It includes new requirements focused on strengthening the integrity of ratings, avoiding conflicts of interest in rating structured credit, and better educating the market about the meaning of ratings and how they are derived.
Michel Prada, chairman of French market regulator AMF, and of Iosco’s technical committee, said the changes would address a number of issues concerning the development and use of ratings that had arisen during the credit crisis. “Iosco’s members expect credit rating agencies to give full effect to the code of conduct,” he added.
Rating agencies “played a critical role in the recent market turmoil”, the organisation’s report said. Some Iosco members, it noted, accuse rating agencies of relying on questionable information when rating structured credit.
“Ratings based on information that fails to pass even a basic ‘sniff test’ – or methodologies that fail to take into consideration market changes that may have an impact on the quality of the information upon which the ratings are based – fundamentally undermine investor confidence in the rating process,” said the report.
Requirements aimed at shoring up the integrity of ratings include urging agencies to ensure that rating actions are objective – by having separate analytical teams dedicated to initial ratings and monitoring, for instance – and that agencies and analysts have sufficient information to properly rate structured credit products. Where assigning ratings for those that have limited historical data upon which to base a rating, the requirements stipulate agencies should make the limitations of the rating clear.
The requirements say agencies should set up a “rigorous and formal review function” to periodically review their methodologies and models – as well as a so-called “new products review” function. This would determine the feasibility of providing ratings for new structures that are materially different from others rated by an agency.
Agencies should also prohibit analysts from making recommendations about the design of credit products that agencies rate – a move prompted by frequently cited concerns over the potential conflicts of interest posed by rating structured credit.
Several other new requirements also look to address the broader issue of conflicts of interest, including one calling for agencies to review the work of analysts who leave them to work for financial firms they have previously dealt with. Others require agencies to review remuneration policies for analysts to ensure they do not compromise the objectivity of their ratings, and disclose where a single issuer, originator, arranger, subscriber or other client makes up more than 10% of its annual revenue.
One concern raised by Iosco’s report is a “failure by some investors to recognise the limitations on rating methodologies for structured finance securities”. Consequently, a number of alterations to its code of conduct give agencies a greater responsibility to educate the market about the meaning of structured credit ratings – including clearly indicating the “attributes and limitations of each credit opinion”. Among other things, the requirements ask agencies to publish historical data about the performance of their ratings, as well as offering more granular information about the methodological basis for them.
The changes also require agencies to differentiate ratings for structured credit from other products such as plain vanilla bonds, preferably using a separate set of symbols - but the major rating agencies say this idea is opposed by their clients and subscribers. A survey concluded by New York-based Moody’s Investors Service earlier this month found that 73% of its respondents, including 73% of buy-side respondents, were hostile to proposals for a new rating scale.
See also: FSF calls for rating agency changes to aid market
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