The International Organization for Securities Commissions (IOSCO) is seeking input from market participants about reducing reliance on third-party credit rating agencies (CRAs). While the “consultation” is aimed at institutional investors and asset managers, the global standards setter would also prize feedback from the flip side—corporate issuers.
“We didn’t directly ask for issuers’ views … but if they can provide information it would be extremely useful,” said Natasha Cazenave, chair of the IOSCO policy committee on investment management.
The report, titled “Good Practices on Reducing Reliance on CRAs in Asset Management,” aims to supplement core principles to reduce reliance on external ratings published in 2010 by the Financial Stability Board (FSB), an international body established in 2009 to monitor and make recommendations about the global financial system. IOSCO is looking to fill in any gaps left by FSB’s effort and reduce investors’ “mechanistic” reliance on third-party credit ratings.
Ending such behavior should serve to reduce “financial-stability threatening herding and cliff effects that could rise from CRA rating thresholds being hard-wired into laws, regulations and market practices,” Ms. Cazenave said.
She added that two studies done since 2011, across 30 jurisdictions, revealed that reliance on CRA ratings in regulations and laws has largely been removed in the asset management space. The focus is now on private contracts.
“To a large extent industry participants continue rely on external ratings because they haven’t found a satisfactory alternative,” Ms. Cazenave said, adding, “So in the meantime ratings remain the common language for investors and their investment managers and probably also bond issuers, for them to understand one another.”
The thrust of the consultation, Ms. Cazenave noted, isn’t to eliminate the use of third-party ratings, but rather to encourage investment managers to have the appropriate expertise to conduct their own internal credit assessments and to use external ratings as one factor in their analysis. In addition to providing a list of best practices, it asks whether there are other practices that should be included and where there may be complications. For example, investment management firms seeking to reduce their reliance on CRA ratings may be forced into automatically selling a security because institutional clients’ guidelines require investments to be above a certain rating.
“We’re trying to scope out where the issues and difficulties are, so if there are also issues from the perspective of bond issuers, we would be interested to know,” Ms. Cazenave said.
Should adherence to IOSCO’s best practices reduce the cliff effect and the severity accompanying market crashes, it would be a boon to corporate bond issuers in at least a couple of ways. For one, while unlikely to eliminate market panics altogether, investors improving their own credit analysis to compensate for reducing reliance on CRA ratings could lessen the shock to bond and stock prices following CRA downgrades.
Conservative managers who are tightly monitoring a company’s credit are likely to sell its securities well before its bonds are downgraded by the ratings agencies. “Other investors may choose to hold on to the paper, but you shouldn’t have as massive a sell off after the announcement of a downgrade,” Ms. Cazenave said.
In addition, corporate treasurers may gain greater insight into their investor bases, since following IOSCO’s best practices would prompt investors and investment managers that previously relied on third-party ratings to seek information from the company as well.
“Companies may end up having more people to talk to, instead of mainly going through the rating agencies,” Ms. Cazenave said. “But it should also be interesting for them to potentially have a better understanding of the end-investors, and who is actually buying the securities.”