
Commercial Paper.
(available at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_SF278537).
17
the financial strength of the sponsor may also be considered relevant to the decision to invest
23
.
To the extent that the financial strength of a guarantor or support provider is a consideration in
evaluating the creditworthiness of securities issued by a structured finance vehicle, asset
managers should not rely exclusively on external credit ratings in assessing the creditworthiness
of those entities.
Questions for consultation:
14. Could you describe your experience of instances where external credit ratings were
mandated by investors? Is it possible to draw a relationship between an investor’s
specific profile and the investor’s greater/lesser reliance on CRAs in a mandate’s
specifications? Please give examples.
15. In your experience, do prudential requirements impact demand for contractual
reliance on external credit ratings?
16. What type of alternative credit information sources could be included in investment
mandate agreements and fund investment objectives?
17. Please describe the process you use for identifying and comparing CRA
methodologies.
18. If a fund manager relies on external credit ratings, is the information that the fund
manager provides to you, as an investor, sufficient to allow you to understand the
potential impact of a change in the external credit rating on the underlying portfolio
of the fund? If not, what additional disclosures would be useful?
19. To what extent is the credit quality of a sponsor a relevant criterion in an investor’s
selection of a fund? Does it differ depending on the fund?
20. How important is the external credit rating of the sponsor of a structured finance
vehicle if the vehicle does not have explicit support from its sponsor?
21. Following the downgrade of a guarantor, could you as an investment manager be
23
See Money Market Fund Reform; Investment Company Act Release No. 28807 (June 30, 2009) at n.54 and
accompanying text (available at http://www.sec.gov/rules/proposed/2009/ic-28807.pdf). Certain CRAs
consider the financial strength of the sponsor when rating a MMF. As reflected in their methodologies, in
addition to other quantitative and qualitative factors, the sponsor of a MMF rated in the highest category
generally has an investment grade rating. Please refer to Moody’s Moody’s Revised Money Market Fund
Rating Methodology and Symbols of 10 March 2011, available at:
https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_131303 (the expectation is that
for MMFs rated in its top category, the sponsoring entity will be “investment grade” or of an equivalent
profile); FitchRatings Global Money Market Fund Rating Criteria J anuary 2014 (available at:
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=727497) (for a MMF rated in the
top category, a fund sponsor typically would be rated (or deemed to be rated) investment grade).
Qualitative considerations regarding sponsors of structured finance vehicles also may influence a CRA’s
rating, but not as strongly as other qualitative or quantitative inputs. For example, in one large CRA’s
rating methodology for asset-backed commercial paper (“ABCP”), the CRA notes that “the financial
strength of the sponsor and the sponsor’s commitment to the capital markets are important qualitative
considerations.”
18
forced to sell the securities issued by the structured finance vehicle? Please explain
as to why or why not this may be the case.
3.2 Quality of counterparties and collateral
While in the context of asset selection, managers and investors tend to have reduced their reliance
on external credit ratings both from the regulatory perspective and market practice; they still
widely refer to them when it comes to determining the quality of collateral and counterparties,
where references to external credit ratings remain both in private contracts and in prudential
rules.
External credit ratings continue to be used in some jurisdictions’ regulations and in private
investment agreements to determine and monitor the credit quality of counterparty and
collateral
24
. In practice, this may translate into a situation where an investment manager could
close out one of its managed funds’ positions, for instance with a derivative counterparty, from
the moment the latter is affected by a credit rating downgrade. For example, a downgrade or the
cancellation of the credit rating of the counterparty is included in the Additional Termination
Event clause of the ISDA Master Agreement which outlines the standard terms applied to a
derivatives transaction between two parties
25
. Under the clause, if a given institution’s credit
rating falls below a predetermined threshold or is withdrawn by one or more credit rating
agencies, the counterparty has the right to close out all derivative contracts with this institution
26
.
Moreover, external credit ratings may also be taken into consideration when it comes to
determining the size of haircuts applicable to certain collateral. For instance, it is our
understanding that the size of the haircuts applied by the European Central Bank (ECB) depends
on the credit quality of the collateral as determined by external ratings
27
.
With respect to regulatory requirements, the revision of asset eligibility rules in many
jurisdictions has led to a reassessment of the use of ratings for collateral exchanged on the basis
24
According to the example cited above (see (iv) Box I), with regard to the credit quality of eligible
counterparties to repo transactions, one relevant article of the relevant regulation provides that “[…] Such
(repo) transactions shall not be permitted with those entities, which in the quality of counterparties, do not
possess a long-term (external) rating above or equal to A-”. Another example can be found in the relative
investment guidelines of a European UCITS fund whereby counterparties to swap derivative contracts must
have a long-term rating above or equal to A-. The same applies for counterparties to repo or securities
lending transactions.
25
The ISDA Master Agreement is the most commonly used agreement for OTC derivatives transactions. It is
published by the International Swaps and Derivatives Association (ISDA), and is a document agreed
between two parties that sets out standard terms that apply to all the transactions entered into between those
parties.
26
On this, please refer to the article Downgrade Termination Costs of Fabio Mercurio, Roberto Caccia and
Massimo Cutuli published in March 2012 in Risk.net magazine; available at
http://www.risk.net/digital_assets/4143/risk_0312_mercurio2.pdf. In this article, the authors demonstrate
that Ratings-based (RB) additional termination event (ATE) clauses in International Swaps and Derivatives
Association agreements can have a significant impact on the valuation of derivatives portfolios when rating
events occur.
27
See The ECB Guidelines on Monetary Policy Instruments and Procedures of the Eurosystem, September
2011, available at: https://www.ecb.europa.eu/ecb/legal/pdf/l_33120111214en000100951.pdf
19
of margining agreements in the context of derivative and securities financing transactions
28
. In
addition, reforms are underway in some jurisdictions to introduce alternative criteria or methods
29
for managers to evaluate the quality of received/posted collateral away from external credit
ratings. Such changes could mitigate the risk of pro-cyclical effects due to sudden credit
downgrades of securities used to secure financial transactions
30
.
When evaluating the quality of collateral, investment managers could consider whether the
collateral fulfils some or all of the following tentative parameters, as appropriate
31
:
• Sufficiently liquid
32
(but at least as liquid as the eligible assets in case the counterparty
does not honour its obligations and the collateral is enforced);
• Valued on a regular basis (e.g., valued on a daily basis and exhibiting a low price
volatility);
• Issued by an entity unaffiliated with the counterparty and/or displaying a low correlation
with it;
• Sufficiently diversified across issuers, markets, industries and/or regions;
28
For instance, in Europe, Article 46 of EU Regulation No. 648/2012 on OTC derivatives, central
counterparties and trade repositories (EMIR) provides that a CCP shall accept highly liquid collateral with
minimal credit and market risk to cover its initial and ongoing exposure to its clearing members. For
financial instruments, the Delegated Regulation No 153/2013 expressly states in its Annexes I and II that
when performing their internal assessments, CCPs shall employ a defined and objective methodology that
shall not fully rely on external opinions (for further details, see Annex 1 of Regulation 153/2013).Available
at: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ :L:2013:052:0041:0074:EN
DF
29
For instance, in the U.S., recent regulatory amendments eliminated the requirement that if the CIS is
looking to the issuer of securities collateralizing a repurchase agreement to satisfy certain requirements
under the Investment Company Act of 1940, collateral other than cash or government securities must be
rated in the highest category by the certain CRAs or be of comparable quality. Instead the amended rule
requires that collateral other than cash or government securities must consist of securities that the fund's
board of directors (or its delegate) determines are: (i) issued by an issuer that has an exceptionally strong
capacity to meet its financial obligations; and (ii) sufficiently liquid that they can be sold at approximately
their carrying value in the ordinary course of business within seven calendar days.
30
According to a comparative study authored by the European Central Bank (ECB), minimum credit ratings
may be an additional requirement in establishing the quality of collateral under the framework of central
banks and of CCPs. As an example, under the Eurosystem, collateral quality is independently assessed on
the basis of the minimum probability of default (PD) calculation (required under the Basel rules for
measuring regulatory capital), which is then compared with the ratings of an external CRA. The Eurosystem
also allows the use of alternative credit assessment systems, such as in-house central bank credit assessment
systems, counterparties’ internal rating-based systems or third-party providers’ rating tools. Other central
banks typically require more than one rating from the external CRAs. For further information, please refer
to the ECB study Collateral Eligibility Requirements: A Comparative Study Across Specific Frameworks
published in July 2013; available at: http://www.ecb.europa.eu/pub/pdf/other/collateralframeworksen.pdf
31
In this sense, as an example, please also refer to the ESMA Guidelines on ETFs and other UCITS issued in
December 2012; available at:
http://www.esma.europa.eu/system/files/2012-832en_guidelines_on_etfs_and_other_ucits_issues.pdf
32
Liquidity is a function of several factors that those managing collateral would need to consider. In general,
factors that may typically affect the liquidity, and hence the valuation, of collateral are demand pressures,
inventory, availability of transparent pricing, etc.
20
• Governed by a clear legal regime allowing it to be enforced immediately (i.e. without the
prior approval of the counterparty) and within well-defined limits for its potential re-
investment;
• Subject to stress-testing to assess the liquidity risk where received collateral represents
more than a minimum portion of a fund’s net asset value (NAV);
• Application of a clear haircut policy across varying asset classes;
• In the case of MMFs, maximum weighted average maturity (WAM) and weighted
average life (WAL) of the securities to be received.
Possible good practice
Regulators could encourage investment managers, when assessing the credit quality of their
counterparties collateral, not to rely solely on external credit ratings and to consider
alternative quality parameters (e.g., liquidity, maturity, etc.)
Questions for consultation:
22. How important to fund managers is the external credit rating in the choice of a fund’s
counterparty(ies)? What are the key factors usually taken into account when
negotiating an agreement with one or more?
23. Following the credit rating downgrade of a key counterparty, depending on the
contents of the relevant agreement, could you as an investment manager be forced to
close out your respective positions? Please explain as to why or why not this may be
the case.
24. How does an investment management company’s size and resources relate to the
investment manager’s ability to perform an internal credit analysis of one or more
counterparties?
25. Are there some strong references to external credit ratings which are channeled
through the ECB guidelines, ISDA Master Agreements or CCPs guidelines?
26. Would you agree with some or all of the above parameters as valuable additional
factors for the internal assessment of collateral quality?
27. Among the above parameters, which one(s) could be considered by counterparties to
replace / supplement external credit ratings when evaluating the quality of collateral?
28. Are there other parameters that could be considered to facilitate the credit assessment
of collateral received and/or posted by the investment manager, independently from
external credit ratings?
3.3 Investment managers soliciting fund ratings
As discussed in the scope section, unlike external credit ratings of individual financial
instruments and of their issuers, fund credit ratings are generally not used in rules and
regulations. For certain types of investment portfolios (e.g., MMFs, bond funds, etc.), investment
21
managers may use fund ratings to publicize the average credit quality of the portfolio
components, and fund credit ratings may be used by investors to compare two or more separate
portfolios. Investment managers are, in some cases, incentivized to request the credit rating of
one or more of the funds they manage to meet investors’ demands.
In this respect, European MMFs are an interesting example. Stakeholders have explained the
development of MMF credit ratings in Europe by the added value provided to investors in the
absence of a defined common regulatory framework
33
. Prior to the introduction of ESMA’s
guidelines on MMFs in 2010, there was no common definition of an MMF in Europe. Investors
therefore used CRA credit ratings to ensure that a fund met minimum standards in terms of credit
quality and liquidity and was subject to appropriate oversight. The Guidelines, by setting a
common framework, appear to have contributed to reducing investor reliance on external ratings.
These stakeholders have also pointed to a number of risks that could stem from the use of MMF
credit ratings, particularly in an environment where the number of financial institutions with a
sufficiently high credit rating has become more limited.
In this context, the likelihood of an MMF’s downgrade and the pressure to maintain the credit
rating have increased. The general approach of CRAs in rating MMFs is to focus primarily on the
basis of preservation of capital and providing liquidity to shareholders
34
. The high credit quality
of the underlying assets – with the resulting highest awarded credit rating by a CRA – are
therefore essential requirements for these funds to be marketed in view of the above objectives.
Thus, if individual securities are downgraded, or even placed under negative review, an MMF
could have a strong incentive to sell those securities in order to keep its portfolio in line with the
criteria set by the CRA notwithstanding the manager’s own credit assessment of the underlying’s
credit quality
35
.
Further, in some cases, investors may use the external credit rating as a proxy for the resilience of
the fund rather than conducting their own due diligence. These investors may therefore have a
strong incentive to redeem an MMF’s shares if the MMF is downgraded or put on negative
watch
36
As boards of institutional investors and corporate treasurers often require an MMF to
33
Please refer to the comment letters from HSBC and IMMFA sent to the European Commission in the
context of a consultation on the UCITS directive; available at:
http://ec.europa.eu/internal_market/consultations/2012/ucits/registered-organisations/hsbc-global-asset-
management_en.pdf , and:
http://ec.europa.eu/internal_market/consultations/2012/ucits/registered-organisations/institutional-money-
market-fund-association_en.pdf.
34
As an example, please refer to Moody’s Moody’s Revised Money Market Fund Rating Methodology and
Symbols of March 2011,
https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_131303.
35
In the U.S., the incentive to sell securities as a result of a credit ratings downgrade may not be a
consequence of the impact on the fund’s rating. Rule 2a-7 under the Investment Company Act governs the
operations of U.S. MMFs. The rule requires an MMF’s board of directors promptly to reassess whether a
security that has been downgraded by a CRA continues to present minimal credit risks and take such action
as the board determines is in the best interests of the fund and its shareholders.
36
See Fitch puts Matrix-owned funds on review due to firm's financial resources, published in
MoneyMarketing on 12 December 2011; available at: http://www.moneymarketing.co.uk/fitch-puts-matrix-
owned-funds-on-review-due-to-firms-financial-resources/1043059.article (including the following
22
have the highest possible credit rating for them to invest, MMFs are often either rated “AAA” or
not rated, which may create a risk of sudden redemptions in a rated MMF if it no longer meets
the requirements for the CRA credit rating. However, investor appetite for credit ratings of
MMFs may be reduced with the strengthening of regulatory frameworks applicable to MMFs
37
.
A CRA rating a global bond fund attaches significant weight to the average credit quality of the
underlying portfolio, its sensitivity to market risk factors, such as duration, spread risk, currency
fluctuations, etc., as well as to it past performance relative to a benchmark
38
. At this stage, it is
C5’s understanding that investors do not rely on credit ratings of different types of fund portfolios
to the same extent. Specifically, between two types of fixed income portfolios, where one is
labeled “high yield” (or “speculative grade”) and the other “investment grade”, end-investors
would rely more heavily on the credit quality of underlying assets of the investment grade fund as
assessed by CRAs. The reliance would be less true for a high yield portfolio where investors
willingly take on greater risks and rely more heavily on a manager’s individual skill.
IOSCO is seeking feedback from representatives of the investment management industry, as well
as investors, to better understand fund rating implications.
Questions for consultation:
29. Why do investment managers seek to have their funds rated?
30. What is the trend regarding fund credit ratings? Are investment managers seeking
fund credit ratings more often or less frequently?
31. Do investors use ratings differently in evaluating MMFs, investment grade bond
funds and high yield bond funds?
32. To what extent, if any, do CRAs provide credit ratings for funds for which they also
rate all or part of the portfolio?
33. In situations where the same CRA rates both the fund and its portfolio, if the CRA
statement from Fitch: “The sponsor’s financial resources are no longer consistent with a ’AAAmmf’ rating,
even after taking into consideration the funds’ conservative investment guidelines.”).
37
The European Commission published in September 2013 a draft Regulation on Money Market Funds where
it proposes to prevent an MMF from soliciting or financing an external credit rating “to ensure that fund
managers and investors stop relying on external credit ratings that could be detrimental to the functioning
of the money market when downgrades occur”. For further details, please see: http://eur-
lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52013PC0615&from=EN
38
As an example, please refer to Fitch’s Global Bond Fund Rating Criteria of August 2013, available at
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715678. Unlike bond funds,
equity funds – defined as those that invest either wholly or predominantly in common stock – that are rated
are generally assessed on the basis of their relative performance over a specific period and on the quality of
the manager, reflected in its financial profile, its client servicing ability, its investment infrastructure, etc.
However, the present report only looks at fund rating to the extent that it reflects the creditworthiness of the
underlying portfolio and could potentially create an undue reliance on CRA. As an example, please refer to
Moody’s Methodology for Assessing the Investment Quality of Equity Funds of February 2012, available
upon request.
23
downgrades or puts under negative watch an underlying security, will the fund be
more prone to sell this security in order to maintain its highest rating?
34. In the case of fund of fund structures, please describe how external credit ratings of
funds are used and how these are taken into account by the investment manager.
Please provide examples.
35. In the case of index funds, do you consider that changes to the external credit rating
of individual index components may be relevant under certain circumstances in
deciding whether the index may continue to be tracked by a fund?
3.4 Managing external credit rating changes
Notwithstanding an investment manager’s (or even investor’s) recourse to its own internal
analysis on the creditworthiness of an instrument and/or its issuer, it is acknowledged that
external credit ratings represent an important and objective benchmark for many market
participants, particularly for those with fewer resources to devote to the development of internal
credit rating scales or models. In this regard, the potential cliff effects that can result from a credit
ratings downgrade may be of particular concern to regulators
39
.
Where they rely more heavily on external credit ratings, investment managers should have
appropriate internal procedures when a security is subject to an external credit rating downgrade.
These procedures may include specific “grace periods” that allow them to delay divesting the
related securities if it would be in the best interests of their investors. In other cases, investment
managers may keep the security in the portfolio or decide not to acquire more of the asset. The
questions below are designed to elicit more information regarding investment managers’ (and
where relevant, investors’) reactions to external credit rating downgrades.
Possible good practice
Where an investment manager (or CIS board, as appropriate) explicitly relies on external
credit ratings among others to assess the creditworthiness of specific assets, a downgrade does
not automatically trigger their immediate sale. Where the manager/board conducts its own
credit assessment, a downgrade may trigger a review of the appropriateness of its internal
assessment. In both cases, should the manager/board decide to divest, the transaction is
conducted within a timeframe that is in the best interests of the investors.
Questions for consultation:
36. How do fund investors generally react to a downgrade of a particular asset, or of a
significant part of a portfolio?
37. Please elaborate on internal procedures that investment managers have implemented
following a downgrade, when for instance managers may need to ensure that the
credit quality of the portfolio is still sufficient to meet the stated fund standards or
39
In this regard, please refer to footnote n°10.
24
managers have set up a grace period before selling the downgraded securities. Are
there differences in procedures depending on the type of fund?
38. Do investment managers’ policies or investors’ investment guidelines provide for
specific “grace periods” that allow a manager time to address the situation that
results from a downgrade? If so, what is the average “grace period” and how are
investors informed of the manager’s plans to restore a portfolio’s desired credit
quality?
39. As a follow-up to the question above, would investment managers behave differently
in the event of a collateral downgrade, or of a downgrade affecting one main fund
counterparty or an asset’s guarantor (or sponsor)? Please explain, possibly with
reference to some examples.
40. In the case of a fund’s performance being benchmarked to a specific index, how does
the fund manager react when a downgrade leads to an asset / issuer being removed
from the index?
25
Appendix A – List of Possible Good Practices
Investment managers make their own determinations as to the credit quality of a financial
instrument before investing and throughout the holding period.
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.
An internal assessment process that is commensurate with the type and proportion of debt
instruments the investment manager may invest in, and a brief summary description of which is
made available to investors, as appropriate.
An internal assessment process that is regularly updated and applied consistently.
Regulators could encourage investment managers to review their disclosures describing
alternative sources of credit information in addition to external credit ratings
Regulators could encourage investment managers– as represented collectively through trade
associations and/or SROs – to include in their credit assessments alternative (internal) sources of
credit information in addition to external credit ratings.
Where external credit ratings are used, investment managers understand the methodologies,
parameters and the basis on which the opinion of a CRA was produced, and have adequate
means and expertise to identify the limitations of the methodology and assumptions used to
form that opinion.
Regulators could encourage investment managers to disclose the use of external credit ratings
and describe in an understandable way how these complement or are used with the manager’s
own internal credit assessment methods.
Regulators could encourage investment managers, when assessing the credit quality of their
counterparties or collateral not to rely solely on external credit ratings and to consider
alternative quality parameters (e.g., liquidity, maturity, etc.)
Where an investment manager (or CIS board, as appropriate) explicitly relies on external credit
ratings among others to assess the credit worthiness of specific assets, a downgrade does not
automatically trigger their immediate sale. Where the manager/board conducts its own credit
assessment, a downgrade may trigger a review of the appropriateness of its internal assessment.
In both cases, should the manager/board decide to divest, the transaction is conducted within a
timeframe that is in the best interests of the investors.
26
Appendix B – List of Questions for consultation
1. Do you agree with the above categorization of uses by investment managers of external
credit ratings? Are there other ways in which investment managers use external credit
ratings? Can you point to situations where you would consider there is no alternative to
credit ratings?
2. What benefits do you as an investment manager see in the use of external credit ratings?
How does your particular size, resources, capabilities, etc. affect the benefits you
perceive?
3. How do investment managers adjust their internal portfolio risk models (e.g.
diversification parameters, liquidity profile, VaR, etc.) to account for external credit rating
changes to their portfolio securities? Among other risk factors (e.g. currency and interest
rate changes), how relevant are external ratings in determining the ultimate risk level of a
specific portfolio? Where possible, please suggest some examples as to why credit rating
changes to the underlying securities may or may not be relevant.
4. As investors, depending on the type of investment vehicle and on your own capacity to
carry out your own internal credit analysis, to what extent is the credit rating of a fund’s
portfolio holdings or of the fund itself, a determining factor in making your investment
decision? Do you require the investment manager to reference one or more CRA ratings?
If yes, is this your own choice or is it required by your specific institution?
5. Before investing, do you as an investor verify that an investment manager has procedures
in place to perform its own credit analysis? Please elaborate on whether the approaches
differ depending on the type of investment vehicle (e.g., a money market fund (“MMF”)
vis-à-vis a high yield bond fund).
6. Do you as an investor have the capabilities to monitor the credit quality of portfolio
securities and/or follow-up on changes to external ratings that affect the portfolio
securities or the fund in which you are invested? Could you briefly describe your
procedures? 7
7. Is the above description of the two models of internal analysis of credit quality within
investment management firms accurate? 8.
8. What factors would be effective in mitigating the conflict described in letter a)?
9. Do investment management companies adopt different internal assessment models
depending on the type of investment management vehicle (e.g. MMFs, equity or bond
funds, alternative or structured investment vehicles, etc.) they manage?
10. How do smaller investment managers use external credit ratings? What methods of credit
assessment do small and medium managers use in addition to review of credit ratings?
11. Do you agree with some or all of the internal credit assessment procedures described
above? Are there other procedures you use or would recommend?
12. To the extent that you have internalized your credit analysis, for what sort of
27
instruments/issuers are you better able to perform it? If external credit ratings remain as a
point of reference, how are these accounted for in the internal analysis and what is their
relative value in determining and monitoring the creditworthiness of an instrument or
issuer?
13. In periods of market stress, are external credit ratings considered as one indicator of
liquidity to be taken into account in the procedures of liquidity risk management and if so
how?
14. Could you describe your experience of instances where external credit ratings were
mandated by investors? Is it possible to draw a relationship between an investor’s specific
profile and the investor’s greater/lesser reliance on CRAs credit ratings in a mandate’s
specifications? Please give examples.
15. In your experience, do prudential requirements impact demand for contractual reliance on
external credit ratings?
16. What type of alternative credit information sources could be included in investment
mandate agreements and fund investment objectives?
17. Please describe the process you use for identifying and comparing CRA methodologies.
18. If a fund manager relies on external credit ratings, is the information that the fund
manager provides to you, as an investor, sufficient to allow you to understand the potential
impact of a change in the external credit rating on the underlying portfolio of the fund? If
not, what additional disclosures would be useful?
19. To what extent is the credit quality of a sponsor a relevant criterion in an investor’s
selection of a fund? Does it differ depending on the fund?
20. How important is the credit rating of the sponsor of a structured finance vehicle if the
vehicle does not have explicit support from its sponsor?
21. Following the credit rating downgrade of a guarantor, could you as an investment manager
be forced to sell the securities issued by the structured finance vehicle? Please explain as
to why or why not this may be the case.
22. How important to fund managers is the external credit rating in the choice of a fund’s
counterparty(ies)? What are the key factors usually taken into account when negotiating
an agreement with one or more?
23. Following the downgrade of a key counterparty, depending on the contents of the relevant
agreement, could you as an investment manager be forced to close out your respective
positions? Please explain as to why or why not this may be the case.
24. How does an investment management company’s size and resources relate to the
investment manager’s ability to perform an internal credit analysis of one or more
counterparties?
25. Are there some strong references to external credit ratings which are channeled through
the ECB guidelines, ISDA Master Agreements or CCPs guidelines?
26. Would you agree with some or all of the above parameters as valuable additional factors
28
for the internal assessment of collateral quality?
27. Among the above parameters, which one(s) could be considered by counterparties to
replace / supplement external credit ratings when evaluating the quality of collateral?
28. Are there other parameters that could be considered to facilitate the credit assessment of
collateral received and/or posted by the investment manager, independently from external
credit ratings?
29. Why do investment managers seek to have their funds rated?
30. What is the trend regarding fund credit ratings? Are investment managers seeking fund
credit ratings more often or less frequently?
31. Do investors use ratings differently in evaluating MMFs, investment grade bond funds and
high yield bond funds?
32. To what extent, if any, do CRAs provide credit ratings for funds for which they also rate
all or part of the portfolio?
33. In situations where the same CRA rates both the fund and its portfolio, if the CRA
downgrades or puts under negative watch an underlying security, will the fund be more
prone to sell this security in order to maintain its highest rating?
34. In the case of fund of fund structures, please describe how external credit ratings of funds
are used and how these are taken into account by the investment manager. Please provide
examples.
35. In the case of index funds, do you consider that changes to the external credit rating of
individual index components may be relevant under certain circumstances in deciding
whether the index may continue to be tracked by a fund?
36. How do fund investors generally react to a downgrade of a particular asset, or of a
significant part of a portfolio?
37. Please elaborate on internal procedures that investment managers have implemented
following a downgrade, when for instance managers may need to ensure that the credit
quality of the portfolio is still sufficient to meet the stated fund standards or managers
have set up a grace period before selling the downgraded securities. Are there differences
in procedures depending on the type of fund?
38. Do investment managers’ policies or investors’ investment guidelines provide for specific
“grace periods” that allow a manager time to address the situation that results from a
downgrade? If so, what is the average “grace period” and how are investors informed of
the manager’s plans to restore a portfolio’s desired credit quality?
39. As a follow-up to the question above, would investment managers behave differently in
the event of a collateral downgrade, or of a downgrade affecting one main fund
counterparty or an asset’s guarantor (or sponsor)? Please explain, possibly with reference
to some examples.
40. In the case of a fund’s performance being benchmarked to a specific index, how does the
fund manager react when a downgrade leads to an asset / issuer being removed from the
29
index?
doc_523016833.pdf
Credit rating agencies (CRAs) play a prominent role in today's global financial markets. Although approaches may differ across jurisdictions, investment managers often use the services of CRAs to form an opinion on the creditworthiness of a particular issuer before purchasing securities, selecting counterparties, or choosing the best collateral to secure transactions.
Good Practices on Reducing Reliance on CRAs in
asset management
Consultation Report
THE BOARD OF THE
INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS
CR04/14 JUNE 2014
This paper is for public consultation purposes only. It has not been approved for any other
purpose by the Board of IOSCO or any of its members.
ii
Copies of publications are available from:
The International Organization of Securities Commissions website www.iosco.org
©International Organization of Securities Commissions 2014. All rights reserved. Brief
excerpts may be reproduced or translated provided the source is stated.
iii
Foreword
The Board of the International Organization of Securities Commissions (IOSCO) has published
this Consultation Report.
This Consultation Report is prepared by the IOSCO Committee 5 on Investment Management
(C5). IOSCO seeks the views of stakeholders on the questions posed in this report to inform its
final Good Practices on Reducing Reliance on CRAs in asset management. Investment managers,
institutional investors and credit rating agencies are the main stakeholders targeted by this
Consultation Report.
How to Submit Comments
Comments may be submitted by one of the three following methods on or before Friday 5
September 2014. To help us process and review your comments more efficiently, please use
only one method.
Important: All comments will be made available publicly, unless anonymity is specifically
requested. Comments will be converted to PDF format and posted on the IOSCO website.
Personal identifying information will not be edited from submissions.
1. Email
• Send comments to [email protected]
• The subject line of your message must indicate [Good Practices on Reducing
Reliance on CRAs in asset management]
• If you attach a document, indicate the software used (e.g., WordPerfect, Microsoft
WORD, ASCII text, etc.) to create the attachment.
• Do not submit attachments as HTML, PDF, GIFG, TIFF, PIF, ZIP or EXE files.
2. Facsimile Transmission
Send by facsimile transmission using the following fax number: +34 (91) 555 93 68.
3. Paper
Send three (3) copies of your paper comment letter to:
Mr Mohamed Ben Salem
General Secretariat
International Organization of Securities Commissions (IOSCO)
Calle Oquendo 12
28006 Madrid
Spain
Your comment letter should indicate prominently that it is a “Public Comment on Good
Practices on Reducing Reliance on CRAs in asset management”.
iv
Contents
Introduction .......................................................................................................................................... 1
Chapter 1 – Scope ................................................................................................................................ 5
Chapter 2 – Internal credit assessment .............................................................................................. 9
Chapter 3 – Uses of external credit ratings by investment managers ........................................... 13
3.1 Asset selection ............................................................................................................. 13
3.1.1 References to external ratings in fund disclosures ...................................... 13
3.1.2 References to external ratings in individual investment mandates ........... 13
3.1.3. Investment managers’ access to underlying credit rating information .... 15
3.1.4 Investment managers’ disclosures on uses of external credit ratings ....... 16
3.1.5 Uses of external ratings to determine the quality of an asset’s guarantor
or of a fund’s sponsor ..................................................................................... 16
3.2 Quality of counterparties and collateral .................................................................. 18
3.3 Investment managers soliciting fund ratings ........................................................... 20
3.4 Managing external credit rating changes ................................................................ 23
Appendix A – List of Possible Good Practices ................................................................................ 25
Appendix B – List of Questions for consultation ............................................................................ 26
1
Introduction
Credit rating agencies (CRAs) play a prominent role in today’s global financial markets.
Although approaches may differ across jurisdictions, investment managers often use the services
of CRAs to form an opinion on the creditworthiness of a particular issuer before purchasing
securities, selecting counterparties, or choosing the best collateral to secure transactions. On their
part, investors often refer to CRA ratings to determine their investment universe before buying
shares of a fund
1
, or when guiding investment managers on the basis of a tailored investment
mandate.
The role of CRAs has come under regulatory scrutiny, mainly as a result of the over-reliance
placed by market participants, including investment 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.
To tackle this concern, in October 2010, the Financial Stability Board (FSB) published its report
on Principles for Reducing Reliance on CRA Ratings (“FSB 2010 Principles”)
2
. The goal of the
Principles is to end mechanistic reliance on ratings by banks, institutional investors, and other
market participants, thereby reducing the financial stability-threatening herding and cliff effects
that could arise from CRA rating thresholds being hard-wired into laws, regulations, and market
practices. The FSB 2010 Principles contain a number of important recommendations.
The relevant FSB Principles for investment managers in detail
Principles I and II provide the general framework requiring that standard setters, authorities
and market participants consider ways to reduce overreliance to CRA ratings.
Principle I. Reducing reliance on CRA ratings in standards, laws and regulations
Standard setters and authorities should assess references to credit rating agency (CRA)
ratings in standards, laws and regulations and, wherever possible, remove them or replace
them by suitable alternative standards of creditworthiness.
Principle II. Reducing market reliance on CRA ratings
Banks, market participants and institutional investors should be expected to make their own
credit assessments, and not rely solely or mechanistically on CRA ratings.
Of particular relevance for investment managers is Principle III.3 thereof:
Investment managers and institutional investors must not mechanistically rely on CRA
ratings for assessing the creditworthiness of assets. This principle applies across the full
range of investment managers and of institutional investors, including money market funds,
pension funds, collective investment schemes (such as mutual funds and investment
companies), insurance companies and securities firms. It applies to all sizes and levels of
1
For the purpose of this consultation report, the term “fund” is understood broadly to include both registered
(e.g., collective investment schemes - CIS) and non-registered (e.g. private funds) collective investment
vehicles across different jurisdictions.
2
Available at: http://www.financialstabilityboard.org/publications/r_101027.pdf.
2
sophistication of investment managers and institutional investors.
Principle III.3.b adds that senior management and boards of institutional investors have a
responsibility to ensure that internal assessments of credit and other risks associated with
their investment are being made, and that the investment managers they use have the skills to
understand the instruments they are investing in and exposures they face, and do not
mechanistically rely on CRA ratings
3
, In addition, senior management, boards and trustees
should ensure adequate public disclosure of how CRA ratings are used in risk assessment
processes.
Principle III.3.c suggests a list of measures that regulators could adopt to avoid the
mechanistic reliance on ratings. These are inter alia:
• Restricting the proportion of a portfolio that is solely CRA ratings-reliant;
• Supervisory monitoring of credit and other risk assessment processes (in the case of
supervised investment managers and institutional investors);
• Requiring the boards, trustees or other governing bodies of investment managers and
institutional investors to regularly review any use of CRA ratings in their investment
guidelines and mandates and for risk management and valuation;
• Requiring public disclosures of internal due diligence and credit risk assessment
processes, including how CRA ratings are or are not used, with the aim of
encouraging investment managers to develop more rigorous and individual processes
included in investment mandates, rather than relying on common triggers;
• Requiring public disclosures of risk assessment policies related not solely to specific
rating thresholds, but also accounting for the types of instruments (thus reflecting the
different nature of the risks applying to, for instance, structured finance products
compared with corporate bonds). Such disclosures should be made in a manner
consistent with the goal of streamlining disclosures for customers.
Finally, Principle III.5.a proposes that standard setters and authorities should review
whether any references to CRA ratings in standards, laws and regulations relating to
disclosure requirements are providing unintended incentives for investors to rely excessively
on CRA ratings and, if appropriate, remove or amend these requirements.
The FSB 2010 Principles concluded with an exhortation for standard setters – including IOSCO -
and regulators to consider steps for translating the principles into more specific policy actions
4
. In
3
In the text accompanying the Principle III.3.b, the FSB report adds that the case of smaller, less
sophisticated investors (who do not have the resources to conduct internal credit assessments for all their
investments or who may outsource all or part of their investment management), this could be carried out
through the trustees or others responsible for directing the investment strategy, ensuring that they
understand the risks implied by the strategy they are following, as well as the appropriate uses and
limitations of CRA ratings.
4
IOSCO has already addressed these issues in a J uly 2009 report on Good Practices in Relation to
Investment Managers´ Due Diligence When Investing in Structured Finance Instruments. Although the
mandate focussed on due diligence when investing in structured finance products, the report recognized that
many of the principles and themes discussed therein could be applied regardless of the type of product. This
3
line with the FSB approach, IOSCO’s Policy Committee on Investment Management (C5)
launched a first mapping exercise in March 2011 to better understand the extent of its Member
jurisdictions’ reliance on regulations explicitly referencing CRA ratings for investment managers
and identify gaps between existing domestic regulations and the FSB 2010 Principles
5
.
As a follow-up to its 2010 Principles, in November 2012, the FSB published its so-called
"Roadmap"
6
, highlighting the short- to medium-term milestones for progress towards lessening
the continued over-reliance on CRAs and for strengthening financial firms’ own risk assessments.
Both the Principles and the Roadmap adopt a dual-track approach, in which the removal of the
“hard-wiring” of references to CRA ratings in standards, laws and regulations is to be
accompanied by promoting incentives for the private sector to develop its own internal credit risk
assessment processes. In this respect, the FSB has conducted a thematic peer review of progress
made in member jurisdictions in implementing the 2010 Principles. The peer review’s main
objective is to assist national jurisdictions in fulfilling their commitments under the Roadmap
7
.
In view of the need to provide guidance to its Member jurisdictions (and indirectly to market
participants to develop alternative credit assessment procedures), IOSCO has launched a series of
new mandates among its policy committees aimed at complementing the on-going FSB peer
review process.
In this light, C5 carried out a second mapping exercise in October 2012. The results of this
second exercise have revealed further progress in reducing the over-reliance on CRAs in national
regulations applicable to investment management in line with the 2010 FSB Principles. In order
to address the outstanding concerns, C5 Members obtained the approval of a mandate under
which C5 could respond, inter alia, to the following objectives
8
.
1. Identify Good Practices by analyzing the type of alternatives to CRA ratings envisaged in
the various C5 jurisdictions and where appropriate build on the previous IOSCO Good
Practices in Relation to Investment Managers´ Due Diligence When Investing in
Structured Finance Instruments of 2009 (“IOSCO 2009 Good Practices”) when investing
in structured finance products;
2. Consider the issue of the ratings of investment funds, or of other collective investment
schemes (CIS), with a view to determine what policy tools could be explored;
3. Monitor the FSB work to ensure the specificities of the investment management industry
are appropriately taken into account.
would concern, in particular, certain good practices related to the use of third parties, including CRAs, in
the due diligence process.
5
Results demonstrated that several jurisdictions had undertaken important steps in amending their relevant
regulations to discourage over-reliance, while identifying areas that had not yet been fully addressed.
6
Available at: http://www.financialstabilityboard.org/publications/r_121105b.pdf
7
The final report on its main findings was published in May 2014 and is available at:
http://www.financialstabilityboard.org/publications/r_140512.pdf
8
For this purpose, a working group within C5 was established. It is co-Chaired by the French AMF and the
U.S. SEC, and is comprised of the following additional regulators: the Australian ASIC, Brazilian CVM,
the J apanese FSA, the Mexican CNBV and the Québec AMF.
4
The present consultation report is designed to gather the views of industry (investment managers
and their representative trade bodies, institutional investors and their associations, including any
interested party, and CRAs) and draw on their practices for the purpose of developing and
finalizing a set of Good Practices in 2014. These will be addressed to national regulators,
investment managers, and investors, where applicable, and will suggest specific practices to
reduce over-reliance on external credit ratings in the asset management space. It should also be
noted that IOSCO’s Policy Committee for the Regulation of Market Intermediaries has launched
a project to identify “good practices” currently in place at intermediaries with regard to the use of
alternatives to credit ratings to assess creditworthiness.
5
Chapter 1 – Scope
Different notions of external rating
This consultation report distinguishes between external ratings of individual financial
instruments, of issuers, and of certain types of pooled investment vehicles (e.g., money market,
structured finance vehicles) that express a view on the overall creditworthiness (hereafter “credit
ratings”) from those that on the other hand emphasize other, non-credit and qualitative aspects of
a selected issuer, such as managerial talent, the effectiveness of a particular strategy in meeting
the desired returns, the quality of internal operations and controls, etc.
9
. It is specifically with
regard to credit ratings that, when used for regulatory purposes or when included in private
investment agreements, concerns arise regarding over-reliance because of the potential “cliff
effects” resulting from a ratings downgrade
10
.
Notwithstanding these concerns, it is widely accepted that credit ratings act as useful, and at
times necessary, benchmarks against which investment managers and investors may wish to
compare their own internal credit analysis when available. Credit ratings rely on a blend of both
quantitative (e.g., the systematic assessment of financial data, the calculation of ratios, running of
models, etc.) and qualitative indicators (e.g., business risks, the impact of regulatory change, the
quality of management, the implied future industry outlook, etc.) to objectively assess the
9
An example of this second category is provided by Morningstar’s methodology for rating funds, split
between the Star Ratings, that are backward-looking, strictly quantitative, assessing a fund’s past
performance in terms of returns adjusted for risk/volatility, of performance vis-à-vis competitors in the same
category, and of value generated for investors over specified periods; and the more recent Analyst Rating
system, where more qualitative and “subjective” factors are taken into account to express a forward-looking
opinion on the people (a fund’s managers), the process (i.e., how a fund’s proclaimed strategy is translated
into a portfolio), the parent (i.e., what are the managing company’s priorities), the performance (i.e., why
did a fund behave in a certain way in certain markets and probability of the same repeating in the future),
and the price (i.e., is a fund a good value proposition for investors compared to peers). The Analyst Rating
system methodology factsheet is available at:
http://corporate.morningstar.com/US/documents/MethodologyDocuments/FactSheets/AnalystRatingforFun
dsFactSheet.pdf.
For further information, please refer to the Morningstar Equity Research Methodology of J anuary 2012,
available at: http://news.morningstar.com/pdfs/Equity_Research_Methodology_010512.pdf.
See also Fitch Ratings with regard to the fund quality ratings criteria: Assessing Funds’ Investment
Processes and Operational Attributes, available at:
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=552845.
The Fitch Quality Ratings have three pillars: (1) an assessment of the investment process, its resources and
the management company; (2) an operational “pass/fail” analysis; and (3) a ‘reality check’ of the qualitative
assessment against the manager’s historical risk-adjusted performance.
10
In the October 2010 Principles for Reducing Reliance on CRA Ratings, the FSB acknowledges that the
hard-wiring of CRA ratings thresholds into laws, regulations and market practices causes financial stability-
threatening herding and cliff effects where the downgrade of a security under a specific threshold may lead
to sudden disproportionate cascading effect.
6
probability of default (PD) or expected loss (EL)
11
.
The present report deals exclusively with this category of credit ratings, as it is with reference to
them that over-reliance raises concern
12
. To the extent that ratings assigned to certain types of
funds by CRAs are based on the analysis of the creditworthiness of the underlying portfolio, the
present report also discusses potential issues with the use of such ratings.
For the purpose of this consultation report only external credit ratings, which express a
predominant and clear outlook on the creditworthiness (i.e., in particular the implied probability
of default) of a particular instrument and/or entity, will be considered.
Uses of external credit ratings by investment managers
Investment managers may refer to external credit ratings to different degrees in the construction
and management of their portfolios. Given the diversity of asset classes and breadth of different
investment vehicles, each following an investment strategy that is set to meet different investor
needs, there is no single way that investment managers use external credit ratings.
According to the results of the mapping exercises conducted among C5 Member jurisdictions
over 2011-2012, investment managers use external ratings predominantly:
• To guide asset selection in the construction and optimization of an investment portfolio;
• To guide the selection of eligible collateral received or posted from/to different
counterparties;
• To assess a counterparty’s overall financial health and ability to uphold its obligations vis-à-
vis one or more funds, as well as to determine the credit quality of certain guarantors or of
sponsors that may provide support to certain pooled investment vehicles (e.g., money market
funds or structured finance vehicles)
13
.
External credit ratings may also be an element that is accounted for in estimating and managing
portfolio risk subject to the methods or metrics used. Depending on the standard industry models
11
Examples of credit ratings are those assigned to individual financial instruments and issuers by the large and
more established CRAs like Standard & Poor’s, Moody’s and Fitch. By definition their ratings are opinions
on the general creditworthiness of an obligor (issuer), or of its creditworthiness in relation to a particular
security or financial obligation, taking into account the foreseeable future events. See Moody’s Investor
Service, Ratings Symbols and Definitions (April 2014) at 4; Standard & Poor’s, About Credit Ratings
(2012), available at:
http://www.standardandpoors.com/aboutcreditratings/RatingsManual_PrintGuide.html; FitchRatings,
Definitions of Ratings and other Forms of Opinion (J an. 2014) at 4
12
Under the IOSCO CRA Code of Conduct in 2008, a credit rating is defined as “an opinion regarding the
creditworthiness of an entity, a credit commitment, a debt or debt-like security or an issuer of such
obligations, expressed using an established and defined ranking system.”
13
In general, a guarantor of a debt security has an unconditional obligation to pay the guarantee holder the
principal amount of the underlying security plus accrued interest upon default. A sponsor of a structured
finance vehicle or MMF on the other hand is not legally obligated to provide support to the entity, but some
sponsors have done so, including in 2008. See Money Market Fund Reform; Investment Company Act
Release No. 28807 (June 30, 2009) at n.54 and accompanying text (available at
http://www.sec.gov/rules/proposed/2009/ic-28807.pdf)
7
used and on prevailing industry practices, C5 Members would like to understand more about how
external ratings are used in this regard, i.e., what effects downgrades may or may not have on the
average risk of the collective portfolio that is evaluated using these methods or metrics.
Uses of external ratings by investors
Investors may consider external credit ratings before investing and throughout the life of their
investments to define the range of assets in which they choose to invest. They may often establish
investment guidelines to direct investment managers as to the types of instruments that investors
wish their fund or managed account to be invested in. As such, external credit ratings represent a
“common language” used by parties to an investment management agreement. In the absence of
external credit ratings provided by CRAs, many investors would need to rely almost exclusively
on the investment manager in determining whether a security is of investment grade or of high
credit quality. As such, references to CRA ratings, even when embedded in investment contracts,
may prove beneficial to investors by offering them alternative information points from a third
party, while establishing that certain expectations as to how the fund should be managed are to be
taken into account by the investment manager. Investors also may rely on credit ratings, among
other factors, when choosing to invest (or remain invested) in a particular investment vehicle
14
.
Questions for consultation:
1. Do you agree with the above categorization of uses by investment managers of
external credit ratings? Are there other ways in which investment managers use
external credit ratings? Can you point to situations where you would consider there
is no alternative to external credit ratings?
2. What benefits do you as an investment manager see in the use of external credit
ratings? How does your particular size, resources, capabilities, etc., affect the
benefits you perceive?
3. How do investment managers adjust their internal portfolio risk models (e.g.,
diversification parameters, liquidity profile, VaR, etc.) to account for external credit
rating changes to their portfolio securities? Among other risk factors (e.g., currency
and interest rate changes), how relevant are external ratings in determining the
ultimate risk level of a specific portfolio? Where possible, please suggest some
examples as to why rating changes to the underlying securities may or may not be
relevant.
4. As investors, depending on the type of investment vehicle and on your own capacity
to carry out your own internal credit analysis, to what extent is the credit rating of a
fund’s portfolio holdings or of the fund itself, a determining factor in making your
investment decision? Do you require the investment manager to reference one or
more CRA ratings? If yes, is this your own choice or is it required by your specific
institution?
14
For example, some investors will only invest in money market funds that have received the highest rating
8
5. Before investing, do you as an investor verify that an investment manager has
procedures in place to perform its own credit analysis? Please elaborate on whether
the approaches differ depending on the type of investment vehicle (e.g. a money
market fund (“MMF”) vis-à-vis a high yield bond fund).
6. Do you as an investor have the capabilities to monitor the credit quality of portfolio
securities and/or follow-up on changes to external ratings that affect the portfolio
securities or the fund in which you are invested? Could you briefly describe your
procedures?
9
Chapter 2 – Internal credit assessment
As set out in the FSB 2010 Principles for reducing reliance on CRA ratings, a key measure to
reduce market reliance on external credit ratings is for investment managers to conduct their own
credit assessments. The FSB 2010 Principles state that investment managers should be able to
make their own determinations of the credit quality of the assets they intend to acquire or have
acquired without mechanistically relying on credit ratings, and should publicly disclose
information about their credit assessment processes. Pursuant to FSB Principles, several
jurisdictions have introduced a requirement for investment managers to conduct their own credit
assessment or due diligence before investing in fixed-income products (e.g., Brazil, EU, South
Africa).
IOSCO’s 2009 Good Practices highlighted certain good practices in relation to investment
managers’ due diligence when investing in structured finance instruments. Among these, the
following still hold true for investment managers for the present report:
• Understanding the methodology, parameters and the basis on which the opinion of a CRA
was produced, and having the adequate means and expertise to question that methodology
and the parameters, notably to identify their limits.
• Understanding how the opinion of the CRA was formed without relying excessively or solely
on it to form an opinion of the assets invested in. External credit ratings do not substitute for a
manager’s due diligence: they may be the beginning of due diligence, but not the end
15
.
The overarching principle is that, while CRA ratings may be used as an input by investment
managers, a manager should have appropriate controls and procedures in place internally to
assess and manage on an on-going basis the credit risk associated with its investment decisions.
A manager has fiduciary duties to its clients, which would encompass an understanding of the
material credit risks of any investments that the investment manager makes or recommends and
that they are appropriate for the client’s risk profile and investment objectives.
For an investment manager, developing its own in-house credit assessment expertise is an
essential added value provided to clients and represents one of the key factors managers use to
differentiate themselves from one another. However, although the approaches adopted by
investment managers to assess credit risk may substantially differ from one another, investment
managers generally should disclose in an understandable way to their investors the approach they
follow.
IOSCO understands that in general two internal models exist for assessing creditworthiness. In
the first model the same person performs both portfolio management and credit assessment tasks;
in the second model, credit research is carried out by a separate team of professionals. As a
general rule, managers should disclose to their investors the internal model used.
a) Depending on the size and resources available to them, some investment management
companies may entrust the credit assessment to the same person in charge of making
investment decisions. Typically, smaller investment management businesses lack the
resources to constitute teams of dedicated credit analysts to cover the whole spectrum of
15
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD300.pdf.
10
their investments. These businesses may be specialized investment firms that focus on
fewer asset categories and allow the managers to develop their own views – more or less
formalised – on the credit quality of the entities they choose to invest in on behalf of their
clients.
The risk of this form of organization lies in the inherent conflict of interest between the
desired “objectivity” of a manager’s credit assessment and the manager’s interest in
pursuing higher returns through less creditworthy investments. Such conflicts are
generally managed and mitigated through internal policies, procedures and controls;
b) Other investment management companies that have ample resources can maintain internal
dedicated teams of analysts to assess and monitor the credit quality of their portfolio
investments. Within such firms, so as to avoid conflicts of interests, the credit analysis
functions are deliberately segregated from those of asset management. The risk
assessment may also be conducted on an intra-group level or outsourced externally to an
independent third party. Furthermore, the function of risk management plays an important
role in ensuring that risk is managed in line with the funds’ investment objectives.
Asset managers willing to invest in fixed-income products should have the appropriate expertise
and processes in place to perform credit risk analysis in line with their investment policy. In
jurisdictions where applicable, regulators may check as part of the authorization process the
adequacy, means and expertise that asset managers put forward to pursue the investment policy.
However, these standard setters and regulators should be wary of imposing regulations relating to
standards for in-house credit assessment, in particular to the extent that it might reintroduce other
types of overreliance and potential trigger effects stemming from an excessive homogeneity of
practices that may result from overly prescriptive rules. In particular, standard-setters and
regulators should take into account the nature, scale and complexity of the activities carried out
by the management company when monitoring the adequacy of its credit assessment process.
While encouraging the development of internal credit assessment procedures, IOSCO recognizes
that external credit ratings can play an important role in providing investment managers with
useful inputs before investing and while managing a portfolio. Noting that the use of external
credit ratings and in-house credit research are not mutually exclusive, it is suggested that the
former may be used as an input for the latter. In this regard, IOSCO acknowledges that its
recommendations should allow for external credit ratings to continue to be used as benchmarks,
among other purposes, complementing a manager’s internal credit analysis and providing an
independent opinion as to the quality of the portfolio constituents.
Possible good practice
Investment managers make their own determinations as to the credit quality of a
financial instrument before investing and throughout the holding period.
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.
Investment managers could consider credit assessment procedures that include some or all of the
following criteria, as appropriate:
11
• Performing the assessment on the basis of an internal assessment scale and through the
application of a rigorous methodology validated by the management board;
• Basing such methodology on all the relevant information available as appropriate to the
type of instruments the funds may invest in or the adviser may recommend;
• Ensuring that information used for the assessment is of sufficient quality, updated
regularly and from trusted sources;
• Reviewing the assignment of internal credit assessments on an on-going basis and
regularly assessing the impact of external events likely to alter the credit quality of an
individual entity (e.g., events in the broader financial market, or specific to the entity such
as a corporate event, a change in the relative external credit rating, etc.);
• Regularly reviewing the assessment procedure so that when there are changes in a fund’s
objectives and financial market conditions, or in case of material change affecting its
parameters the assessment procedure can be updated accordingly;
• Documenting, where relevant, the assessment procedure and the meaning of each internal
assessment so as to provide the rationale underlying specific assessments, including a
description of parameters, data sources, assessment models and their underlying
assumptions, ratings’ assignment processes, and events likely to trigger changes in the
assessments;
• Specifying if, how, and the extent to which external ratings are taken into consideration
and clarifying in the procedure the type of measures the investment manager would put in
place in the event of a downgrade by a CRA where external ratings are used as inputs in
the internal process;
• Making available to investors, for instance, through a link on the investment manager’s
website or in the annual reports of the funds, a brief summary description of these internal
assessment procedures focusing on salient information.
It should also be noted that external credit ratings may be used as an indicator of liquidity, in
particular in periods of market stress where it may be seen as a quality seal, this being
particularly true for structured finance instruments. In periods of stress, managers may be more
prone to sell downgraded assets not only because of a change in the CRA’s credit quality
assessment, but also as managers fear the assets become illiquid. In such situations, internal credit
assessment models may need to take into account other market indicators to evaluate the liquidity
of a finance instrument.
Possible good practice
An internal assessment process that is commensurate with the type and proportion of
debt instruments the investment manager may invest in, and a brief summary
description of which is made available to investors, as appropriate.
An internal assessment process that is regularly updated and applied consistently.
12
Questions for consultation:
7. Is the above description of the two models of internal analysis of credit quality within
investment management firms accurate?
8. What factors would be effective in mitigating the conflict described in letter a)?
9. Do investment management companies adopt different internal assessment models
depending on the type of investment management vehicle (e.g., MMFs, equity or
bond funds, alternative or structured investment vehicles, etc.) they manage?
10. How do smaller investment managers use external credit ratings? What methods of
credit assessment do small and medium managers use in addition to review of credit
ratings?
11. Do you agree with some or all of the internal credit assessment procedures described
above? Are there other procedures you use or would recommend?
12. To the extent that you have internalized your credit analysis, for what sort of
instruments/issuers are you better able to perform it? If external credit ratings remain
as a point of reference, how are these accounted for in the internal analysis and what
is their relative value in determining and monitoring the creditworthiness of an
instrument or issuer?
13. In periods of market stress, are credit ratings considered as one indicator of liquidity
to be taken into account in the procedures of liquidity risk management, and if so
how?
13
Chapter 3 – Uses of external credit ratings by investment managers
3.1 Asset selection
The following sub-sections address concerns regarding the way investment managers use external
credit ratings for asset selection, how credit ratings may influence the relative weight of certain
securities in an investment portfolio and investment managers’ access to the information
underlying the credit ratings.
3.1.1 References to external ratings in fund disclosures
Despite the long standing efforts to reduce mechanistic reliance on CRAs ratings, external credit
ratings continue to be used by investment managers to communicate the level of credit risk of a
given portfolio and by investors when selecting the risk profile of a fund. It remains common
practice to describe in a fund’s disclosures the investment universe of a specific fixed income
fund by referring to a minimum external credit rating that limits the securities in which the fund
can invest.
Acknowledging that there is to date no fully satisfactory alternative to external credit ratings,
IOSCO could encourage investment managers to review their disclosures and consider providing
a description of the targeted level of credit risk that does not refer solely to external credit ratings.
External credit ratings could remain as an illustration.
Possible good practice
Regulators could encourage investment managers to review their disclosures describing
alternative sources of credit information in addition to external credit ratings.
3.1.2 References to external ratings in individual investment mandates
External ratings can be viewed as a “common language”, used by the parties to an investment
management agreement to better identify the desired level of credit risk underlying the portfolio.
It is worth noting that a manager’s asset selection may often be conditioned by the internal risk
guidelines imposed by the manager’s investor. Such may be the case for instance if the investor
imposes strict investment restrictions that are derived from regulatory requirements or the
investor’s internal rules. For instance, an investor that is a bank or an insurance company subject
to the Basel framework or in Europe the Solvency regime may determine its investment universe
based on the capital cost incurred for specific instruments. Apart from these international
standards, some investors may still be subject to national laws and regulations that incorporate
CRA ratings in prescribing investments for those entities. For instance, in some jurisdictions
retirement plans may be required by law to define their investment universe according to CRA
ratings.
In such circumstances, managers may establish privately managed accounts that are tailored to
the specific profile and needs of the investor (e.g., a large pension or insurance fund). The
investment manager would exercise its discretion within specific bounds by purchasing only
those securities rated at or above a minimum external credit rating in conformity with the
guidelines established by the investor. The following box illustrates this with examples of the sort
of language that has been used by (i) a large pension fund, client to a large global manager, in an
14
excerpt taken from the relevant investment guidelines; by (ii) and (iii) with excerpts taken from
the investment guidelines relative to a managed account run by another large global manager in
the interest of institutional clients; and by (iv) in a national self-regulatory organization (SRO)
regulation concerning certain complementary pension schemes with regard to asset eligibility
rules.
Box I - Examples of references to external credit ratings in fund investment mandates
or in national SRO standards
According to (i), “Fixed income securities shall not be rated less than Baa3 or its
equivalent.” […] “All securities must be rated by either Moody’s or Standard & Poor’s.”
According to (ii), “Securities must be rated either by S&P or Moody’s. […] Securities rated
equal to or lower than BBB+/Baa1 must have no more than 50% of the Fund’s total NAV. In
case of a downgrade, the Investment Manager can hold securities rated equal to or lower
than BB+/Ba1 but must be no more than 10% of the Fund’s total NAV.”
According to (iii), the following table illustrates the relative weight of government and
corporate bonds as a percentage of the account’s portfolio relative to their long-term rating
issued by S&P
16
:
Long-term grade
at time of
purchase
Bonds issued (or
guaranteed) by a
sovereign with a
minimum rating of
A-
Other bonds
(corporates) with a
rating between
AAA and AA-
Other bonds
(corporates) with a
rating between A+
and A-
Other bonds
(corporates) with a
rating of BBB+or
lower
Max. portfolio
weight per issuer
35% 5% 3% 1%
According to (iv) “Bonds and other types of debt instruments comprising the minimum 60%
quota of a portfolio must obtain an (external) rating above or equal to A- or equivalent
(where no rating is available, the rating of the issuer may be referred to). Nevertheless, in
the case of a managed account or of a dedicated investment fund mandate, securities rated
below A- or above or equal BBB- are allowed to be invested in up to a limit of 5% of a
portfolio on condition that those rated at least A- represent at least 60% of the portfolio.”
In this regard, a privately managed account can offer the investor a greater degree of flexibility in
negotiating a mandate, including the desired minimum credit quality of the individual assets to
constitute the portfolio.
The degree of CRA rating reliance largely depends on the sort of investment vehicle, on the
investment purpose this serves, and on the degree to which the investment manager must observe
minimum external credit ratings under private agreement with the investor. References to
external credit ratings may trigger mechanistic reliance if embedded in trigger clauses;
16
The mandate further admits that the comparable ratings of Moody’s and Fitch are also taken into account
and where “split ratings” occur, the lowest of among three CRAs shall be considered.
15
conversely, if used for reaching a consensus between client and agent for defining the investment
criteria, these references may be less problematic.
As a general principle, for the purpose of reducing over-reliance on external credit ratings,
regulators could encourage investment managers, as applicable, to include in investment mandate
agreements references to alternative credit information sources
17
. For example, the external credit
rating could be reviewed internally by the manager using an appropriate internal credit
assessment procedure and the results of that procedure approved by a board of the management
company.
Possible good practice
Regulators could encourage investment managers– as represented collectively through
trade associations and/or SROs – to include in their credit assessments alternative
(internal) sources of credit information in addition to external credit ratings.
3.1.3. Investment managers’ access to underlying credit rating information
When referring to external credit ratings to guide asset selection, managers should be able to
form an opinion on the methodologies that the chosen CRAs have used to determine their credit
ratings. In this respect, an investment manager would benefit from an adequate level of
disclosure, accompanied by inquiries, when appropriate, for the chosen CRAs about rating
methodologies, credit outlooks, as well as broader market events or factors likely to affect the
average credit quality of the invested portfolios. Such disclosures are also in line with IOSCO’s
planned revision of the 2008 Code of Conduct Fundamentals for CRAs concerning the important
role that transparency can play by allowing investment managers to understand and compare the
processes of various CRAs
18
, to identify, where necessary, the limitations of the CRAs’
methodologies, models and key parameters, as well as to develop their own internal credit
assessments, which may incorporate data disclosed by CRAs
19
.
Possible good practice
Where external credit ratings are used, investment managers understand the
methodologies, parameters and the basis on which the opinion of a CRA was produced,
and have adequate means and expertise to identify the limitations of the methodology
and assumptions used to form that opinion.
17
IOSCO also could encourage investors (represented collectively by their trade associations and self-
regulatory organizations - SROs), but recognizes that such investors may be outside of the scope of
securities regulation.
18
Please refer to the letter from IOSCO Board Chairman, Greg Medcraft, to the Finance Ministers and Central
Bank Governors of the G20 of 15 April 2013; Available at:
http://www.iosco.org/library/briefing_notes/pdf/IOSCOBN01-13.pdf
19
In this regard, especially for certain types of structured products, investment managers could decide to
exercise their own due diligence in conformity with the IOSCO 2009 Good Practices, which notes that a
good practice for the investment manager is to understand the methodology, parameters and the basis on
which the opinion of the third party (e.g., the CRA) was produced, and to have the adequate means and
expertise to challenge that methodology and the parameters (notably, to identify their limits).
16
3.1.4 Investment managers’ disclosures on uses of external credit ratings
The C5 2011-2012 mapping exercises have shown that requirements for investment managers to
disclose their use of external credit ratings vary among jurisdictions, as well as across asset
classes, or types of investment contract (e.g., discretionary investment contracts or not). In some
jurisdictions, disclosures remain at the discretion of the manager or depend on the significance
that external credit ratings may have in determining the risk profile of a fund portfolio
20
.
In light of the above and given the importance of fostering greater transparency for investors,
investment managers could be encouraged to make available their policies with regard to the use
of external credit ratings, for example, in prospectuses and/or in the relevant sales documents.
Information could contain some or all of the following elements, as appropriate:
• The sensitivity of the invested portfolio to changes in the assigned credit ratings,
downgrades on the return/risk profile
21
and redemptions from the fund. Such description
could include the likely effects resulting from changes in the external credit quality of
collateral or of a counterparty, or where appropriate, of a guarantor or sponsor where this
could have a material impact on the portfolio;
• A description (or reference to public availability) of the methodology underlying any
CRA ratings on which the manager relies, with the main assumptions;
• Where the investment manager performs its own internal assessment, a general
description of its methodology, including its underlying assumptions, including, if
appropriate, the use of external credit ratings.
Possible good practice
Regulators could encourage investment managers to disclose the use of external credit
ratings and describe in an understandable way how these complement or are used with
the manager’s own internal credit assessment methods.
3.1.5 Uses of external ratings to determine the quality of an asset’s guarantor
or of a fund’s sponsor
Credit ratings also may be used to assess guarantors and other potential providers of credit
support for certain assets. In the context of structured finance vehicles, external credit ratings
may be considered where an evaluation of securities issued by the vehicle may include
consideration of the credit quality of a guarantor or explicit support provider
22
. In case of MMFs,
20
For instance, in one jurisdiction only if instruments subject to credit risk form a “significant” part of the
portfolio, and where CRA ratings are given significant weighting by the manager in making credit
assessments, would they be required to be disclosed. Furthermore, such disclosure is required only where
investment is sought from investors who are neither professional nor sophisticated.
21
In this regard, please also refer to the IOSCO 2009 Good Practices.
22
For example, CRAs may consider the rating of the guarantor or support provider when rating securities
issued by a structured finance vehicle. Please refer to Moody’s Approach to Rating Asset-Backed
Commercial Paper.
(available at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_SF278537).
17
the financial strength of the sponsor may also be considered relevant to the decision to invest
23
.
To the extent that the financial strength of a guarantor or support provider is a consideration in
evaluating the creditworthiness of securities issued by a structured finance vehicle, asset
managers should not rely exclusively on external credit ratings in assessing the creditworthiness
of those entities.
Questions for consultation:
14. Could you describe your experience of instances where external credit ratings were
mandated by investors? Is it possible to draw a relationship between an investor’s
specific profile and the investor’s greater/lesser reliance on CRAs in a mandate’s
specifications? Please give examples.
15. In your experience, do prudential requirements impact demand for contractual
reliance on external credit ratings?
16. What type of alternative credit information sources could be included in investment
mandate agreements and fund investment objectives?
17. Please describe the process you use for identifying and comparing CRA
methodologies.
18. If a fund manager relies on external credit ratings, is the information that the fund
manager provides to you, as an investor, sufficient to allow you to understand the
potential impact of a change in the external credit rating on the underlying portfolio
of the fund? If not, what additional disclosures would be useful?
19. To what extent is the credit quality of a sponsor a relevant criterion in an investor’s
selection of a fund? Does it differ depending on the fund?
20. How important is the external credit rating of the sponsor of a structured finance
vehicle if the vehicle does not have explicit support from its sponsor?
21. Following the downgrade of a guarantor, could you as an investment manager be
23
See Money Market Fund Reform; Investment Company Act Release No. 28807 (June 30, 2009) at n.54 and
accompanying text (available at http://www.sec.gov/rules/proposed/2009/ic-28807.pdf). Certain CRAs
consider the financial strength of the sponsor when rating a MMF. As reflected in their methodologies, in
addition to other quantitative and qualitative factors, the sponsor of a MMF rated in the highest category
generally has an investment grade rating. Please refer to Moody’s Moody’s Revised Money Market Fund
Rating Methodology and Symbols of 10 March 2011, available at:
https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_131303 (the expectation is that
for MMFs rated in its top category, the sponsoring entity will be “investment grade” or of an equivalent
profile); FitchRatings Global Money Market Fund Rating Criteria J anuary 2014 (available at:
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=727497) (for a MMF rated in the
top category, a fund sponsor typically would be rated (or deemed to be rated) investment grade).
Qualitative considerations regarding sponsors of structured finance vehicles also may influence a CRA’s
rating, but not as strongly as other qualitative or quantitative inputs. For example, in one large CRA’s
rating methodology for asset-backed commercial paper (“ABCP”), the CRA notes that “the financial
strength of the sponsor and the sponsor’s commitment to the capital markets are important qualitative
considerations.”
18
forced to sell the securities issued by the structured finance vehicle? Please explain
as to why or why not this may be the case.
3.2 Quality of counterparties and collateral
While in the context of asset selection, managers and investors tend to have reduced their reliance
on external credit ratings both from the regulatory perspective and market practice; they still
widely refer to them when it comes to determining the quality of collateral and counterparties,
where references to external credit ratings remain both in private contracts and in prudential
rules.
External credit ratings continue to be used in some jurisdictions’ regulations and in private
investment agreements to determine and monitor the credit quality of counterparty and
collateral
24
. In practice, this may translate into a situation where an investment manager could
close out one of its managed funds’ positions, for instance with a derivative counterparty, from
the moment the latter is affected by a credit rating downgrade. For example, a downgrade or the
cancellation of the credit rating of the counterparty is included in the Additional Termination
Event clause of the ISDA Master Agreement which outlines the standard terms applied to a
derivatives transaction between two parties
25
. Under the clause, if a given institution’s credit
rating falls below a predetermined threshold or is withdrawn by one or more credit rating
agencies, the counterparty has the right to close out all derivative contracts with this institution
26
.
Moreover, external credit ratings may also be taken into consideration when it comes to
determining the size of haircuts applicable to certain collateral. For instance, it is our
understanding that the size of the haircuts applied by the European Central Bank (ECB) depends
on the credit quality of the collateral as determined by external ratings
27
.
With respect to regulatory requirements, the revision of asset eligibility rules in many
jurisdictions has led to a reassessment of the use of ratings for collateral exchanged on the basis
24
According to the example cited above (see (iv) Box I), with regard to the credit quality of eligible
counterparties to repo transactions, one relevant article of the relevant regulation provides that “[…] Such
(repo) transactions shall not be permitted with those entities, which in the quality of counterparties, do not
possess a long-term (external) rating above or equal to A-”. Another example can be found in the relative
investment guidelines of a European UCITS fund whereby counterparties to swap derivative contracts must
have a long-term rating above or equal to A-. The same applies for counterparties to repo or securities
lending transactions.
25
The ISDA Master Agreement is the most commonly used agreement for OTC derivatives transactions. It is
published by the International Swaps and Derivatives Association (ISDA), and is a document agreed
between two parties that sets out standard terms that apply to all the transactions entered into between those
parties.
26
On this, please refer to the article Downgrade Termination Costs of Fabio Mercurio, Roberto Caccia and
Massimo Cutuli published in March 2012 in Risk.net magazine; available at
http://www.risk.net/digital_assets/4143/risk_0312_mercurio2.pdf. In this article, the authors demonstrate
that Ratings-based (RB) additional termination event (ATE) clauses in International Swaps and Derivatives
Association agreements can have a significant impact on the valuation of derivatives portfolios when rating
events occur.
27
See The ECB Guidelines on Monetary Policy Instruments and Procedures of the Eurosystem, September
2011, available at: https://www.ecb.europa.eu/ecb/legal/pdf/l_33120111214en000100951.pdf
19
of margining agreements in the context of derivative and securities financing transactions
28
. In
addition, reforms are underway in some jurisdictions to introduce alternative criteria or methods
29
for managers to evaluate the quality of received/posted collateral away from external credit
ratings. Such changes could mitigate the risk of pro-cyclical effects due to sudden credit
downgrades of securities used to secure financial transactions
30
.
When evaluating the quality of collateral, investment managers could consider whether the
collateral fulfils some or all of the following tentative parameters, as appropriate
31
:
• Sufficiently liquid
32
(but at least as liquid as the eligible assets in case the counterparty
does not honour its obligations and the collateral is enforced);
• Valued on a regular basis (e.g., valued on a daily basis and exhibiting a low price
volatility);
• Issued by an entity unaffiliated with the counterparty and/or displaying a low correlation
with it;
• Sufficiently diversified across issuers, markets, industries and/or regions;
28
For instance, in Europe, Article 46 of EU Regulation No. 648/2012 on OTC derivatives, central
counterparties and trade repositories (EMIR) provides that a CCP shall accept highly liquid collateral with
minimal credit and market risk to cover its initial and ongoing exposure to its clearing members. For
financial instruments, the Delegated Regulation No 153/2013 expressly states in its Annexes I and II that
when performing their internal assessments, CCPs shall employ a defined and objective methodology that
shall not fully rely on external opinions (for further details, see Annex 1 of Regulation 153/2013).Available
at: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ :L:2013:052:0041:0074:EN
DF 29
For instance, in the U.S., recent regulatory amendments eliminated the requirement that if the CIS is
looking to the issuer of securities collateralizing a repurchase agreement to satisfy certain requirements
under the Investment Company Act of 1940, collateral other than cash or government securities must be
rated in the highest category by the certain CRAs or be of comparable quality. Instead the amended rule
requires that collateral other than cash or government securities must consist of securities that the fund's
board of directors (or its delegate) determines are: (i) issued by an issuer that has an exceptionally strong
capacity to meet its financial obligations; and (ii) sufficiently liquid that they can be sold at approximately
their carrying value in the ordinary course of business within seven calendar days.
30
According to a comparative study authored by the European Central Bank (ECB), minimum credit ratings
may be an additional requirement in establishing the quality of collateral under the framework of central
banks and of CCPs. As an example, under the Eurosystem, collateral quality is independently assessed on
the basis of the minimum probability of default (PD) calculation (required under the Basel rules for
measuring regulatory capital), which is then compared with the ratings of an external CRA. The Eurosystem
also allows the use of alternative credit assessment systems, such as in-house central bank credit assessment
systems, counterparties’ internal rating-based systems or third-party providers’ rating tools. Other central
banks typically require more than one rating from the external CRAs. For further information, please refer
to the ECB study Collateral Eligibility Requirements: A Comparative Study Across Specific Frameworks
published in July 2013; available at: http://www.ecb.europa.eu/pub/pdf/other/collateralframeworksen.pdf
31
In this sense, as an example, please also refer to the ESMA Guidelines on ETFs and other UCITS issued in
December 2012; available at:
http://www.esma.europa.eu/system/files/2012-832en_guidelines_on_etfs_and_other_ucits_issues.pdf
32
Liquidity is a function of several factors that those managing collateral would need to consider. In general,
factors that may typically affect the liquidity, and hence the valuation, of collateral are demand pressures,
inventory, availability of transparent pricing, etc.
20
• Governed by a clear legal regime allowing it to be enforced immediately (i.e. without the
prior approval of the counterparty) and within well-defined limits for its potential re-
investment;
• Subject to stress-testing to assess the liquidity risk where received collateral represents
more than a minimum portion of a fund’s net asset value (NAV);
• Application of a clear haircut policy across varying asset classes;
• In the case of MMFs, maximum weighted average maturity (WAM) and weighted
average life (WAL) of the securities to be received.
Possible good practice
Regulators could encourage investment managers, when assessing the credit quality of their
counterparties collateral, not to rely solely on external credit ratings and to consider
alternative quality parameters (e.g., liquidity, maturity, etc.)
Questions for consultation:
22. How important to fund managers is the external credit rating in the choice of a fund’s
counterparty(ies)? What are the key factors usually taken into account when
negotiating an agreement with one or more?
23. Following the credit rating downgrade of a key counterparty, depending on the
contents of the relevant agreement, could you as an investment manager be forced to
close out your respective positions? Please explain as to why or why not this may be
the case.
24. How does an investment management company’s size and resources relate to the
investment manager’s ability to perform an internal credit analysis of one or more
counterparties?
25. Are there some strong references to external credit ratings which are channeled
through the ECB guidelines, ISDA Master Agreements or CCPs guidelines?
26. Would you agree with some or all of the above parameters as valuable additional
factors for the internal assessment of collateral quality?
27. Among the above parameters, which one(s) could be considered by counterparties to
replace / supplement external credit ratings when evaluating the quality of collateral?
28. Are there other parameters that could be considered to facilitate the credit assessment
of collateral received and/or posted by the investment manager, independently from
external credit ratings?
3.3 Investment managers soliciting fund ratings
As discussed in the scope section, unlike external credit ratings of individual financial
instruments and of their issuers, fund credit ratings are generally not used in rules and
regulations. For certain types of investment portfolios (e.g., MMFs, bond funds, etc.), investment
21
managers may use fund ratings to publicize the average credit quality of the portfolio
components, and fund credit ratings may be used by investors to compare two or more separate
portfolios. Investment managers are, in some cases, incentivized to request the credit rating of
one or more of the funds they manage to meet investors’ demands.
In this respect, European MMFs are an interesting example. Stakeholders have explained the
development of MMF credit ratings in Europe by the added value provided to investors in the
absence of a defined common regulatory framework
33
. Prior to the introduction of ESMA’s
guidelines on MMFs in 2010, there was no common definition of an MMF in Europe. Investors
therefore used CRA credit ratings to ensure that a fund met minimum standards in terms of credit
quality and liquidity and was subject to appropriate oversight. The Guidelines, by setting a
common framework, appear to have contributed to reducing investor reliance on external ratings.
These stakeholders have also pointed to a number of risks that could stem from the use of MMF
credit ratings, particularly in an environment where the number of financial institutions with a
sufficiently high credit rating has become more limited.
In this context, the likelihood of an MMF’s downgrade and the pressure to maintain the credit
rating have increased. The general approach of CRAs in rating MMFs is to focus primarily on the
basis of preservation of capital and providing liquidity to shareholders
34
. The high credit quality
of the underlying assets – with the resulting highest awarded credit rating by a CRA – are
therefore essential requirements for these funds to be marketed in view of the above objectives.
Thus, if individual securities are downgraded, or even placed under negative review, an MMF
could have a strong incentive to sell those securities in order to keep its portfolio in line with the
criteria set by the CRA notwithstanding the manager’s own credit assessment of the underlying’s
credit quality
35
.
Further, in some cases, investors may use the external credit rating as a proxy for the resilience of
the fund rather than conducting their own due diligence. These investors may therefore have a
strong incentive to redeem an MMF’s shares if the MMF is downgraded or put on negative
watch
36
As boards of institutional investors and corporate treasurers often require an MMF to
33
Please refer to the comment letters from HSBC and IMMFA sent to the European Commission in the
context of a consultation on the UCITS directive; available at:
http://ec.europa.eu/internal_market/consultations/2012/ucits/registered-organisations/hsbc-global-asset-
management_en.pdf , and:
http://ec.europa.eu/internal_market/consultations/2012/ucits/registered-organisations/institutional-money-
market-fund-association_en.pdf.
34
As an example, please refer to Moody’s Moody’s Revised Money Market Fund Rating Methodology and
Symbols of March 2011,
https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_131303.
35
In the U.S., the incentive to sell securities as a result of a credit ratings downgrade may not be a
consequence of the impact on the fund’s rating. Rule 2a-7 under the Investment Company Act governs the
operations of U.S. MMFs. The rule requires an MMF’s board of directors promptly to reassess whether a
security that has been downgraded by a CRA continues to present minimal credit risks and take such action
as the board determines is in the best interests of the fund and its shareholders.
36
See Fitch puts Matrix-owned funds on review due to firm's financial resources, published in
MoneyMarketing on 12 December 2011; available at: http://www.moneymarketing.co.uk/fitch-puts-matrix-
owned-funds-on-review-due-to-firms-financial-resources/1043059.article (including the following
22
have the highest possible credit rating for them to invest, MMFs are often either rated “AAA” or
not rated, which may create a risk of sudden redemptions in a rated MMF if it no longer meets
the requirements for the CRA credit rating. However, investor appetite for credit ratings of
MMFs may be reduced with the strengthening of regulatory frameworks applicable to MMFs
37
.
A CRA rating a global bond fund attaches significant weight to the average credit quality of the
underlying portfolio, its sensitivity to market risk factors, such as duration, spread risk, currency
fluctuations, etc., as well as to it past performance relative to a benchmark
38
. At this stage, it is
C5’s understanding that investors do not rely on credit ratings of different types of fund portfolios
to the same extent. Specifically, between two types of fixed income portfolios, where one is
labeled “high yield” (or “speculative grade”) and the other “investment grade”, end-investors
would rely more heavily on the credit quality of underlying assets of the investment grade fund as
assessed by CRAs. The reliance would be less true for a high yield portfolio where investors
willingly take on greater risks and rely more heavily on a manager’s individual skill.
IOSCO is seeking feedback from representatives of the investment management industry, as well
as investors, to better understand fund rating implications.
Questions for consultation:
29. Why do investment managers seek to have their funds rated?
30. What is the trend regarding fund credit ratings? Are investment managers seeking
fund credit ratings more often or less frequently?
31. Do investors use ratings differently in evaluating MMFs, investment grade bond
funds and high yield bond funds?
32. To what extent, if any, do CRAs provide credit ratings for funds for which they also
rate all or part of the portfolio?
33. In situations where the same CRA rates both the fund and its portfolio, if the CRA
statement from Fitch: “The sponsor’s financial resources are no longer consistent with a ’AAAmmf’ rating,
even after taking into consideration the funds’ conservative investment guidelines.”).
37
The European Commission published in September 2013 a draft Regulation on Money Market Funds where
it proposes to prevent an MMF from soliciting or financing an external credit rating “to ensure that fund
managers and investors stop relying on external credit ratings that could be detrimental to the functioning
of the money market when downgrades occur”. For further details, please see: http://eur-
lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52013PC0615&from=EN
38
As an example, please refer to Fitch’s Global Bond Fund Rating Criteria of August 2013, available at
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715678. Unlike bond funds,
equity funds – defined as those that invest either wholly or predominantly in common stock – that are rated
are generally assessed on the basis of their relative performance over a specific period and on the quality of
the manager, reflected in its financial profile, its client servicing ability, its investment infrastructure, etc.
However, the present report only looks at fund rating to the extent that it reflects the creditworthiness of the
underlying portfolio and could potentially create an undue reliance on CRA. As an example, please refer to
Moody’s Methodology for Assessing the Investment Quality of Equity Funds of February 2012, available
upon request.
23
downgrades or puts under negative watch an underlying security, will the fund be
more prone to sell this security in order to maintain its highest rating?
34. In the case of fund of fund structures, please describe how external credit ratings of
funds are used and how these are taken into account by the investment manager.
Please provide examples.
35. In the case of index funds, do you consider that changes to the external credit rating
of individual index components may be relevant under certain circumstances in
deciding whether the index may continue to be tracked by a fund?
3.4 Managing external credit rating changes
Notwithstanding an investment manager’s (or even investor’s) recourse to its own internal
analysis on the creditworthiness of an instrument and/or its issuer, it is acknowledged that
external credit ratings represent an important and objective benchmark for many market
participants, particularly for those with fewer resources to devote to the development of internal
credit rating scales or models. In this regard, the potential cliff effects that can result from a credit
ratings downgrade may be of particular concern to regulators
39
.
Where they rely more heavily on external credit ratings, investment managers should have
appropriate internal procedures when a security is subject to an external credit rating downgrade.
These procedures may include specific “grace periods” that allow them to delay divesting the
related securities if it would be in the best interests of their investors. In other cases, investment
managers may keep the security in the portfolio or decide not to acquire more of the asset. The
questions below are designed to elicit more information regarding investment managers’ (and
where relevant, investors’) reactions to external credit rating downgrades.
Possible good practice
Where an investment manager (or CIS board, as appropriate) explicitly relies on external
credit ratings among others to assess the creditworthiness of specific assets, a downgrade does
not automatically trigger their immediate sale. Where the manager/board conducts its own
credit assessment, a downgrade may trigger a review of the appropriateness of its internal
assessment. In both cases, should the manager/board decide to divest, the transaction is
conducted within a timeframe that is in the best interests of the investors.
Questions for consultation:
36. How do fund investors generally react to a downgrade of a particular asset, or of a
significant part of a portfolio?
37. Please elaborate on internal procedures that investment managers have implemented
following a downgrade, when for instance managers may need to ensure that the
credit quality of the portfolio is still sufficient to meet the stated fund standards or
39
In this regard, please refer to footnote n°10.
24
managers have set up a grace period before selling the downgraded securities. Are
there differences in procedures depending on the type of fund?
38. Do investment managers’ policies or investors’ investment guidelines provide for
specific “grace periods” that allow a manager time to address the situation that
results from a downgrade? If so, what is the average “grace period” and how are
investors informed of the manager’s plans to restore a portfolio’s desired credit
quality?
39. As a follow-up to the question above, would investment managers behave differently
in the event of a collateral downgrade, or of a downgrade affecting one main fund
counterparty or an asset’s guarantor (or sponsor)? Please explain, possibly with
reference to some examples.
40. In the case of a fund’s performance being benchmarked to a specific index, how does
the fund manager react when a downgrade leads to an asset / issuer being removed
from the index?
25
Appendix A – List of Possible Good Practices
Investment managers make their own determinations as to the credit quality of a financial
instrument before investing and throughout the holding period.
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.
An internal assessment process that is commensurate with the type and proportion of debt
instruments the investment manager may invest in, and a brief summary description of which is
made available to investors, as appropriate.
An internal assessment process that is regularly updated and applied consistently.
Regulators could encourage investment managers to review their disclosures describing
alternative sources of credit information in addition to external credit ratings
Regulators could encourage investment managers– as represented collectively through trade
associations and/or SROs – to include in their credit assessments alternative (internal) sources of
credit information in addition to external credit ratings.
Where external credit ratings are used, investment managers understand the methodologies,
parameters and the basis on which the opinion of a CRA was produced, and have adequate
means and expertise to identify the limitations of the methodology and assumptions used to
form that opinion.
Regulators could encourage investment managers to disclose the use of external credit ratings
and describe in an understandable way how these complement or are used with the manager’s
own internal credit assessment methods.
Regulators could encourage investment managers, when assessing the credit quality of their
counterparties or collateral not to rely solely on external credit ratings and to consider
alternative quality parameters (e.g., liquidity, maturity, etc.)
Where an investment manager (or CIS board, as appropriate) explicitly relies on external credit
ratings among others to assess the credit worthiness of specific assets, a downgrade does not
automatically trigger their immediate sale. Where the manager/board conducts its own credit
assessment, a downgrade may trigger a review of the appropriateness of its internal assessment.
In both cases, should the manager/board decide to divest, the transaction is conducted within a
timeframe that is in the best interests of the investors.
26
Appendix B – List of Questions for consultation
1. Do you agree with the above categorization of uses by investment managers of external
credit ratings? Are there other ways in which investment managers use external credit
ratings? Can you point to situations where you would consider there is no alternative to
credit ratings?
2. What benefits do you as an investment manager see in the use of external credit ratings?
How does your particular size, resources, capabilities, etc. affect the benefits you
perceive?
3. How do investment managers adjust their internal portfolio risk models (e.g.
diversification parameters, liquidity profile, VaR, etc.) to account for external credit rating
changes to their portfolio securities? Among other risk factors (e.g. currency and interest
rate changes), how relevant are external ratings in determining the ultimate risk level of a
specific portfolio? Where possible, please suggest some examples as to why credit rating
changes to the underlying securities may or may not be relevant.
4. As investors, depending on the type of investment vehicle and on your own capacity to
carry out your own internal credit analysis, to what extent is the credit rating of a fund’s
portfolio holdings or of the fund itself, a determining factor in making your investment
decision? Do you require the investment manager to reference one or more CRA ratings?
If yes, is this your own choice or is it required by your specific institution?
5. Before investing, do you as an investor verify that an investment manager has procedures
in place to perform its own credit analysis? Please elaborate on whether the approaches
differ depending on the type of investment vehicle (e.g., a money market fund (“MMF”)
vis-à-vis a high yield bond fund).
6. Do you as an investor have the capabilities to monitor the credit quality of portfolio
securities and/or follow-up on changes to external ratings that affect the portfolio
securities or the fund in which you are invested? Could you briefly describe your
procedures? 7
7. Is the above description of the two models of internal analysis of credit quality within
investment management firms accurate? 8.
8. What factors would be effective in mitigating the conflict described in letter a)?
9. Do investment management companies adopt different internal assessment models
depending on the type of investment management vehicle (e.g. MMFs, equity or bond
funds, alternative or structured investment vehicles, etc.) they manage?
10. How do smaller investment managers use external credit ratings? What methods of credit
assessment do small and medium managers use in addition to review of credit ratings?
11. Do you agree with some or all of the internal credit assessment procedures described
above? Are there other procedures you use or would recommend?
12. To the extent that you have internalized your credit analysis, for what sort of
27
instruments/issuers are you better able to perform it? If external credit ratings remain as a
point of reference, how are these accounted for in the internal analysis and what is their
relative value in determining and monitoring the creditworthiness of an instrument or
issuer?
13. In periods of market stress, are external credit ratings considered as one indicator of
liquidity to be taken into account in the procedures of liquidity risk management and if so
how?
14. Could you describe your experience of instances where external credit ratings were
mandated by investors? Is it possible to draw a relationship between an investor’s specific
profile and the investor’s greater/lesser reliance on CRAs credit ratings in a mandate’s
specifications? Please give examples.
15. In your experience, do prudential requirements impact demand for contractual reliance on
external credit ratings?
16. What type of alternative credit information sources could be included in investment
mandate agreements and fund investment objectives?
17. Please describe the process you use for identifying and comparing CRA methodologies.
18. If a fund manager relies on external credit ratings, is the information that the fund
manager provides to you, as an investor, sufficient to allow you to understand the potential
impact of a change in the external credit rating on the underlying portfolio of the fund? If
not, what additional disclosures would be useful?
19. To what extent is the credit quality of a sponsor a relevant criterion in an investor’s
selection of a fund? Does it differ depending on the fund?
20. How important is the credit rating of the sponsor of a structured finance vehicle if the
vehicle does not have explicit support from its sponsor?
21. Following the credit rating downgrade of a guarantor, could you as an investment manager
be forced to sell the securities issued by the structured finance vehicle? Please explain as
to why or why not this may be the case.
22. How important to fund managers is the external credit rating in the choice of a fund’s
counterparty(ies)? What are the key factors usually taken into account when negotiating
an agreement with one or more?
23. Following the downgrade of a key counterparty, depending on the contents of the relevant
agreement, could you as an investment manager be forced to close out your respective
positions? Please explain as to why or why not this may be the case.
24. How does an investment management company’s size and resources relate to the
investment manager’s ability to perform an internal credit analysis of one or more
counterparties?
25. Are there some strong references to external credit ratings which are channeled through
the ECB guidelines, ISDA Master Agreements or CCPs guidelines?
26. Would you agree with some or all of the above parameters as valuable additional factors
28
for the internal assessment of collateral quality?
27. Among the above parameters, which one(s) could be considered by counterparties to
replace / supplement external credit ratings when evaluating the quality of collateral?
28. Are there other parameters that could be considered to facilitate the credit assessment of
collateral received and/or posted by the investment manager, independently from external
credit ratings?
29. Why do investment managers seek to have their funds rated?
30. What is the trend regarding fund credit ratings? Are investment managers seeking fund
credit ratings more often or less frequently?
31. Do investors use ratings differently in evaluating MMFs, investment grade bond funds and
high yield bond funds?
32. To what extent, if any, do CRAs provide credit ratings for funds for which they also rate
all or part of the portfolio?
33. In situations where the same CRA rates both the fund and its portfolio, if the CRA
downgrades or puts under negative watch an underlying security, will the fund be more
prone to sell this security in order to maintain its highest rating?
34. In the case of fund of fund structures, please describe how external credit ratings of funds
are used and how these are taken into account by the investment manager. Please provide
examples.
35. In the case of index funds, do you consider that changes to the external credit rating of
individual index components may be relevant under certain circumstances in deciding
whether the index may continue to be tracked by a fund?
36. How do fund investors generally react to a downgrade of a particular asset, or of a
significant part of a portfolio?
37. Please elaborate on internal procedures that investment managers have implemented
following a downgrade, when for instance managers may need to ensure that the credit
quality of the portfolio is still sufficient to meet the stated fund standards or managers
have set up a grace period before selling the downgraded securities. Are there differences
in procedures depending on the type of fund?
38. Do investment managers’ policies or investors’ investment guidelines provide for specific
“grace periods” that allow a manager time to address the situation that results from a
downgrade? If so, what is the average “grace period” and how are investors informed of
the manager’s plans to restore a portfolio’s desired credit quality?
39. As a follow-up to the question above, would investment managers behave differently in
the event of a collateral downgrade, or of a downgrade affecting one main fund
counterparty or an asset’s guarantor (or sponsor)? Please explain, possibly with reference
to some examples.
40. In the case of a fund’s performance being benchmarked to a specific index, how does the
fund manager react when a downgrade leads to an asset / issuer being removed from the
29
index?
doc_523016833.pdf