Improved Australian Controls for Credit Rating Agencies and Research Houses

III. Changes in the role and use of credit ratings

Quality of the rating process

CRAs should improve the quality of the ratings process and manage conflicts of interest in rating structured products.

(April Report) III.1 IOSCO will revise its Code of Conduct Fundamentals for Credit Rating Agencies (IOSCO Code) by mid-2008.

Currently: A revised IOSCO Code was issued on 28 May 2008. ASIC participated in the development of the new code. It strengthens the oversight of CRAs in the key areas of (1) quality of the ratings process; (2) conflicts of interest; (3) CRA responsibilities to the investing public, ie differentiated ratings; and (4) greater transparency regarding ratings.

The three major CRAs operating in Australia have relief from AFSL requirements subject to them disclosing how their own codes of conduct fully implement the IOSCO Code or, where they deviate, explaining how their code meets the relevant underlying principles and objectives.

Action: At the instruction of the Government, Treasury and ASIC have reviewed the Australian regulation of CRAs and examined international developments, especially those measures recommended by the FSF. ASIC concluded that the exemption from CRAs holding an AFSL is to be revoked, and CRAs will be licensed under the AFSL regime.
ASIC has concluded that CRAs operating in Australia will provide an IOSCO Code Annual Compliance Report to ASIC on their compliance with all aspects of the IOSCO Code. The IOSCO Code Annual Compliance Report will strengthen transparency surrounding CRA activities and their accountability. As the IOSCO Code is in place it will address some of the causes of recent market turmoil.

Impact: Requiring CRAs to have an AFSL and issue an IOSCO Code Annual Compliance Report will improve oversight of CRAs and increase transparency and accountability over their actions. These measures will also improve the conduct of CRAs and do so specifically with regard to structured financial products.

(October Report) 3.1 The IOSCO Taskforce on CRAs will (i) conduct a review of CRA's adoption of codes of conduct based on the revised IOSCO Code of Conduct and will publish its findings in January 2009 (ii) work toward developing by January 2009 mechanisms by which national regulators can coordinate their monitoring of CRAs with the substance of the IOSCO Code and (iii) examine the possibility of developing an international monitoring body for interacting with CRAs.

Action / Impact: Given the global nature of CRAs these measures seem prudent and will maintain the momentum for better oversight of CRAs. As indicated above, ASIC has concluded that CRAs that operate in Australia will provide an IOSCO Code Annual Compliance Report, in-line with IOSCO's proposed course of action. As ASIC is a member of IOSCO they will monitor and contribute to the efforts of the IOSCO CRA Taskforce.

Given ASIC's extensive cooperative arrangements with other regulators and its participation in IOSCO, Australia is well placed to contribute to IOSCO's forward work program.
It will be necessary to monitor developments with respect to a global oversight body for CRAs given there is no clear way forward at present. Given the global nature of CRAs, a global body would avoid unnecessary global fragmentation and regulatory complexity. We suggest in-principle support for a global approach at this stage.

(April Report) III.2 CRAs should quickly revise their codes of conduct to implement the revised IOSCO Code. Authorities will monitor the implementation of the revised IOSCO Code by CRAs, in order to ensure that CRAs quickly translate it into action.

Currently: The three major CRAs operating in Australia have relief from AFSL requirements subject to them disclosing how their own codes of conduct fully implement the IOSCO Code or, where they deviate, explaining how their code meets the relevant underlying principles and objectives.

Action: ASIC has concluded that CRAs that operate within Australia will be required to issue an IOSCO Code Annual Compliance Report to ASIC on their compliance with the IOSCO Code. These measures will ensure that ASIC is aware of CRA compliance with the IOSCO Code.

Impact: Requiring CRAs to have an AFSL and to issue an IOSCO Code Annual Compliance Report will improve oversight of CRAs and increase transparency and accountability over their actions. This requirement will position ASIC to monitor implementation of the IOSCO Code by CRAs.

(April Report) III.3 CRAs should demonstrate that they have the ability to maintain the quality of their service in the face of rapid expansion of their activities, and to allocate adequate resources to both the initial rating and to the rating's regular review.

Currently: The three major CRAs operating in Australia have relief from AFSL conditions subject to them disclosing how their own codes of conduct fully implement the IOSCO Code or, where they deviate, explaining how their code meets the relevant underlying principles and objectives.

Action: The exemption for CRAs from having an AFSL is to be revoked. CRAs operating in Australia are to be licensed.

Action (adequate organizational resources): Several AFSL obligations require licensees to have adequate organizational resources to maintain the quality of ratings in the face of rapid expansion of activities: eg have adequate resources available to provide services under the licence (s912A(1)(d)).

Impact: This gives ASIC direct oversight of the adequacy of CRAs' resources.

Action (conflict of interest): Introducing an AFSL requirement will ensure adequate arrangements for the management of conflicts of interest that may arise in relation to the provision of credit ratings (Corporations Act 2001, s912A(1)(aa)).

A CRA would be required to have in place arrangements (i.e. internal measures, processes and procedures) to avoid, control and disclose conflicts: see Regulatory Guide 181 Licensing: managing conflicts of interest (RG 181)).

A good example is the requirement to have arrangements for rigorous approval of a credit rating (for instance a review committee) before release. It would be required to document these policies and procedures, how they are implemented and monitor them and keep records of this.

Impact (conflict of interest): This would mitigate the scope for the mis-rating of financial products due to inappropriate relations between CRAs and those firm's products that they rate.

Action (review of ratings): Introducing an AFSL would enable the imposition of a requirement for CRAs to have adequate arrangements to monitor and regularly update ratings. A licence condition of this type would support the principles on monitoring and updating ratings articulated in the IOSCO Code.

Impact (review of ratings): This would improve the internal review and oversight of CRAs of their own activities and enable better quality ratings.

Action (IOSCO Code): The IOSCO Code requires CRAs to have sufficient resources to undertake their tasks (section 1.7–1.8) and ensure regular review of ratings (section 1.9).

Impact (IOSCO Code): Compliance with the IOSCO Code by CRAs should lead them to improve the quality of their ratings.

Differentiated ratings and expanded information on structured products

CRAs should differentiate ratings on structured finance from those on bonds, and expand the initial and ongoing information provided on the risk characteristics of structured products.

(April Report) III.4 and (October Report) 3.2 CRAs should clearly differentiate, either with a different rating scale or with additional symbols, the ratings used for structured products from those for corporate bonds, subject to appropriate notification and comment.

Currently: There is no differentiation of the symbols used to rate structured products compared to other products.

Action: As a small market Australia should not proceed to introduce its own additional rating requirements, such as different symbols for structured products, but should proceed in line with international developments.

The IOSCO Code (section 3.5(a–c)) and a regulatory initiative of the SEC will introduce differentiated ratings for structured products. Given the global importance of the IOSCO Code and the SEC's regulatory initiative such differentiation for structured products should flow through to Australia.

In addition, ASIC has concluded that CRAs will be required to issue an IOSCO Code Annual Compliance Report to ASIC, including their compliance with additional symbol requirements as established under the IOSCO Code.

Impact: The introduction and use of differentiated ratings for structured products will provide users of ratings with a clear indication that they are considering a rating for a product type that has previously contributed to market turbulence.

(April Report) III.5 and (October Report) 3.2 CRAs should expand the initial and ongoing information that they provide on the risk characteristics of structured products.

Currently: The three major CRAs operating in Australia have relief from AFS licensing subject to them disclosing how their own codes of conduct fully implement the IOSCO Code or, where they deviate, explaining how their code meets the relevant underlying principles and objectives.

Action (AFSL): There is a general Corporations Act 2001 obligation on a CRA in providing its services efficiently, honestly and fairly to adequately explain its credit ratings (s912A(1)(a)). In the absence of specific disclosure obligations, ASIC will introduce an AFSL condition on CRAs requiring disclosure of their procedures, methodologies and assumptions that result in a credit rating (s912A(1)(b)).

Impact (AFSL): ASIC's proposed measures would improve the obligations on a CRA to undertake more effective and transparent rating processes. An AFSL improves scope for compliance action by ASIC should CRAs fail to comply with conditions of their licence. This should encourage better decision making by those using ratings.

Action (IOSCO Code): The IOSCO Code (section 3.1–3.10, but also specifically 3.5) requires transparent and timely disclosure of ratings.

Impact (IOSCO Code) Compliance with the IOSCO Code, reported via an IOSCO Code Annual Compliance Report, should improve the quality of information available to users of ratings and therefore improve decisions based upon such ratings.

CRA assessment of underlying data quality

CRAs should enhance their review of the quality of the data input and of the due diligence performed on underlying assets by originators, arrangers and issuers involved in structured products.

(April Report) III.6 CRAs should review the quality of the data input and the due diligence performed by originators, arrangers and issuers.

Currently: The three major CRAs operating in Australia have relief from the AFSL regime, subject to them disclosing how their own codes of conduct fully implement the IOSCO Code or, where they deviate, explaining how their code meets the relevant underlying principles and objectives.

Action (AFSL): The proposed AFSL regime will support enhanced transparency by CRAs regarding the procedures, methodologies and assumptions used in their ratings, specifically licensees have general obligations to:

• do all things necessary to ensure that their financial services (including
  advice) are provided efficiently, honestly and fairly: s912A(1)(a);
• take steps to ensure that they comply with the financial services laws: s912A(1)(c) & (ca); and
• maintain the competence to provide those financial services: s912A(e).

Impact (AFSL) : The obligations that would be imposed on CRAs under the AFS licensing regime support a quality ratings process. CRAs that adopt international best practice, by relying on reasonable assumptions and adopting "reasonable measures", will provide more accurate credit ratings and minimise the risk that the credit ratings they provide are misleading.

Action (IOSCO Code): Section 3.7 of the IOSCO Code seeks to encourage CRAs to more critically assess the input from issuers.

Impact (IOSCO Code): Compliance with the IOSCO Code, reported via an IOSCO Code Annual Compliance Report, should encourage better ratings by CRAs, this in turn should enable better decision making by those who rely on ratings.

(October Report) 3.3 CRAs should enhance their review of the quality of the data input and of the due diligence performed n underlying assets by originators, arrangers and issuers involved in structured products.
IOSCO plans to ask originators and sponsors of securitization programs to develop best practices on due diligence and risk management practices. The objective is to ensure that the assets originated for transfer off their balance sheets are of the same quality and subject to the same valuations as those kept on-balance sheets.

Action: Given the global nature of CRA advice, we support the measures that IOSCO is to take to improve due diligence and risk management practices by those that use ratings.

Given ASIC's extensive cooperative arrangements with other regulators and its participation in IOSCO, Australia is well placed to contribute to IOSCO's forward work program.

Minister Sherry has written to industry associations asking them to contribute to international efforts to develop best practice due diligence and risk management practices. Minister Sherry will convene a meeting of industry associations to progress this matter.

Impact: IOSCO's measures should provide a best practice guide to due diligence and contribute to better assessment of the rating advice provided by CRAs. This should contribute to better and more informed decision making with regard to the use of CRAs.

Uses of ratings by investors and regulators

Investors should address their over-reliance on ratings. Investor associations should consider developing standards of due diligence and credit analysis for investing in structured products.

(April Report) III.7 Investors should reconsider how they use credit ratings in their investment guidelines and mandates and for risk management and valuation. Ratings cannot and should not replace appropriate risk analysis and management on the part of investors. Investors for whom such analysis is not cost-effective should refrain from investing in structured products.

Currently: Institutions have various duties to their members or investors to carefully consider how they use ratings.

Action: Minister Sherry has written to relevant Australian industry associations requesting that they consider actively participating in international efforts such as those lead by IOSCO to reduce investor reliance. Minister Sherry will convene a meeting of industry associations to progress this matter.

Impact: This should provide a best practice guide to due diligence and contribute to better assessment of the rating advice provided by CRAs. This should contribute to better and more informed decision making with regard to the use of CRAs.

(October Report) 3.4 Investors should address their over-reliance on ratings. Investor associations should consider developing standards of due diligence and credit analysis for investing in structured products,

• IOSCO is reviewing the adequacy of due diligence typically conducted by investment managers when making investments in structured finance products, and will set out guidance to enhance practices as needed upon completion of the review by 2009.
• IOSCO will also undertake a study of the risk modeling and internal control systems of financial firms buying structured products and develop principles to address any concerns identified.

Action: Given the global nature of CRA advice, we support the measures that IOSCO is to take to improve due diligence and risk management practices by those that use ratings.
Given ASIC's extensive cooperative arrangements with other regulators and its participation in IOSCO, Australia is well placed to contribute to IOSCO's forward work program
Minister Sherry has written to relevant Australian industry associations requesting that they consider actively participating in international efforts such as those lead by IOSCO to reduce investor reliance on CRA ratings. Minister Sherry will convene a meeting of industry associations to progress this matter.

Impact: This should provide a best practice guide to due diligence and contribute to better assessment of the rating advice provided by CRAs. This should contribute to better and more informed decision making with regard to the use of CRAs.

Authorities will review the use of ratings in the regulatory and supervisory framework.

(April Report) III.8 Authorities should examine whether the roles that they have assigned to ratings in regulation and supervisory rules are consistent with the objective of having investors make independent judgment of risks and perform their own due diligence, and do not induce uncritical reliance on credit ratings as a substitute for that independent evaluation.

(October Report) 3.4 Authorities will review their use of ratings in the regulatory and supervisory framework..

Currently: As in other countries, ratings are used as risk proxies in the Australian Prudential Regulatory Authority's prudential capital frameworks for insurers and deposit-taking institutions, the latter mandated under the internationally agreed Basel II capital regime. Even so, under APRA's prudential requirements, regulated institutions must still conduct their own credit risk assessments. APRA is participating in the Joint Forum review of credit rating agencies and will consider any changes to the use of ratings in its capital frameworks based on the results of the various international reviews that are occurring. To date, APRA has recognised ratings provided by CRAs that are regulated by the United States Securities and Exchange Commission and APRA has also released guidelines setting out the eligibility criteria by which it would recognise other CRAs for purposes of the ADI capital framework.

Action – ASIC – financial product regulation: ASIC has not relied heavily on recognition of CRAs in its regulatory policy. For example, CRAs' ratings do not form part of any regulatory definitions (e.g. for cash management trusts) and they are not mandatory in a prospectus for debt issues. Nor do they play a role in ASIC's financial requirements policy for AFS licensees. However, there are two areas in which ASIC does acknowledge the role of CRAs:

• Class Order (07/428) Consent to quote: Citing credit ratings, trading data and geological reports in disclosure documents and PDS which gives relief for securities and financial product issuers to cite credit ratings in a fundraising disclosure documents without the consent of ratings agencies; and
• Benchmark 4 in ASIC Regulatory Guide 69 Debentures—improving disclosure for retail investors which outlines ASIC's expectations on issuers having their unlisted debentures rated for credit risk by a recognised credit rating agency.

The fact that ASIC requires an explanation of the rating in both of these cases is recognition of the limitations of the credit rating as a risk tool.

(April Report) III.8 Authorities should examine whether the roles that they have assigned to ratings in regulation and supervisory rules are consistent with the objective of having investors make independent judgment of risks and perform their own due diligence, and do not induce uncritical reliance on credit ratings as a substitute for that independent evaluation.

(October Report) 3.4 Authorities will review their use of ratings in the regulatory and supervisory framework..

Action – APRA – prudential regulation: APRA will review the use of ratings in the regulatory and supervisory framework in light of any recommendation that emerge from international bodies.