Study on the feasibility of alternatives to credit ratings : final report.
Date: 2016-04-15
Institutions: Directorate-General for Financial Stability, Financial Services and Capital Markets Union
Subjects: banking policy, claim, credit policy, feasibility study, financial institution, financial market

Study on the Feasibility of 
Alternatives to Credit Ratings
Final Report 

December 2015 

 
 
 
 
 
DISCLAIMER 

The information and views set out in this study are those of the authors and do not 
necessarily reflect the official opinion of the European Commission. The European 
Commission does not guarantee the accuracy of the data included in this study. 
Neither the European Commission nor any person acting on the European 
Commission’s behalf may be held responsible for the use which may be made of the 
information contained therein. 

EUROPEAN COMMISSION 

Directorate-General for Financial Stability, Financial Services and Capital Markets Union 

doi:10.2874/370060 

ISBN: 978-92-79-50590-4 

© European Union, 2015 

Reproduction is authorised provided the source is acknowledged. 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EUROPEAN COMMISSION 

Study on the Feasibility of 
Alternatives to Credit Ratings
Final Report 

December 2015 

EV-04-15-587 EN

 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

Table of Contents 

Abstract .......................................................................................................... 1 
List of acronyms and abbreviations ..................................................................... 2 
Introduction ......................................................................................... 4 
1 

1.1  Research methodology .......................................................................... 5 

1.1.1 
1.1.2 
1.1.3 
1.1.4 

Literature review ............................................................................ 5 
Semi-structured stakeholder interviews ............................................. 6 
Online surveys ............................................................................... 6 
Validation workshop........................................................................ 6 

1.2  Caveats and limitations ......................................................................... 7 
1.3  Structure of the report .......................................................................... 7 

2 

The use of external credit ratings ............................................................ 8 

2.1  Scale of application ............................................................................... 8 
2.2  Regulatory references to external ratings ............................................... 13 

2.2.1 

International and EU efforts to reduce regulatory references to external 

2.2.2 

credit ratings ....................................................................................... 14 
The extent to which financial sector regulation is driving the use of 
external credit ratings ........................................................................... 22 

2.3  The use of external ratings by market participants................................... 28 
2.4  The use of external ratings in financial contracts ..................................... 32 

2.4.1 
2.4.2 

Typology of uses in contracts ......................................................... 32 
Contractual references to ratings ‘potential to trigger sole and 

mechanistic reliance.............................................................................. 34 
Mitigating measures ..................................................................... 35 

2.4.3 

3 

Mapping and feasibility assessment of alternatives to external credit ratings 37 

3.1  Approaches to credit risk assessment .................................................... 37 
Internal credit risk assessment ............................................................. 39 
3.2 

3.2.1 
Strengths .................................................................................... 41 
3.2.2  Weaknesses ................................................................................ 42 

3.3  External measures and ratings.............................................................. 45 

3.3.1 
3.3.2 
3.3.3 

Market implied ratings .................................................................. 45 
Accounting-based measures........................................................... 48 
Third part assessments (non-commercial): OECD Country Risk 

3.3.4 

3.3.5 

Classifications ...................................................................................... 51 
Third party assessments (non-commercial): Scoring / assessment by 
Central Banks ...................................................................................... 53 
Third party assessments (commercial): Automated scorings based on 
computational models ........................................................................... 55 

3.3.6 

Third party assessments (commercial): ratings produced by registered 

and certified credit rating agencies as recognized by ESMA ......................... 56 

3.4  Summary overview table ..................................................................... 61 

4 

The US experience .............................................................................. 65 

4.1  The Dodd-Frank Act ............................................................................ 65 

4.1.1 

The key provision of the Dodd Franck Act related to external credit 
ratings ................................................................................................ 65 

 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

4.1.2 
4.1.3 

Regulatory developments prior to the enactment of the Dodd-Frank Act66 
Implications of the Dodd Frank Act ................................................. 67 

4.2 
Implementation of Article 939A of the Dodd-Frank Act ............................. 69 
4.3  Analysis of the proposed alternatives in the US context ............................ 76 
4.4  The US approach and the international standards .................................... 77 
4.5  Remaining regulatory references to ratings in the US ............................... 77 
4.6  Changes in market practices and impact of the Dodd Frank Act ................. 79 

5 

Main findings and conclusions ............................................................... 80 

 
 
 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

Abstract 

This study maps the various alternatives to external credit ratings that are currently 
being used by market participants across Europe. These include: (i) internal measures 
and ratings where bulk of the analysis is performed in-house by the investor using 
qualitative and qualitative information collected from a variety of sources; (ii) market 
implied ratings e.g. bonds/ equity pricing information, CDS spreads; and (iii) 
accountancy based measures such as profitability and leverage ratios.  Third party 
assessments conducted by non-commercial entities such as the OECD and Central 
Banks are also considered as an alternative to ratings produced by Credit Rating 
Agencies.   

The study then assesses the feasibility of implementing the identified alternatives in a 
European context based on a consideration of criteria such as costs, market 
acceptability, accuracy and reliability, comparability, suitability for regulatory purposes 
etc. while drawing lessons from the US experience of implementing the Dodd-Frank 
Act of 2010 which, inter alia,  requires all relevant US agencies to  remove all 
regulatory references to or requirements of reliance on credit ratings and substituting 
these with alternative standards of creditworthiness. 

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Study on the Feasibility of Alternatives to Credit Ratings 

List of acronyms and abbreviations 

Acronyms  Meaning 

CRR/ CRD IV  Capital Requirements Regulation and Directive 

CCRs 

Central Credit Registers  

CFSDs 

Central Financial Statements Databases 

CCP 

CDS 

CRA 

EBA 

Central CounterParty 

Credit Default Swap 

Credit Rating Agency 

European Banking Authority 

EBITDA 

Earnings Before Interest, Taxes, Depreciation and Amortisation 

EBSCO  

Elton Bryson Stephens Company 

ECAF 

ECAI 

EIB 

Eurosystem Credit Assessment Framework  

External Credit Assessment Institutions 

European Investment Bank 

EIOPA  

European Insurance and Occupational Pensions Authority 

EMIR 

ESA 

ESMA 

ESRB 

European Market Infrastructure Regulation 

European Supervisory Authority 

European Securities and Markets Authority 

European Systemic Risk Board 

Euro PP 

Euro Private Placement 

FCM 

FDIC 

Futures Commission Merchant 

Federal Deposit Insurance Corporation 

FE Rule 

Filing Exempt Rule  

FED  

FHFA 

Federal Reserve System  

Federal Housing Finance Agency  

FIBEN  

Fichier Bancaire des Entreprises 

FSB 

GDP 

IMF 

IORPD 

IOSCO 

IRB  

ISE 

ITS 

MFI 

MMF 

Financial Stability Board 

Gross Domestic Product 

International Monetary Fund 

Institutions for Occupational Retirement Provision Directive 

International Organization of Securities Commissions 

Internal Ratings-Based 

Intermediate-Sized Enterprises 

Implementing Technical Standards  

Monetary Financial Institution 

Money Market Fund 

MMMF 

Money Market Mutual Fund 

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Study on the Feasibility of Alternatives to Credit Ratings 

NAIC 

NCUA 

NPRM 

National Association of Insurance Commissioners  

National Credit Union Administration  

Notice of Proposed Rulemaking  

NRSRO  

National Recognized Statistical Rating Organisation 

OCC 

OECD 

OTC 

Office of the Comptroller of the Currency 

Organisation for Economic Co-operation and Development 

Over The Counter 

OTCD  

Over The Counter Derivative 

RBC 

REIT 

Risk-Based Capital 

Real Estate Investment Trust 

RMBS 

Residential Mortgage-Backed Security 

RTS 

S&P 

SCA 

SEC 

SME 

SVO 

SWOT 

UCITS 

WKSI 

Regulatory Technical Standards 

Standard and Poor's 

Sectoral Competent Authority 

Securities and Exchange Commission  

Small and Medium Enterprise 

Securities Valuation Office 

Strengths, Weaknesses, Opportunities and Threats 

Undertakings for Collective Investment in Transferable Securities 

Well-Known Seasoned Issuer  

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Study on the Feasibility of Alternatives to Credit Ratings 

1 

Introduction 

It is widely acknowledged that external credit ratings enhance capital market 
efficiency and transparency by reducing the information asymmetry between 
borrowers (issuers) and lenders (investors); and, by providing market participants 
with a means of comparing different potential investments and a common standard or 
language to refer to credit risk. Blind faith in external ratings can however, have a 
destabilising effect on financial markets and the wider economy. During the 2009 
global financial crisis and the Euro area sovereign crisis that followed, it became 
apparent that: 

(cid:121)  The growing use of rating references - and specifically ratings produced by the 
‘big three’ Credit Rating Agencies (CRAs) namely, Standard & Poor’s, Moody’s 
and Fitch) - within elements of prudential regulation and financial contracts 
prior to the crisis, has not only created a captive demand for external ratings by 
market participants over time, but has also reduced incentives for market 
participants to develop their own capacity for credit risk assessment, thus 
promoting sole and mechanistic reliance on external ratings.   

(cid:121)  Sole and mechanistic reliance on external ratings can cause herding behaviour 
and “cliff effects”1, thus amplifying pro-cyclicality and resulting in systemic 
disruption to financial systems.  

Since the crisis, there has been a concerted effort at both a global and an EU level to 
(a) eliminate references to external ratings in financial standards, laws and 
regulations; and (b) encourage market participants to establish stronger internal 
credit risk assessment practices as an alternative.  

In the EU, the basic principles to reduce reliance on CRA ratings are set out in the CRA 
Regulation2, which stipulates that: 

(cid:121)  Market participants shall not rely solely and mechanistically on credit ratings, 

but rather conduct their own credit risk assessment (Article 5a); 

(cid:121)  Sectoral competent authorities (SCAs) shall monitor the adequacy of the credit 
risk assessment processes put in place by supervised entities, assess the use of 
contractual references to credit ratings and, where appropriate, encourage 
them to mitigate the impact of such references (Article 5a);  

(cid:121)  The European supervisory authorities shall not refer to credit ratings in their 
guidelines, recommendations and draft technical standards where such 
references have the potential to trigger sole or mechanistic reliance on credit 
ratings by the competent authorities, the sectoral competent authorities and 
market participants (Article 5b); 

(cid:121)  The European Systemic Risk Board (ESRB) shall not refer to credit ratings in its 
warnings and recommendations where such references have the potential to 
trigger sole or mechanistic reliance on credit ratings (Article 5b); 

(cid:121)  The Commission shall continue to review whether references to credit ratings in 
EU law trigger or have the potential to trigger sole or mechanistic reliance on 
credit ratings, with a view to deleting all such references by 1 January 2020, 
provided that appropriate alternatives to credit risk assessment can be 
identified and implemented (Article 5c). 

This report contributes to the above policy and regulatory objectives by: 

1 abrupt sell-offs of securities when ratings are downgraded 
2  Regulation  (EU)  No  462/2013  of  the  European  Parliament  and  of  the  Council  of  21 
May 2013 amending Regulation (EC) No 1060/2009 on credit rating agencies  

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

a)  Identifying and mapping the various alternatives to external credit ratings 

that are currently being used by market participants across Europe; 

b)  Drawing lessons from the US experience of implementing the Dodd-Frank 
Act of 2010 which, inter alia,  requires all relevant US agencies to  remove 
all regulatory references to or requirements of reliance on credit ratings and 
substituting these with alternative standards of creditworthiness; 

c)  Assessing the feasibility of implementing the identified alternatives in a 

European context (while taking account of the US experience); 

d)  Describing the implementation of Article 5a(2) of the CRA III Regulation by 

competent national authorities in select EU Member States; and 

e)  Identifying measures for mitigating the potential negative effects of 

contractual references to ratings. 

The research was undertaken by ICF Consulting Services in association with Professor 
Lawrence J. White (Stern School of Business New York University), Professor John 
Ryan (University of Cambridge) and Pedro Maia Gomes (Assistant Professor at the 
Department of Economics at Universidad Carlos III de Madrid).  The remainder of this 
section describes the research that was carried out, the limitations of the study and 
the structure of this report.  

1.1  Research methodology 

This study is based on data collected from a variety of sources: literature review, 
stakeholder consultations and surveys, expert inputs and a validation workshop.  

Figure 1.  Research methods used for this study 

Each of these methods is described below. 

1.1.1  Literature review 

A literature review was undertaken in the early stages of the study to take stock of 
existing information on: 

(cid:121)  The scale and scope of application of external credit ratings by regulators and 

market participants; 

(cid:121)  Evidence of sole and mechanistic reliance on credit ratings; 

(cid:121)  Alternatives to external credit ratings. 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

The literature review covered all major academic research as well as grey literature on 
the above topics, including: 

(cid:121)  Reports published by International organisations such as the Financial Stability 

Board (FSB), the Basel Committee on Banking Supervision and the 
International Organiszation of Securities Commissions (IOSCO); 

(cid:121)  Relevant reports published by European institutions and bodies like the 
European Commission, the European Banking Authority (EBA) and the 
European Securities and Markets Authority (ESMA); and 

(cid:121)  News articles, blogs etc. 

Annex 1 provides a list of references used in this study.  

1.1.2  Semi-structured stakeholder interviews 

Semi-structured interviews were conducted with a range of stakeholders including: 

(cid:121)  Regulators and Sectoral Competent Authorities (SCAs); 

(cid:121)  Market participants such as banks, asset management companies, investment 
and pension funds, Central Counterparties (CCPs), insurance/ re-insurance 
companies, representatives of corporate issuers etc. 

Overall 114 individuals, representing 73 discrete organisations (including 8 US based 
organisations) were interviewed during the course of the study. 

A list of organisations consulted and the topics explored with each stakeholder group 
can be found in Annexes 2 and 3 respectively.  

1.1.3  Online surveys 

Four online surveys were designed to collect inputs from the following stakeholder 
groups: (i) Sectoral Competent Authorities; (ii) Credit rating agencies; (iii) National 
central banks; (iv) National treasuries. The surveys were designed and implemented 
by ICF, but promoted by DG FISMA. 

Table 1 shows the number of responses received for each survey. Unfortunately, not a 
single national central bank responded to our online survey. As we did not have the 
contact details of survey participants, it was not possible to follow-up directly with 
non-respondents in order to boost response. 

Table 1.  Survey responses 

Number of responses received 

Sectoral Competent Authorities (SCAs) 

Credit rating agencies 

National central banks  

National treasuries 

29 

8 

0 

14 

1.1.4  Validation workshop 

A validation workshop was organised on 30 October 2015 in Brussels to test the 
preliminary findings of the study and to explore some issues in further detail. 
Workshop participants included representatives of regulatory bodies, European 
Commission officials, academics and a range of market participants. A list of 
participants and workshop notes can be found in Annex 4. 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

1.2  Caveats and limitations 

The substantial issue of resource constraints needs to be noted as it impacted upon 
the depth and breadth of the research that could be undertaken by us. The study ToR 
raised a number of ‘big issues’ with a limited budget and a tight timetable (6 months). 
This inevitably imposed certain limitations which need to be explicitly acknowledged: 

(cid:121)  The study is based on qualitative research methods and purposively drawn 
samples. It explores the use of external credit ratings and alternatives by 
various market participants as well as the strengths and weaknesses of the 
different approaches from their perspectives.  It presents the full spectrum of 
opinions expressed by stakeholders, but does not seek to draw generalisations. 
Nor does it attempt to quantify the scale of application of alternatives. 

(cid:121)  The US case study is based on a limited number of interviews and desk 

research. As such it provides an overview rather than a comprehensive account 
of how the Dodd Frank Act is being implemented in the US.  

1.3  Structure of the report 

The remainder of this document is structured as follows: 

(cid:121)  Section 2 describes the use of credit ratings by regulators and market 

participants; 

(cid:121)  Section 3 provides a mapping and feasibility assessment of the various 

approaches to credit risk assessment; 

(cid:121)  Section 4 presents the first results from the US experience; 

(cid:121)  Section 5 presents the main conclusions of the study. 

A separate document contains the following annexes: 

(cid:121)  Annex 1: List of references; 

(cid:121)  Annex 2: List of interviewees; 

(cid:121)  Annex 3: Final set of research tools (topic guides and survey questionnaires); 

(cid:121)  Annex 4: Workshop notes; 

(cid:121)  Annex 5: Additional research findings; 

(cid:121)  Annex 6: Implementation of the Dodd Frank Act in the US  Financial sector 

regulatory framework 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

2 

The use of external credit ratings  

The use of external ratings by investors and other market participants has grown 
significantly over time, driven by an expansion in the number and types of issuers 
accessing capital markets, international diversification of investors’ portfolios, and the 
advent of new and complex financial products such as asset-backed securities and 
credit derivatives.  Moreover, the extensive use of external ratings in financial sector 
regulation (e.g. tying disclosure requirements, legal investment standards, or capital 
requirements to external ratings) and private financial contracts (e.g. setting of 
minimum rating requirements in investment mandates, the use of rating triggers in 
loan and bond covenants etc.) has further enhanced their significance in the 
marketplace. This section describes the scale and scope of application of external 
ratings by regulators and market participants in the European context. 

2.1  Scale of application 

External credit ratings originated in the US in 1909 for railroad bonds. Since then, the 
application of external credit ratings has expanded from corporate bonds to a range of 
instruments including loans, commercial paper, bank deposits and structured finance 
products. Moreover, different types of ratings have developed over time: 

(cid:131) 

Issuer ratings e.g.  non-financial corporates, financial corporates such as banks 
and insurance companies, sovereign, special purpose vehicles (for structured 
finance products), sub-sovereign entities such as municipalities etc. 

(cid:131)  Ratings of specific issues - each specific bond issue or loan from the same 

entity is separately rated in case of corporate debt; 

(cid:131)  Target market of the issue – there are separate ratings for debt being raised on 

domestic markets and that being raised internationally; 

(cid:131)  Short term and long-term credit rating. 

One of the main reasons behind this expansion in the scope and scale of application of 
external credit ratings is that capital markets are playing an increasing role in 
financing governments and businesses –a trend that is likely to continue for years to 
come as banks are subject to higher capital requirements and other restrictions.  

The European bond market has more than doubled in size since 2002. As of December 
2014, the total outstanding amount of debt securities3 in the EU stood at €22.9 trillion 
or almost twice the EU’s GDP.  Figure 2 illustrates the size, growth, and make-up of 
the European bond market.  Two groups of debtors account for the vast majority of 
the outstanding stock of debt securities: financial institutions (48 per cent4) and the 
public sector (44 percent5), although the total volume of MFI corporate bonds 
outstanding has  been declining in both absolute and relative terms since 2012 due to 
deleveraging in the financial sector. 

3 Excluding shares and financial derivatives 
4  Monetary  Financial  Institutions  (MFI)  =  28  per  cent  (€6.5  trillion)  and    Non-MFI 
financial institutions =  20 per cent (€4.5 trillion)  in 2014 
5 Central and state governments = € 9.6 trillion (42 percent) and local governments=  
€ 0.5 trillion (2 percent) in 2014 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

Figure 2.  Outstanding debt securities in the EU 28,  2002 to 2014 [in trillion EUR, 

nominal values] 

Source: European Central Bank 

Figure 3.  Outstanding debt securities in the EU 28 broken down by issuer  

Source: European Central Bank 

The non-financial corporate bonds market on the other hand, has grown steadily 
during the post-crisis period, reaching €1.7 trillion in 2014.  Corporations are 
increasingly turning to debt capital markets due to growing investor appetite for 
corporate debt (driven by a search for better yields in a low return environment) and 
reduced availability of bank lending in some countries (a consequence of the financial 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

crisis and more stringent regulatory requirements)6. According to an article in the 
Financial Times, a growing number of unrated European companies have been tapping 
capital markets in recent years. On average, unrated issuance accounted for a tenth of 
overall European corporate bonds issuance during the period 2010 to 2013, with much 
of the volume driven by first-time issuers, typically small and medium-sized 
enterprises.7  

The economic recession has also seen a strong increase in the volume of central 
government bonds outstanding. As of end 2014, EU-28 sovereign securities, including 
both short-term (with maturity equal to or less than a year) and long-term securities 
amounted to an aggregate value of €9.6 trillion outstanding.  As indicated in Figure 3 
all EU-28 Member States are externally rated. In the past, governments tended to 
seek ratings on their foreign currency obligations exclusively, because foreign currency 
bonds were more likely than domestic currency offerings to be placed with 
international investors. In recent years, however, international investors have 
increased their demand for bonds issued in currencies other than traditional global 
currencies, leading more sovereigns to obtain domestic currency bond ratings as well. 
Sovereign ratings are important not only because central governments represent the 
largest group of borrowers in capital markets in terms of volume, but also because 
these ratings have a cascading effect i.e. sovereign ratings affect the ratings assigned 
to borrowers domiciled in the same country.  

Table 2.  Sovereign ratings coverage of EU Member States 

EU Member 

Capital 

DBRS 

EIU

Feri 

Fitch 

Moody’s 

S&P 

Intelligence 

AUSTRIA 

BELGIUM 

BULGARIA 

CROATIA 

CYPRUS 

S 

CZECH 
REPUBLIC 

DENMARK 

ESTONIA 

FINLAND 

FRANCE 

GERMANY 

GREECE 

HUNGARY 

IRELAND 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U

U 

S 

S 

S 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U

U 

U 

U 

U 

U 

U 

S 

S 

S 

S 

S 

S 

S 

S

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

U

U

U

S

S

S

S

S

S

S

S

S

S

S

U 

U 

6 DB Research (2013) Corporate bond issuance in Europe: Where do we stand and where are we 
heading? 
7  Thompson,  C.  (2011)  Unrated  bond  issues  double  in  Europe,  The  Financial  Times,  1  August 
2013 

December 2015 

10

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                          
Study on the Feasibility of Alternatives to Credit Ratings 

EU Member 

Capital 

DBRS 

EIU

Feri 

Fitch 

Moody’s 

S&P 

Intelligence 

ITALY 

LATVIA 

LITHUANIA 

LUXEMBOURG 

MALTA 

NETHERLANDS   

POLAND 

PORTUGAL 

ROMANIA 

SLOVAKIA 

SLOVENIA 

S 

SPAIN 

SWEDEN 

UNITED 

U 

U 

U 

U

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U 

U

U 

U 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

S 

U 

U 

U 

U 

U 

U 

U 

U

U 

U

S

S

S

S

S

S

S

S

S

S

S

U 

U

U= unsolicited; S = solicited 

Source: ESMA (2014) Technical Advice in accordance with Article 39(b) 2 of the CRA Regulation 
regarding the appropriateness of the development of a European creditworthiness assessment 
for sovereign debt,17 September 2014| ESMA/2014/850rev.  

As regards sub-sovereign debt8 raised on capital markets, there are big differences 
across Europe.  While the Länder and local authorities in Germany raise almost half 
(47 per cent) of their debt via the capital market, the share of sub-sovereign debt that 
is bond financed is only 6 per cent in France and 5 per cent in the UK. Bond financing 
of sub-sovereign debt is however, gradually gaining importance in the EU. Some 
Member States such as France and the United Kingdom have recently set up municipal 
financing agencies to diversify the funding requirements of local units. 

8 Borrowings of regional and local public authorities 

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Study on the Feasibility of Alternatives to Credit Ratings 

Figure 4.  The role of bonds as regional and local debt instruments in Europe 

Source: Deutsche Bank Research (2014) Small is beautiful? Capital market funding for sub-
sovereign authorities on the rise 

For the time being, the market for sub-sovereign bonds in Europe is dominated by 
Germany's subordinate levels of government, which alone constitute 72 per cent of 
the total volume. The lion's share of this is accounted for by the Länder, which benefit 
from Germany's excellent sovereign rating. While the Länder ratings are the same or 
only slightly lower than the AAA sovereign rating for Germany, the ratings for the 
regions in Italy and Spain vary by up to five notches. Atypically, a few regions with 
particularly low levels of debt currently have even better ratings than the central 
government. For example, some agencies have higher ratings for the Basque Country 
and Navarre than for Spain. Both regions have per-capita income that is well above 
average, relatively low debt and limited autonomy in setting taxes. For Italy, Moody’s 
ratings of the autonomous provinces of Bolzano and Trento are two notches higher 
than for the central government, while for Lombardy the rating is one notch higher. 
Bolzano and Trento enjoy a special status with greater financial and legislative 
autonomy, they have an extraordinarily strong fiscal position and low levels of debt9. 

Structured finance products represent another big asset class where external credit 
ratings play an important role. The outstanding amount of structured finance products 
in the EU is currently about €1.4 trillion. Since its peak in 2009, there has been a 
constant decline in the outstanding stock of structured finance as well as the volume 
of new issuance (see Figure 4).  Generally speaking, European banks are far less 
inclined to use securitisation nowadays, as compared to the pre-crisis period. Prior to 
the crisis, all primary issuances were placed with end-investors and banks; nowadays, 
almost all deals are retained by the originating banks and many are placed as 
collateral with central banks.   

9 Deutsche Bank Research (2014) Small is beautiful? Capital market funding for sub-sovereign 
authorities on the rise 

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Study on the Feasibility of Alternatives to Credit Ratings 

Figure 5.  Outstanding amounts and new issuance of structured finance products in 

the EU [in trillion EUR, nominal values]   

Source: AFME Securitization Data Reports 

Structured financial products are designed to take advantage of different investor risk 
preferences and investment time horizons. Ratings therefore, play an important role in 
the structuring of these transactions. Moreover, as with corporate debt securities, 
many investors require that a structured finance debt security be rated by a CRA 
before they will purchase it. Not all structured finance products are however, rated by 
CRAs. Indeed, for many particularly complicated or risky CDOs, credit ratings are 
unusual. Further, some issuers create structured products specifically for a particular 
investor that does not require a credit rating because it relies solely on internal 
analytics to assess the credit risk of the security10. 

In 2014, 55 per cent of European issued structured products had AAA rating followed 
by 6 per cent with AA, 21 per cent with A and 6 per cent with BBB or below. Only 
around 13 per cent of the value of European issuance in 2014 was not rated11.  

2.2  Regulatory references to external ratings 

The first regulatory reference to the ratings can be traced back to the early 1930s, 
when US federal bank regulators started introducing the use of ratings for accounting 
practices of commercial banks. Bonds that commercial banks had purchased and were 
holding in their portfolios had to be marked to market (i.e., valued at market prices) if 
the bonds were rated as “speculative”; but the bonds could be valued at their original 
purchase cost if the bonds were rated as “investment grade”. In 1936, federal bank 
regulators went further, mandating that commercial banks could invest only in 
“investment grade” bonds as determined by “recognised rating manuals.”12 During the 
following decades, regulators in the US as well as in other countries around the world 
started incorporating external ratings into laws and regulations to set capital 
requirements for regulated entities, provide a disclosure framework, and restrict 

10 IOSCO (2008) The Role of Credit Rating Agencies in Structured Finance Markets, Final Report, 
May 2008 
11 AFME, 2015. Securitisation Data Reports. Available at: 
http://www.afme.eu/Documents/Statistics-and-Reports.aspx  
12 White, L (2011) An Assessment of the Credit Rating Agencies: Background, Analysis, and 
Policy 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

investments. Box 1 provides an overview of the main uses of external ratings within 
financial sector regulatory frameworks. 

Box 1: Regulatory uses of external ratings 

(1) Calculation of Regulatory Capital Requirement. 

(2) Classifying the riskiness and concentration level of assets for regulated institutional 
investors, such as pension funds and life insurance companies. 

(3) Assessing the credit risk of securitised instruments based on the underlying riskiness of their 
assets. 

(4) Assessing the credit risk of issuers of listed securities as part of overall capital market 
disclosures requirements. 

(5) Determining eligibility of a prospectus for public offering 

Source: Joint Committee Final Report on mechanistic references to credit ratings in ESA’s 
guidelines and recommendations  

Since the financial crisis, regulators have taken several steps to eliminate the 
mandatory use of ratings in financial sector regulations. These are summarised below. 

2.2.1  International and EU efforts to reduce regulatory references to external 

credit ratings 

The figure below provides a snapshot of coordinated efforts being made at an 
international level to reduce regulatory references to ratings. 

Figure 6.  Timeline of coordinated international efforts coordinated on reducing 

regulatory references to ratings 

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14

 
 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

As regards specific steps taken by individual jurisdictions, the United States (U.S.) has 
made the most significant changes in its regulatory framework. In 2010, the Dodd 
Frank Act was passed, which requires all U.S. agencies to remove references to 
external credit ratings in their legislation. The U.S. experience of implementing the 
Dodd Frank Act is further examined in section 5.  

The EU’s policy response, on the other hand, has been much more measured. The 
general conceptual framework to reducing reliance on CRA ratings in the EU is based 
on a multi-layer approach13 which is illustrated in Figure 7 and described in the sub-
sections that follow. 

Figure 7.  The EU’s conceptual framework for reducing reliance on CRA ratings  

Source: The EU Action Plan to reduce reliance on CRA ratings 

2.2.1.1  The CRA Regulation 

The first layer consists of the CRA III Regulation14 (Regulation 462/2013), which sets 
out the basic principles for reducing reliance on CRA ratings. It came into force in 
2013 and amends earlier versions of 2009 (Regulation 1060/2009) and 2011 
(Regulation 513/2011). 

Its Article 5a notably requires financial institutions “to make their own credit risk 
assessment and not solely and mechanistically rely on credit ratings for assessing the 
creditworthiness of an entity or financial instrument.” 

In the CRA III Regulation, reducing sole or mechanistic reliance on credit ratings is 
seen as a long term and gradual process. Article 5c of the CRA III Regulation invites 
the Commission to continue reviewing the use of references to external credit ratings 
in Union law that trigger or have the potential to trigger sole or mechanistic reliance. 
It also foresees that provided that appropriate alternatives to credit risk assessment 
are identified and implemented, the Commission will consider, if appropriate, 
removing all remaining  

13 EU Action Plan to reduce reliance on CRA ratings. Available at: 
http://ec.europa.eu/finance/rating-agencies/docs/140512-fsb-eu-response_en.pdf 
14 REGULATION (EU) No 462/2013 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 21 
May 2013 amending Regulation (EC) No 1060/2009 on credit rating agencies 

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The CRA III Regulation also triggers action at the other levels such as the national 
sectoral competent authorities.  

2.2.1.2  Changes to EU level sectoral legislation 

The second layer involves changes to EU sectoral legislation. This legislation covers 
the following sectors: 

(cid:121) 

(cid:121) 

(cid:121) 

the asset management sector;  

the banking sector;  

the insurance sector; and 

(cid:121)  central counterparties. 

The table below provides an overview of the main regulatory provisions by sector. It 
can be seen from the table that references to ratings within EU sectoral legislation still 
remain (e.g. CRR and Solvency II Directives), although measures have been 
introduced to reduce sole and mechanistic reliance on ratings. 

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Study on the Feasibility of Alternatives to Credit Ratings 

Table 3.  References to external ratings in EU sectoral legislation 

Sector 

Reference text 

Main references to ratings 

Banking 

The Capital Requirements 
Directive (CRD IV) 

The  Capital Requirements 
Regulation (CRR) 

NB:  CRD IV/CRR entered into 
force on 1 January 2014. 

In the banking sector, there is a risk-based 
approach to calculating capital 
requirements. Capital requirements can be 
calculated in two ways (see Article 107 of 
the CRR): using the standardised approach 
(SA) (see Chapter 2 on the Standardised 
Approach in the CRR) or using an internal 
model approved by the relevant supervisor 
(see Article 143 of the CRR) 

Provisions mitigating risks of sole and 
mechanistic reliance 

Mitigation measures include 

(cid:121)  CRR/CRD IV encourage “sophisticated” 
credit institutions (i.e. institutions 
significant in terms of their size, internal 
organisation and the nature, scale and 
complexity of their activities) to have 
their own procedures for credit risk 
assessment. (Article 77 (1) of the CRD 
IV) 

CRR/CRD IV still refer to a large extent on 
external ratings under the SA to determine 
credit risk, counterparty credit risk, market 
risk, and for large exposures (see section 2 
on risk weights of the Chapter 2 on the 
Standardised Approach in the CRR). 

(cid:121) 

 CRR/CRD IV  require competent 
authorities to ensure that institutions do 
not rely solely and mechanistically on 
external credit ratings for the purpose of 
calculating regulatory capital 
requirements (Article 77 (2) of the CRD 
IV) 

With regard to securitisation exposures, the 
EU recalls the lack of sufficiently objective 
internal methodologies within banks and 
refers to the work of Basel Committee on 
Banking Supervision (BCBS) for future 
developments in this specific area (see 
page 9 of the EU Action Plan). 

Insurance 

Solvency II (Directive 
2009/138/EC) - as amended 
by Directive 2014/51/EU 

NB: Solvency I did not contain references 
to ratings.  

The upcoming Solvency II moves to a risk-

Solvency II contains provisions specifying 
that sole and mechanistic reliance is 
forbidden. 

December 2015 

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Sector 

Reference text 

Main references to ratings 

Provisions mitigating risks of sole and 
mechanistic reliance 

('Omnibus II') 

NB: the new Solvency II 
Directive will be applicable 
from 1 January 2016. 

Commission Delegated 
Regulation (EU) 2015/35 of 10 
October 2014 supplementing 
the Solvency II 

based approach to calculate capital 
requirements. Similar to the approach 
adopted in the banking sector, the capital 
requirements can be calculated in two 
ways: using a standard formula or, subject 
to supervisory approval, using a full or 
partial internal model (see Article 100 of 
the Solvency II Directive).  

Insurers have to use additional assessments 
whenever practically possible, and 
necessarily for large and complex exposures 
(internal ratings cannot however overrule 
external ratings for those under the 
standard formula) (Article 4 of the delegated 
act) 

Under the standard formula, capital 
requirements, in all different modules 
(market risk, spread risk, concentration 
risk), are derived from external ratings (see 
Article 4 of the Commission Delegated 
Regulation). They are also used to assess 
counterparty risk. 

Solvency II introduces the Credit Quality 
Step terminology: it does not refer directly 
to external ratings but to Credit Quality 
Steps (against which the external ratings 
are mapped) (Article 109a of the Solvency II 
directive). 

There are mixed views on whether Solvency 
II has the potential to trigger sole and 
mechanistic reliance, despite the safeguards 
which have been introduced – see section 
2.2.2.2. 

Asset 
management 

Directive 2013/14/EU 
amending 

(cid:121) 

 Directive 2003/41/EC 
regarding Institutions for 
Occupational Retirement 

The relevant EU level legislation in the 
investment fund management sector does 
not contain references to external credit 
ratings. 

The main focus of the amendments passed 
in 2013 is to call on SCAs to better monitor, 
and where necessary, minimise the use of 
external ratings. Relevant actors are 
expected to strengthen their own credit risks 
assessments (see Articles 1, 2 and 3 of the 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

Sector 

Reference text 

Main references to ratings 

Provision (IORPD)  

(cid:121) 

 Directive 2009/65/EC 
regarding undertakings for 
collective investments 
(UCITS)  

(cid:121)  Directive 2011/61/EU on 
alternative investment 
funds managers (AIFMD) 

Provisions mitigating risks of sole and 
mechanistic reliance 

Directive). 

In practice, the 2013 directive implies that 
the risk should be assessed against reliable 
and updated information, both quantitative 
and qualitative. 

Where no internal credit assessment is 
carried out, companies are still expected to 
check the consistency of external ratings 
with business indicators and market data. 

CCP 

European Markets 
Infrastructure Regulation 
(EMIR) No 648/2012 

EMIR does not contain any references to 
external credit ratings.  

NB: for OTC derivative contracts not 
cleared through a CCP 

EMIR requires CCPs to “employ a defined 
and objective methodology” and not to “fully 
rely” on external opinions (see Articles 41, 
42, 44, 45, Annex I and Annex II) 

The draft Regulatory Technical Standard 
(RTS)[1] outlining the framework of EMIR he
RTS allows the use of internal-ratings-
based (IRB) approaches to credit 
institutions authorised under the CRR.  In 
the absence of an approved IRB for the 
collateral or if the two counterparties do not 
agree on the use of the IRB approach 
developed by one counterparty, the two 
counterparties can define a list of eligible 
collateral relying on the external credit 

[1]Second  consultation  paper  -  draft  Regulatory  Technical  Standards  (RTS)  on  risk  mitigation  techniques  for  OTC  derivatives  not  cleared  by  a 
central  counterparty  (CCP),  10  June  2015.  Available  at:  https://www.eba.europa.eu/-/esas-consult-on-margin-requirements-for-non-centrally-
cleared-derivatives   

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

Sector 

Reference text 

Main references to ratings 

Provisions mitigating risks of sole and 
mechanistic reliance 

assessments of recognised external credit 
assessment institutions (ECAIs). The 
minimum Credit Quality Step (CQS) is set 
to two for most collateral types. The use of 
the CQS must be consistent with the 
Implementing Technical Standards (ITS) on 
the mapping of the credit assessments to 
risk weights.  

The current draft RTS allows the use of 
either internal models for the calculation of 
haircuts or the use of standardised 
haircuts. 

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Study on the Feasibility of Alternatives to Credit Ratings 

2.2.1.3  Changes to European Supervisory Authorities’ guidelines 

Article 5b of CRA III provides that the European Supervisory Authorities (ESAs) “shall 
not refer to credit ratings in their guidelines, recommendations and draft technical 
standards where such references have the potential to trigger sole or mechanistic 
reliance on credit ratings by the competent authorities, the sectoral competent 
authorities, the entities referred to in the first subparagraph of Article 4(1) or other 
financial market participants”.  

Accordingly, the ESAs reviewed and removed all references to external credit ratings 
in existing guidelines and recommendations that had the potential to promote sole and 
mechanistic reliance on external ratings. To achieve this aim, the ESAs launched a 
Consultation Paper15 which set-out the joint view of the three ESAs on revision and 
removal of rating references and sought to gather external views on foreseen 
modifications. The purpose of the exercise was also to agree upon a definition of “sole 
or mechanistic reliance” mentioned in Art 5b.  

The output of the exercise is the Final Report on Mechanistic references to credit 
ratings in the ESAs’ guidelines and recommendations, published in February 201416. 
The report summarises stakeholder response to the above consultation. It presents 
the following agreed definition of “sole or mechanistic reliance”: “It is considered that 
there is sole or mechanistic reliance on credit ratings (or credit rating outlooks) when 
an action or omission is the consequence of any type of rule based on credit ratings 
(or credit rating outlooks) without any discretion”. The report clarifies that the 
adoption of this formal definition is fully in line with the understanding shared by the 
European Parliament, the Council, and the Commission during the negotiations on the 
CRA III Regulation.  

In addition, the report identifies provisions containing references to ratings that should 
not be viewed as “sole or mechanistic” as well as a set of provisions that would require 
revision. The following guidelines and recommendations (currently in force) were 
found to contain references to ratings which can be regarded as promoting sole or 
mechanistic reliance:  

(cid:121)  The guidelines detailing how CRR/CRD IV should be implemented17. However, 

as mentioned above, the report does not propose any action and call for change 
with regards to mechanistic reliance on external ratings in the standardised 
approach. It nevertheless states that the risk of sole and mechanistic reliance 
on external ratings is minimised by the fact that exposure classes where 
external ratings may be used are precisely the exposures for which external 
ratings are not commonly available (e.g. corporate exposures related to smaller 
and medium-sized companies are typically unrated) and/or for which the 
CRR/CRD IV dis-incentivises the use external ratings.  

(cid:121)  The MMF Guidelines18. The report emphasise the risks of mechanistic reliance 
on external ratings in the current investment guidelines such as cliff effects. 

15 EBA, EIOPA and ESMA (2013) Joint Consultation Paper on Mechanistic references to credit 
ratings in the ESAs’ guidelines and recommendations (JC CP 2013 02). Available at: 
http://www.esma.europa.eu/system/files/jc-cp-2013-
02_mechanistic_references_to_credit_ratings.pdf 

16 EBA, EIOPA and ESMA (2014) Final Report on Mechanistic references to credit ratings in the 
ESAs’ guidelines and recommendations (JC 2014 004) 

17 CEBS (2010) Revised Guidelines on the recognition of External Credit Assessment 
Institutions. Available at: http://www.eba.europa.eu/documents/10180/16094/Revised-
Guidelines.pdf 

18 http://www.esma.europa.eu/bg/system/files/10-
049_cesr_guidelines_mmfs_with_disclaimer.pdf  

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Considering that the EU money market funds industry has about €1 trillion in 
assets under management, the impacts of such an event could be very 
detrimental. The ESAs proposed to keep a reference to external ratings, but 
instead suggested removing the reference to a certain threshold below which 
money market instruments are automatically excluded from the investment 
universe. The current version of the guidelines available online includes the 
proposed changes in track changes for information, even if the modifications 
have not yet formally been adopted. 

Finally, the report also highlights the possible detrimental effects of the upcoming 
Solvency II regulation in the insurance sector (discussed further in section 2.2.2.2). 

2.2.1.4  National sectoral competent authorities 

The last layer of the EU’s policy response refers to the implementation of sectoral 
legislation at the national level. Article 5a (2) of the CRA III requires national sectoral 
competent authorities to monitor the adequacy of the credit risk assessment processes 
of financial institutions, taking into account the nature, scale and complexity of their 
activities. In addition, sectoral authorities are also invited to assess the use of 
contractual references to credit ratings and, where appropriate, encourage them to 
mitigate the impact of such references, with a view to reducing sole and mechanistic 
reliance on credit ratings, in line with specific sectoral legislation. 

2.2.2  The extent to which financial sector regulation is driving the use of 

external credit ratings  

Despite the developments noted above, research carried out in the context of this 
study confirms that regulation remains a key driver behind the use of external ratings 
by market participants in following sectors: (i) banking (ii) insurance and (iii) asset 
management. Table 4 provides a high level summary of the research findings, while 
the sub-sections that follow elaborate these findings in further detail.   

Table 4.  Drivers of the use of external ratings by market participants  

Type of 
Regulation 

Credit 
Institutions/ 
Banks 

Insurance/ Re-
insurance 
companies  

Asset Managers 

Other 
Institutional 
Investors e.g. 
pension funds 

Sectoral 
regulation, 
guidelines or 
standards 

High           
(determining capital 
and liquidity 
requirements) 

High* 

(determining capital 
requirements) 

Low** 

Medium*** 

Regulation 
from other 
sectors 

Low 

Low 

(To a minor extent)

(To a minor extent)

High 

(Regulation 
applicable to 
investors) 

N/A 

* Under Solvency I, insurance companies in many countries had investment limits for specific 
asset classes defined in terms of ratings. This reference to ratings will disappear in 2016 when 
Solvency II will be applied. 

**Within the MMF Guidelines there is no longer a threshold below which money market 
instruments are automatically excluded from the investment universe but references to external 
ratings remain, whereby “a downgrade below the two highest short-term credit ratings by any 
agency registered and supervised by ESMA that has rated the instrument should lead the 

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Study on the Feasibility of Alternatives to Credit Ratings 

manager to undertake a new assessment of the credit quality of the money market instrument 
to ensure it continues to be of high quality”.19 

* In some countries, there are regulatory provisions stipulating minimum rating requirements or 
investment limits (defined with reference to external ratings) for pension funds – CRA III had 
the ambition to reduce overreliance in the pension fund sector. 

2.2.2.1  Banking  

Key messages: 

(cid:121)  CRR/CRD IV still rely to a large extent on external ratings under the 

standardised approaches to determine credit risk, counterparty credit 
risk,  market risk, and for large exposures 

(cid:121)  Liquidity provisions within the EU regulatory framework also rely to some 

extent on external ratings 

(cid:121)  In the Basel III securitisation framework, an Internal Ratings-Based 
Approach comes first in the hierarchy of approaches to credit risk 
assessment, but the complexity of securitisation transactions and data 
availability issues might act as a practical constraint 

The use of CRA ratings in the banking sector is based on international standards set 
by the Basel Committee on Banking Supervision (BCBS). The Basel III framework is 
implemented within the EU via the Capital Requirements Directive IV (CRD IV). 

Mirroring the Basel III framework, CRD IV still relies to a large extent on external 
ratings under the standardised approach (as indicated in Table 3). As part of the 
international efforts to reduce overreliance on ratings, the Basel Committee on 
Banking Supervision (BCBS) has set up a Task Force on Standardised Approaches. 
One of its objectives is to reduce sole and mechanistic reliance on external ratings. A 
public consultation was launched at the end of 201420. Comments on the proposal 
were open until March 2015. As outlined in the consultative document, the BCBS 
envisages replacing references to external ratings, as used in the current standardised 
approach, with a limited number of risk drivers that provide a meaningful 
differentiation for risk. Thus, for instance, bank or corporate exposures would no 
longer be risk-weighted by reference to the external credit rating of the issuer, but 
rather on the bank's capital adequacy and its asset quality or the firm's revenue and 
leverage, respectively. 

The alternatives proposed by the BCBS task force were however, seen by some 
stakeholders as too simplistic and the complete removal of references to ratings was 
considered as unnecessary and undesirable. The Committee therefore, reintroduced 
the use of ratings, in a non-mechanistic manner, for exposures to banks and 
corporates in its second consultative document21. The revised proposal also includes 
alternative approaches for jurisdictions that do not allow the use of external ratings for 
regulatory purposes. 

19 http://www.esma.europa.eu/bg/system/files/10-
049_cesr_guidelines_mmfs_with_disclaimer.pdf  
20 BCBS (2014), Consultative Document - Standards Revisions to the Standardised Approach 
provides for credit risk. Available at: http://www.bis.org/bcbs/publ/d307.pdf 
21 BCBS (2015) Revisions to the Standardised Approach for credit risk – second 
consultative document, December 2015. Available at: 
http://www.bis.org/bcbs/publ/d347.htm 

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The BCBS also finalised its revisions to the securitisation framework in December 
201422. This framework will come into force in January 2018. It, inter alia, seeks to 
reduce mechanistic reliance on external ratings. Securitisation is indeed one of the 
areas where the most extensive use of CRA ratings is made23. The revision of the 
securitisation framework builds on two public consultations carried out in the years 
2012-2014 and two quantitative impact studies.  

The revised securitisation framework introduces a revised hierarchy of approaches to 
assess the risks of securitised products: Internal Ratings-Based Approach is now 
presented as the best option, provided that banks have the capacity and supervisory 
approval to use internal models. External Ratings-Based Approach and the 
standardised approach come next. 

One large bank interviewed in the context of this study however, mentioned that the 
use Internal Ratings-Based Approach was feasible only for those transactions which 
are originated by the bank itself.  

2.2.2.2  Insurance 

Key messages: 

(cid:121)  Ambiguous impact of the upcoming Solvency II regulation 

(cid:121)  On the positive side: 

-  Provisions prohibiting sole and mechanistic reliance on external 

ratings 

-  Use of credit quality step terminology 

(cid:121)  On the negative side: 

-  Reliance on external credit ratings under the standard formula 

-  Pro-cyclical capital charges increasing exponentially for lower rated 
assets, giving incentives to insurers to closely follow ratings and 
promptly divest downgraded assets 

The insurance sector is currently transitioning to Solvency II, which come into force 
from 2016 onwards. Interviewees expressed mixed views regarding the potential of 
the Solvency II Directive to reduce sole and mechanistic on credit ratings24.  

One the one hand, it was highlighted that the Solvency II framework aims to prevent 
sole and mechanistic reliance on external ratings and there are several angles through 
which this objective is reflected in the Directive: 

(cid:121)  Provisions relating to risk management processes of insurance companies / 

encouraging them to make own assessments.  

- 

Insurance companies have the option to develop their own internal models 
for calculating capital requirements. This model needs to be approved ex-
ante by the regulator through a much scrutinised process. This includes 
scrutiny over the use of internal ratings and in some cases a comparison 

22 BCBS (2014), Basel III Document - Revisions to the securitisation framework, 11 December 
2014. Available at: http://www.bis.org/bcbs/publ/d303.pdf 
23 FSB (2013), Credit Rating Agencies Reducing reliance and strengthening oversight - Progress 
report to the St Petersburg G20 Summit. 29 August 2013. Available at: 
http://www.financialstabilityboard.org/wp-content/uploads/r_130829d.pdf?page_moved=1 
24 Not all interviewees would agree that there is a problem associated with overreliance on 
credit ratings in the insurance sector. 

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with external ratings. Supervisors need to be satisfied that there is a good 
system of governance around how internal ratings have been derived. These 
models are developed with the perspective of lowering capital requirements 
and/or to better capture the risk profile of individual insurance companies 
(compared to what is captured by the standard formula). Developing an 
internal model to calculate capital requirements is however, a big step even 
for insurance companies which have an internal credit risk assessment 
models in place for facilitating investment decisions. Some insurance 
companies have therefore, developed partial models only.  Many insurance 
companies use the standard approach which is primarily based on external 
ratings. 

-  Under the standard formula [Article 4 of the Commission Delegated 

Regulation (EU) 2015/35 of 10 October 2014 supplementing Solvency II]25, 
insurance undertakings may use an external credit assessment for 
calculating capital requirements, provided it has been produced by a 
recognised CRA26. 

- 

Insurers may refer to external ratings, but sole and mechanistic reliance is 
forbidden [Article 259 (4) in the delegated act of Solvency II].  

-  Where external credit assessments are used, insurers have to use additional 
assessments whenever practically possible [see Art. 44 (4a) of the Solvency 
II Directive]. More specific requirements on the additional assessment will 
be included in an ITS [the final draft will be made available on the EIOPA 
website]27. 

- 

Insurance companies using the standard formula are also required to make 
an additional internal assessment for larger / complex exposures. [See 
Article 4 of the delegated act mentioned above]. 

-  The same article stipulates that insurers have to nominate CRAs for each 
asset class, in order to prevent them from cherry-picking ratings for a 
specific investment. [See Article 4 of the delegated act]. 

-  These provisions also require at least two ratings for securitization positions. 

Where only one rating is available, it would be treated as an unrated 
position (by implication, higher capital requirements would apply). [See 
Article 6 of the same delegated act]. 

-  Solvency II requires all insurance companies to document the processes 
underlying their risk management strategy and their investment strategy 
[Article 44 of the Directive 2009/138/EC of the European Parliament and of 
the Council on the taking-up and pursuit of the business of Insurance and 
Reinsurance (Solvency II)]28.  Risk management systems of the companies 
will need to be approved by the governing bodies of the companies – while 
the national sectoral competent authority will check that these processes are 
documented and in line with the risk appetite of the company concerned. 

25  http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32015R0035 
26 The list of registered and certified CRAs can be found here: 
http://www.esma.europa.eu/page/List-registered-and-certified-CRAs  
27 https://eiopa.europa.eu/Publications/Reports/EIOPA-BoS-15-
117_Final_report_ITS_Assessing_credit.pdf 
28 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:02009L0138-
20150331&qid=1440690085488&from=EN 

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(cid:121)  Additional provisions regarding outsourcing of important functions apply also to 
CRAs [See article 49 of the Solvency II directive; section 4 of the delegated act. 
Section 11: Outsourcing of the Guidelines on systems of governance29]. These 
provisions stipulate that it is the insurance company’s responsibility to ensure 
that the service provider (i.e. the CRA) has proper risk management systems in 
place, makes use of qualified staff etc. 

(cid:121)  Prior to Solvency II, in some EU countries, insurance companies had 

requirements relating to quality of assets and limits on exposures which were 
expressed in terms of external credit ratings. This was not the case in all EU 
countries (Solvency I was implemented in a fragmented manner across 
Europe). Now, with the risk based regulatory capital requirements introduced 
by Solvency II, this type of provision will not be necessary anymore. Insurance 
companies would have greater flexibility in determining their holdings in 
investment grade vs non-investment grade assets, provided that adequate 
capital is set aside to reflect the credit risk of their investments.  

(cid:121)  Solvency II does not refer to external ratings but to credit quality steps. 

Insurance companies need to classify their assets according to the credit quality 
steps (ex-ante approval by the regulator is not requirement, but possibility of 
ex post checks as part of regular surveillance by the regulator).  

On the other hand, it was argued by some interviewees that Solvency II contains 
references to ratings which may in fact induce sole and mechanistic reliance on 
external ratings: 

(cid:121)  Solvency II, mentions credit quality steps, but these have been mapped against 

CRA ratings in the draft Implementing Technical Standards (ITS)30.  

(cid:121)  Insurance companies which use the standard formula need to make an 

additional assessment for large and complex exposures. The internal ratings 
produced in that context, however, cannot be used to determine capital 
requirements if they generate lower capital requirements, meaning external 
ratings override internal ratings [Article 4 of the delegated act]. 

(cid:121)  Although Solvency II stipulates that those insurers who will use an internal 

model will be able calculate capital requirements without referring to external 
ratings, insurance sector representatives believe that only a small group of the 
largest insurers in Europe may opt for an internal model, largely because of the 
higher costs of doing (as compared to the standard approach). Smaller 
insurance companies would most likely opt for the standard formula and would 
therefore, de facto rely more on external ratings. The amount of capital to set 
aside is basically defined by the spread risk, which is a function of the external 
rating. Similarly, the concentration risk module and the counterparty default 
risk module use CRA ratings. For companies using the standard formula, 
regulation would be a key driver for the use of ratings, which as noted by the 
interviewees, is in contradiction with the stated objective of reducing 
mechanistic reliance on external credit ratings.  

(cid:121)  Some interviewees highlighted that there are incentives within the regulation 

(beyond the cost and resources issue) to continue using the standard formula. 

29 https://eiopa.europa.eu/Publications/Consultations/EIOPA_EIOPA-BoS-14-253-
Final%20report_Governance.pdf  
30  Joint  consultation  Paper  of  the  ESAs  -  Draft  Implementing  Technical  Standards  on  the 
allocation of credit assessments of ECAIs to an objective scale of credit quality steps 
under Article 109 (a) of Directive 2009/138/EC,  6 March 2015. Available at: 
http://www.eba.europa.eu/documents/10180/1006707/JC+CP+2015+001+%28Joint+CP+on+
draft+ITS+on+mapping+of+ECAIs+under+SII%29.pdf (mapping table on page 7).  

December 2015 

26

 
 
 
                                          
Study on the Feasibility of Alternatives to Credit Ratings 

For example, it has been decided that there is no spread risk charge for 
government bonds under the standard formula (lower capital requirement). 

(cid:121)  In some countries, even insurance companies using a validated internal model 
need to provide the regulator with the calculation using the standard model. 
The regulator can use the standard formula calculation as a benchmark, for 
comparison, to check if there are any deviations. 

(cid:121)  Solvency II is favouring external ratings in the sense that when there are no 

ratings, there are higher capital requirements. For example, unrated institutions 
which have an explicit guarantee from a public authority (e.g. social housing 
companies) are given the same treatment as unrated corporates under the 
standard formula (which is counter-intuitive and punitive in terms of capital 
requirements according to some market participants). It was suggested that a 
more logical and pragmatic approach would have been to assign the same 
rating to that entity as that of the public authority backing it.  

(cid:121)  The capital charges under Solvency II are also pro-cyclical, with capital charges 
increasing exponentially for lower rated assets. For a 10 year bond, Credit 
Quality Step 2 is charged 10.5% capital (which corresponds to a CRA rating of 
‘A’), Credit Quality Step 3  (or ‘BBB’) is charged 20% capital and Credit Quality 
Step 4 (or ‘BB’) is charged 35% capital [see first table of article 176 of the 
delegated acts]. It was mentioned by some interviewees that these wide 
differences provide a strong incentive for insurers using the standardised 
approach to focus on external ratings, and would potentially encourage them to 
insert trigger clauses with selling commitments, to avoid the punitive capital 
requirements in case of a downgrade. 

Considering that prudential supervision of insurance companies has traditionally 
placed only minor reliance on external ratings, Solvency II is perceived by many 
market participants as a step backwards in this respect. 

2.2.2.3  Asset management  

Key messages: 

(cid:121)  In the asset management sector, significant progress has been made towards 

removing regulatory references to ratings 

(cid:121)  Nonetheless, external ratings continue to be widely used in investment 

mandates  and constitute a “common language” between investors and asset 
managers 

(cid:121)  The use of ratings in investment mandates is primarily driven by sectoral 
legislation applicable to investors (e.g. banks, pension funds, insurance 
companies) and/ or the investor’s internal rules 

Asset managers in Europe are subject to extensive internal assessment requirements 
under UCITS and AIFMD31. These Directives require asset managers to carry out own 
internal risk management  when assessing counterparty and credit risk of each 
potential investment with the aim of preventing sole and mechanistic reliance on 
ratings. These obligations apply to all asset managers regardless of their size.  

31 See for UCITS: article 51 of the Directive 2009/65/EC (UCITS directive) and article 38-40 of 
Directive 2010/43/EU (the UCITS Level 2 Management Company Passport Directive). For AIFM, 
see Article 15 and 16 of the Directive 2011/61/EU (AIFMD) 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

UCITS / AIFMD directives foresee a system of checks and balances (described as 
proportionate by some interviewees) where external credit ratings are still used and 
accepted as evidence of an informed decision, but are not the sole basis for decision 
making. When documenting the credit risk assessment processes, both internal ratings 
and external ratings can be used. In case external ratings are used, funds have an 
obligation to make sure that they can rely on a specific rating (i.e. they have an 
obligation to assess the rating methodology and to perform a quality check).  

The biggest challenge for asset managers is to move away from a mechanistic reliance 
on external credit ratings while still responding to their clients’ demands, including the 
request to continue to use external ratings as an essential reference point. Moreover, 
ratings are often used as an instrument of governance by trustees in order to protect 
investors.  

Asset managers manage assets on behalf of their clients in line with a defined 
investment mandate. An investor may impose investment restrictions linked to ratings 
within investment mandates that are derived from regulatory requirements or the 
investor’s internal rules. For example, an investor that is a bank (subject to CRR/CRD 
IV) or an insurance company (subject to the Solvency regime) may determine its 
investment policy based on the capital cost incurred for holding specific asset classes.  

Moreover, investors are sometimes constrained to only invest in or retain securities 
that are investment grade, according to ratings given by some specific CRAs. For 
example, in some jurisdictions, pension funds are required by law to restrict 
investment in assets that exceed pre-defined (CRA) rating thresholds. The extent to 
which certain categories of investors (notably pension funds and insurance 
companies), in different jurisdictions are restricted by law to invest only in securities 
rated above a particular threshold, or have investment limits (in terms e.g. of a 
percentage of assets under management) on securities rated below a particular 
threshold, is not known and beyond the scope of the present study to establish. 
However, stakeholder interviews provided some anecdotal evidence. For example, an 
interviewee reported that in Germany, insurance companies must invest in investment 
grade instrument only32 while in some other countries no restrictions were reported. It 
does however confirm that external ratings are used by regulators to limit risks as far 
as credit quality is concerned. 

2.3  The use of external ratings by market participants 

Table 1 provides an overview of the different purposes for which external ratings are 
used by market participants. Our research finds that the use of external ratings is 
widespread within the financial sector, but ratings are also used for a variety of 
purposes in the non-financial sector. A sector specific summary of the main uses of 
external ratings and their importance is provided below: 

Banking sector 

(cid:121)  Banks use external ratings in their classical lending business (corporate / SME 

lines of credit) only to a limited extent as the rating coverage of corporates and 
particularly SMEs is small.  Classical bank lending is typically based on internal 
credit risk assessment by the bank.  

32  In Germany, there were recent amendments to the insurance regulation which intend to 
facilitate the granting of loans to infrastructure companies and of high-yield loans to companies 
with a rating below investment grade (fort up to 5% of their assets). However, the borrower 
must have at least a speculative grade rating. See D&P (2015) New German Investment 
Regulation Adopted. Available at: 
http://www.debevoise.com/~/media/files/insights/publications/2015/03/20150316anewgermani
nvestmentregulation%20adopted.pdf  

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Study on the Feasibility of Alternatives to Credit Ratings 

(cid:121)  External ratings (where these exist) are however, taken into consideration in a 

commercial bank’s investment decisions (i.e. when investing in bonds, 
structured finance products). Some credit institutions have introduced 
investment guidelines setting investment limits per rating grade and/or 
minimum rating requirements. External ratings are at times used to define 
those concentration limits, despite the fact that banks produce internal ratings 
to back their investment decisions. 

(cid:121)  Investment banks use ratings to help price and place new issues at the time of 

offering. 

(cid:121)  Largest banks are also issuers of debt securities which will typically be rated. 

(cid:121)  When borrowing on the interbank market, external ratings are an important 

parameter. 

(cid:121)  In the structured finance segment, ratings are instrumental in the structuring of 

the transaction.   

(cid:121)  For banks, the main drivers for using ratings are to comply with regulatory 

requirements (Liquidity Coverage Requirements and capital requirements) and 
for accessing wholesale funding via capital markets or interbank lending 
market. 

Asset management / investment funds/ hedge funds/ pension funds 

In the asset management sector, external ratings are used for three primary 
purposes: 

(cid:121)  Defining the investment universe and investment limits (to reflect investors’ 

expectations, and also because investors use external ratings as a governance 
tool).  

(cid:121)  Benchmarking i.e the performance of portfolios or funds is assessed against so 
called benchmarks that are defined in terms of ratings (e.g. investment grade 
benchmarks, high yield benchmarks).  

(cid:121)  Ongoing monitoring and managing portfolio risk. 

Additionally, asset managers use external ratings to assess the creditworthiness of 
their counterparties and of financial instruments. Funds themselves can also be rated. 
Finally, ratings are used for reporting / communication purposes, to describe the 
composition of the portfolio. 

Insurance sector 

(cid:121)  Insurance companies use external ratings when assessing investment 

opportunities. They also refer to ratings in their investment guidelines, for 
example, by saying that only investments with a certain minimum credit quality 
– expressed in terms of external ratings - can be made. If the asset 
management function is outsourced, then, those limits are reflected in 
investment mandates. Ratings are thus used to set investment restrictions/ 
limits which are then reflected in contracts with asset managers, and used to 
monitor and manage the performance of these contracts on an ongoing basis. 

(cid:121)  The role of insurance companies as issuers is limited as very few insurance 

companies issue debt (as insurance companies receive upfront funding, namely 
receive premiums before paying claims).  

(cid:121)  In reinsurance contracts, the ceding insurance companies often use external 
ratings as one reference point to assess counterparty risk. The rating of the 
company itself is therefore often more relevant for a reinsurer than for a direct 
insurer.  

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

Table 5. 

The use of ratings by market participants 

Type of use 

Borrowing and 
lending activities 

Collateral 
frameworks 

Contractual uses 
(investor 
protection) 

Regulatory uses 

To access finance (by demonstrating creditworthiness) 

Making investment decisions (assess creditworthiness) 

Offering trade credit 
Credit enhancement / structured finance transactions 
Monitoring and managing credit risk 
Disclosure, communication and reporting portfolio risk 
Defining the investment universe 
Value and eligibility of collateral 
Haircuts 
Investment mandates/ guidelines 
Reinsurance arrangements 
Loan agreements, guarantees, letters of credit 
Derivative covenants/ OTC derivatives  contracts 
Prospectuses (bonds, funds) 
Fund rating 
Collateral agreements (repo and swap transactions) 
Monitoring of systemic risk/ stress tests  
Determining capital requirements 
Determining securitisation exposures 
Liquidity 

most common uses of external ratings 

December 2015 

Credit 
Institutions/ 
Banks 

Asset 
Managers / 
Investment 
funds / 
Hedge funds

Insurance/ 
Re-insurance 
companies  

Pension 
Funds 

Non -financial 
corporations 

CCPs 

Central 
banks 

Government 
(national/ 
sub-national) 

(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 

(cid:57)  
(cid:57)  

(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 
(cid:57) 

(cid:57) 
(cid:57) 
(cid:57) 
(cid:57) 

(cid:57) 

(cid:57) 

(cid:57) 

30 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
Study on the Feasibility of Alternatives to Credit Ratings 

Non-financial corporates 

(cid:121)  From an issuer point of view, companies need ratings to access capital markets. 
Companies of a certain size (which are financed through bonds rather bank 
loans) have ratings for each of their issuances. The issuer also frequently has a 
rating.  

(cid:121)  Their short term instruments – e.g commercial paper – are also rated (on a 

different scale by the CRAs). 

(cid:121)  Corporates typically have a rating matrix / triggers in contracts (e.g. loan 

contracts with banks). 

(cid:121)  However, the importance of credit rating for non-financial corporation goes 

beyond financial issues. Any business partner (e.g. suppliers, potential partners 
for a joint venture) can have an interest in their external credit rating. 

(cid:121)  Ratings are an input into corporate decision making such as M&A decisions 

(cid:121)  Ratings can also be helpful for a firm that is negotiating leases or other long 

term contracts.  

(cid:121)  Auditing firms are also users of ratings. As per IFRS 9, impairment rules will be 

triggered by change in credit – and external ratings will be a source of 
information. 

Central counterparties  

CCPs use external ratings for a variety of purposes: 

To determine membership eligibility 

To become a clearing member (counterparty) of a CCP, the CCP will conduct a credit 
assessment. CCPs use external ratings in their credit assessment, but on a relatively 
small scale and typically as one input into their credit risk assessment methodology/ 
model. A party can become a clearing member when the internal model of the CCP 
indicates that a party has at least a certain score. One CCP indicated that external 
credit ratings have a weight of less than 10% in their internal credit score. 

To determine eligibility of collateral 

Depending on the type of collateral, pledged assets have a certain rating, especially if 
not being cash. CCPs take external ratings into considerations when determining if 
certain collateral can be accepted.  

To determine initial margin/ haircuts 

The external rating of a party posting initial margin can be used as one of the input 
factors for the initial margin determination of the counterparty risk. The lower the 
rating, the higher the perceived risk and its corresponding margin.  

The size of the haircut is determined by the perceived risk of the collateral. To 
determine the risk, credit ratings are taken into account.  

Central banks 

(cid:121)  Central banks use external ratings in their eligibility criteria for collateral (for 

lending facilities). For example, the ECB uses the Eurosystem Credit 
Assessment Framework (ECAF) to determine which sources of credit 
assessment the Eurosystem would base the eligibility assessment of assets 
eligible as collateral for Eurosystem credit operations. This means that any 
asset that the ECB wants to add to its portfolio has to have at least two ratings 
by CRAs under ECAF.  In an effort to reduce reliance on external ratings, the 
Bank of England has however, removed references to external ratings in its 
collateral eligibility criteria. 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

(cid:121)  References to external ratings can be found in investment guidelines and 

mandates for foreign reserves operations. 

(cid:121)  Central banks also use external ratings when conducting stress tests. 

Government/ public authorities 

(cid:121)  As the main issuers of debt on capital markets, governments/ public authorities 

use external ratings to demonstrate their creditworthiness to potential 
investors. 

(cid:121)  Ratings are also used by governments to assess counterparty risk. For 

example, ratings are taken into account when governments provide loan 
guarantees to corporates to facilitate access to finance. 

2.4  The use of external ratings in financial contracts  

Key messages: 

(cid:121)  External ratings are extensively used in private contracts such as investment guidelines, 

mandates, bond documentation, loan covenants 

(cid:121)  Contractual references to external ratings vary in degree of impact from harmful to 

relatively benign. In its most harmful form, trigger clauses with the right to terminate 
credit availability/ selling commitments can result in serious liquidity crisis for the 
borrower or cliff effects 

(cid:121)  Within the asset management sector, contractual references to external ratings can be 

more harmful if the approach to fund management is “passive” 

2.4.1  Typology of uses in contracts 

The use of references to external ratings in contracts was generally recognized by the 
market participants and confirmed by SCAs (Figure 8). SCA views on the use of 
external ratings in financial contracts by supervised entities. 

Figure 8.  Contractual references to external ratings  

Source: ICF survey of SCAs; n=28 

December 2015 

32

 
 
 
 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

The main types of rating uses in contracts are described below. 

Rating constraints and guidelines in investment mandates/ asset manager 
contracts.  

Investment mandates and guidelines often specify minimum rating requirements. For 
example, investment mandates may constrain asset managers to only invest in or 
retain securities that are rated as investment grade by specific agencies (typically the 
Big 3). Alternatively, investment mandates may specify minimum rating criteria for a 
certain percentage of the assets under management.   

Contractual references to external ratings are used by asset owners to convey their 
risk appetite and investment preferences. Ratings provide investors with a “common 
language” enabling them to compare different potential investments ex ante and the 
performance of different portfolios ex post. Market participants suggested that 
defining investment grade without reference to a common standard of credit risk is not 
an easy task.  Some participants highlighted the potential downside of including 
contractual references to external ratings in investment mandates. According to them, 
ratings based portfolio constraints drive attention away from the true drivers of risk 
and return.  

Rating triggers are often used in loan and bond covenants, swap transactions 
(e.g. swap termination events) 

Rating triggers refer to contractual provisions that give counterparties and lenders the 
right to terminate credit availability, accelerate credit obligations or have the borrower 
post additional collateral in the event of specified rating actions. The associated 
changes can also be a change in the coupon in case of fixed income securities, or in 
the case of products structured finance products, a need to replace downgraded 
obligors by better rated obligors.  

Loan agreements sometime include a pricing matrix, whereby the cost of borrowing / 
interest margin is linked to the borrower’s credit rating. One bank explained that this 
type of covenant is not standard, but reserved for special cases (e.g. syndicated loans 
for large corporates). 

Finally, market participants mentioned covenants which are dormant when rating is 
above a certain level, and activate below the threshold. Covenants are related to 
actions the companies should /should not take in case of a downgrade (e.g. 
investments which can be made). It allows for a controlled dialogue to take place 
between the bank and the company, in case the situation gets difficult. 

Collateral agreements/ frameworks, including for OTC derivatives.  

Lenders impose minimum rating standards on securities accepted as collateral for a 
loan. This can be the result of voluntary lending policy guidelines or regulatory 
references to ratings. Similarly, central banks do not accept securities below 
investment grade as collateral for commercial bank borrowing. 

Other contractual references include prospectuses, re-insurance agreements, 
letters of credit and specific documentation. 

Prospectuses frequently include describe the risk of the portfolio with references to 
external ratings. These references are intended to better describe the investment 
policy that will be followed and the type and quality of assets that will be bought for 
the portfolio. Similarly, prospectuses for bond issues will mention the rating assigned 
to it by one or more CRAs.  

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Study on the Feasibility of Alternatives to Credit Ratings 

Another concrete topical example involves the documentation related to hybrid 
bonds33. Such documentation may contain provisions allowing the issuer to defer 
interest payments or delay redemption in case of a rating event.  

2.4.2  Contractual references to ratings ‘potential to trigger sole and 

mechanistic reliance 

Stakeholders’ views were mixed as regards to the extent to which these references 
had the potential to trigger sole and mechanistic reliance on CRA ratings. Most SCAs 
do not think that this is an issue (Figure 9). 

Figure 9.  SCAs’ views on evidence of excessive or formulaic reliance on ratings in 

contractual agreements 

Source: ICF survey of SCAs; n=28 

Asset  managers  explained  that  the  extent  to  which  the  minimum  credit  quality 
criterion  represents  a  strict  requirement  (or  rather  an  indicative  target  /  a  guidance) 
depends from client to client, from case to case. In practice, there appears to be some 
flexibility.  There  might  be  good  reasons  to  decide  to  invest  in  a  corporate  bond, 
although it might not meet the minimum rating requirement (e.g. for an infrastructure 
project whose rating will improve after the construction phase) and the client might be 
willing to hear that.  

33 Hybrid bonds are best-known for their use in bank capital. Banks have been issuing 
hybrid  bonds  for  a  while,  most  recently  as  part  of  the  effort  to  strengthen  their 
balance-sheets  after  the  financial  crisis.  Investors  in  such  issues  can  be  “bailed  in” 
(their  debt  converted  into  equity)  if  the  bank  gets  into  trouble.  But  corporate  hybrid 
bonds  are  different.  Their  main appeal  is  that  they  are  treated  by  rating  agencies  as 
part-bond,  part-equity,  leading  to  lower  assessments  of  indebtedness,  and  in  turn, 
reduced  borrowing  costs.  At  the  same  time,  issuing  a  hybrid  bond  is  cheaper  for  the 
company  than  raising  the  same  amount  of  money  in  the  form  of  simultaneous  bond 
and  equity  issues,  partly  because  the  interest  on  bond  issues  is  tax-deductible  for 
issuers,  but  the  dividends  on  equity  are  not  (Source:  Economist  (2013)  Hybrid 
corporate bonds: the rating game) 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

A major area of is however, is trigger clauses with selling commitments. Clauses with 
selling commitment are to be avoided, as per the CRA regulation. It was however 
mentioned that pieces of legislation such as Solvency II encourages market 
participants to insert such clauses. 

A distinction which was made by market participants was active asset management 
versus passive asset management. The risks for “sole and mechanistic” reliance on 
external ratings were seen as less prominent where asset management is active, as 
one core task for an asset manager is to understand the intrinsic value of the asset 
(beyond the external rating – which is one input factor), to see if it will outperform / 
underperform compared to what is reflected in the market data. In the passive 
management sector, however, analysts benefit from less room for maneuver; indices, 
which are based on ratings, need to be tracked. Now this type of management is 
increasingly developing over the recent years and e.g. favoured by the large sovereign 
wealth funds. 

2.4.3  Mitigating measures 

Key messages: 

Mitigating measures include: 

(cid:121)  Introduction of grace periods in contracts; 

(cid:121)  Inclusion of a small high yield / unrated bucket in the mandate; 

(cid:121)  Introducing the requirement to consult the investor before taking action 

following a downgrade; 

(cid:121)  Introducing the requirement to conduct additional internal analysis or using 
additional measures before closing the position following a downgrade; 

(cid:121)  Rating requirements which do not need to hold throughout the investment 

cycle; 

(cid:121)  Defining investment grade in terms of internal ratings; 

(cid:121)  Having the possibility to override external ratings; 

(cid:121)  Use of multiple ratings, including the use of ratings by smaller agencies. 

Asset managers interviewed in the context of this study seem to value flexibility and 
appeared keen to avoid very strict investment mandates and trigger clauses. They 
also stressed the need to act in the interest of the investor and, pointed out that when 
a security is downgraded, it may not be a good to sell.   

One asset manager noted that in general, internal systems (commonly used by asset 
managers) are ahead of external ratings since unlike asset managers, CRAs have 
committees to go through before announcing a downgrade. In that sense, the number 
of cases where action by the manager has not preceded the downgrade is rather 
small. The capacity of an asset manager to react before a downgrade is also 
something which is sought after by asset owners when selecting asset managers, who 
draft selection criteria related to research capabilities going into that direction 
(requirement on the number and qualifications of analysts, independence from 
portfolio management).  

In line with IOSCO good practices, the introduction of a grace period (flexibility in 
terms of timing for selling the asset) was also promoted, to protect against market 
disruption while still using the common language provided by external ratings. It is a 
frequently quoted mitigating factor. On this point, some interviewees suggested that 
the grace period should be “long enough”. One interviewee mentioned a three-month 
timeframe during which he/she is not forced sell the downgraded asset in a way that 
harms the portfolio, with an option for open discussion at the end of the three-month 

December 2015 

35

 
 
Study on the Feasibility of Alternatives to Credit Ratings 

period. This is not yet a universal practice, with one investor admitting that managers 
only had “days to act”, in case a downgrade requires some action. 

The inclusion of a few percentage point high yield bucket, or unrated bucket in the 
mandate was quoted as a mitigating factor. Assets downgraded below investment 
grade can move to that bucket. One manager explained how in case the prospect of 
forced selling materialises, there is always a possibility to negotiate with the client e.g. 
negotiate additional percentage points in high yield bucket for a certain period of time. 
Rather logically, the manager would engage in such a negotiation only if their internal 
credit assessment suggests that it would be better to hold the position than to sell. 
The outcome of such negotiations however, cannot be predicted. One asset manager 
reported one emblematic case where mandates were adapted to avoid mass selling 
during the sovereign debt crisis. An insurance company stated that they systematically 
insert a provision specifying the asset managers could temporally exceed the size of 
the high yield bucket, up to certain amount expressed in terms of Solvency II capital 
requirements. It was further explained that the extent to which insurance companies 
will be prone to use such mitigating factors will depend on several factors: whether 
the availability of own funds is a constraint for them, whether they use an internal 
model or not. 

Besides, investment mandates specify requirements which do not necessarily need to 
hold throughout the investment cycle. It can be that the debt needs to be rated as 
investment grade at the time of investment only.  

Recently, asset managers have been trying to define investment grade more in terms 
of internal ratings.  Although many asset owners/ investors can be reluctant to accept 
internal measures, this could work if the methodology for producing internal ratings is 
transparent and recognized as sound by both parties. Investors might think that it will 
be burdensome for them to acquaint themselves with too many methodologies. To 
counter this argument, the asset managers will need to take a consistent view of the 
notion of investment grade and convince their clients that their investment policy has 
not changed despite the use of a new type of rating. One manager assumed it would 
be easier to persuade retail investors, compared to institutional investors (who might 
be constrained by regulatory requirements). Some asset managers stated that 
acceptance is also a matter of relationship and trust. 

As another mitigating measure, some asset managers indicated they first check 
whether the internal system also detects a need for a downgrade, before taking 
action; although if there is a trigger clause with selling commitment they are obliged 
to take action, unless the internal rating is accepted as a reference.  Contractual 
provisions can be inserted to allow asset managers to conduct additional internal 
analysis overruling the external rating. References to external ratings therefore, 
continue to be used for common language purposes, but the hands of the manager are 
not tied. 

That said, even if the internal rating is accepted as a reference, some investors feared 
they would need to justify their actions / be held accountable, should they not follow 
the move of the CRAs and should that prove detrimental to the investor and explained 
that in that context it would be hard to overrule the CRA rating. 

Finally, asset management companies directly owned by investors such as pension 
funds or insurance companies felt they had more discretion to invest in high yield 
assets and did not see a push from their owners to use external ratings. Investors 
mandating independent asset managers tend to be more incline to insert references to 
external ratings as an instrument of governance 

December 2015 

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Study on the Feasibility of Alternatives to Credit Ratings 

3  Mapping and feasibility assessment of alternatives to 

external credit ratings 

There are two broad approaches to credit risk assessment :(i) internal approaches and 
(ii) external measures and ratings.  A basic alternative to CRA ratings is internal credit 
risk assessment carried out by investors/ lenders. Approaches to internal credit risk 
assessment vary across asset classes and market participants depending upon their 
size, sophistication and sector. Aside from CRA ratings, market participants use a 
variety of other external measures such as market based measures, accountancy 
based measures and credit risk assessments or ratings produced by other third 
parties. This section describes each approach in further detail along with a 
consideration of their relative strengths and weaknesses. 

3.1  Approaches to credit risk assessment 

Market participants typically use a variety of measures/ approaches to credit risk 
assessment - a high level summary of these approaches is presented in Table 6. 
Interviews and online surveys conducted as part of this study suggest that these 
approaches are not mutually exclusive and are rarely used in isolation. Instead, 
market participants (particularly, the larger and more sophisticated players) typically 
draw upon a combination of measures/ approaches.  

Table 6.  Classification of different approaches to credit risk assessment 

Type  

Approach 

Description 

Input data / 
sources of 
information 

Internal 
approaches 
to credit 
risk 
assessment 
– bulk of the 
analytical 
work is 
performed in 
house by the 
investor/ 
lender 

Internal credit 
risk 
assessment – 
purely based 
on statistical 
models 

Proprietary models 
or vendor solutions 
generating 
quantitative 
measures of risk 
such as probability 
of default (PD), Loss 
given default (LGD), 
Exposure at default 
(EAD) 

Based on actuarial data 
i.e. historical data on 
defaulted and non-
defaulted borrowers; 
recovery rates; losses 
etc. 

Transaction specific 
factors like the nature of 
the product, terms of 
repayment, collateral 
etc. 

Internal credit 
risk 
assessment  – 
incorporating 
human 
judgement 

Credit risk 
assessment is 
carried out on the 
basis of a 
methodology 
comprising objective 
and subjective 
criteria  

A computational 
model may or may 
not be used to 
estimate PD, LGD, 
EAD 

Quantitative data such 
as 

(cid:121)  Market-based 
measures 

(cid:121)  Accounting-based 

measures  

(cid:121)  Third party 

assessments 

(cid:121)  Default statistics 

Qualitative information 
such as: 

Human judgement is 
used to include  
additional 
information in the 
model 

Corporates: 
management and 
auditor quality, 
corporate strategy, 
competition etc. 

Application 

(cid:121)  Used to assess 
risk across a 
portfolio of 
credits 

(cid:121)  Structured 
finance 
products 

Used  for 
counterparty risk 
assessment and to 
assess risk of 
individual lending 
decisions 

Applicable to: 

(cid:121)  Sovereign / 

sub-sovereign 
debt 

(cid:121)  Corporate debt 

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37

 
 
 
 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

Type  

Approach 

Description 

External 
measures 
and ratings 

Market 
implied 
ratings (as 
proxy 
measures of 
risk) 

that is not reflected 
in the available data 
or applied 
afterwards to tweak 
or override the 
results of the model

Credit default swap 
(CDS) spreads 

Equity pricing data –
volatility  or the 
standard deviation, 
σ, of an obligor’s 
stock price 

Bond pricing 
information/ bond 
spreads 

Application 

Input data / 
sources of 
information 

Sovereign: e.g. political 
risk, institutional set-up 
etc.   

CDS markets  

(cid:121)  Sovereign/ 

sub-sovereign 
debt  

(cid:121)  Corporate debt 

(cid:121)  Structured 

products  

Stock markets 

(cid:121)  Corporate debt

Secondary markets  

(cid:121)  Sovereign/ 

sub-sovereign 
debt  

(cid:121)  Corporate debt

(cid:121) 

(cid:121)  Corporate debt

(cid:121)  Corporate debt

Accounting 
based 
measures 

Financial ratios e.g. 
profitability and 
leverage ratios 

Data  from sources such 
as Dun & Bradstreet, 
Amadeus, company 
website etc. is  

Market data + data  
from sources such as 
Dun & Bradstreet, 
Amadeus, company 
website etc 

Financial data in 
combination with 
market indicators 
e.g. Leverage or 
total liabilities ÷ 
market value of 
assets 

Cash flow or EBITDA 
÷ market value of 
assets 

OECD country risk 
classification 

Third party 
assessment 
(non-
commercial)  Scoring by central 

bank based on 
central credit 
registers (CCRs) and 
central financial 
statements 
databases (CFSDs) 

Data collection and 
analysis is carried out 
by the OECD 

Data collection and 
analysis is carried out 
by the Central Bank 

(cid:121)  Sovereign debt

(cid:121)  Corporate debt

Third party 
assessment 
(commercial) 

Automated scorings 
based on 
computational 
models 

Data collection and 
analysis is carried out 
by commercial entities 
(data providers, 
consultancies) 

(cid:121)  Corporate debt

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Type  

Approach 

Description 

Ratings produced by 
registered and 
certified credit rating 
agencies  as 
recognised by ESMA

Input data / 
sources of 
information 

Application 

Data collection and 
analysis is carried out 
by rating agencies 

(cid:121)  Sovereign/ 

sub-sovereign 
debt 

(cid:121)  Corporate debt

(cid:121)  Structured 
products 

The sub-sections that follow provide a detailed description and feasibility assessment 
of each of the approaches mapped above. 

3.2  Internal credit risk assessment 

A basic alternative to external credit ratings is investors’ own internal credit risk 
assessment. Under this approach, the bulk of the analytical work is performed in-
house by market participants. Internal credit risk assessment usually encapsulates a 
combination of sources and techniques and relies on both quantitative and qualitative 
analysis. For example, for a corporate, it involves analysing its financial statements 
and health, its management and competitive advantages, and its competitors and 
markets.  

One market participant explained that they use the CAMELS rating methodology, 
which uses a standard set of parameters for assessing credit risk: 

(cid:131) 

(cid:131) 

(cid:131) 

(cid:131) 

(cid:131) 

(cid:131) 

(C)apital adequacy; 

(A)sset quality; 

(M)anagement Capability; 

(E)arnings; 

(L)iquidity; 

(S)ensitivity. 

Market-based measures (e.g. equity/ bond pricing data, CDS spreads), accounting-
based measures34 and third party assessments, including the external ratings 
produced by the big three credit rating agencies, are often used as inputs into internal 
analysis. 

Depending on the extent to which statistical models are used (see Table 7), internal 
analysis can be more or less automated, incorporating human judgement to different 
degrees. These models can be either developed internally or provided by financial-
intelligence vendors. There are a number of vendors (e.g. Oracle, SAP, Sunguard etc.) 
producing and selling products that are designed to support credit-risk measurement 
and management functions within financial institutions. 

34  Accounting-based  measures  refer  to  financial  ratios  calculated  based  on  publicly 
available  financial  statements.  Examples  of  such  ratios  include  liquidity  ratios, 
profitability  ratios,  leverage  ratios  and  efficiency,  activity  or  turnover  ratios.  These 
ratios  are  usually  analysed  through  a  judgemental  method  (and  are  thus  more 
subjective). 
Unlike  market-based  methods,  accounting-based  measures  are  not  forward  looking. 
They are based on historical data and are thus not really applicable to new entrants.  

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In a more developed form, internal credit risk assessment is based on (internal) 
proprietary tools and methodologies, incorporating own research and analysis, 
externally sourced data and human judgement. 

Table 7.  Modelling based approaches to credit risk assessment 

Type of model 

Description 

Probability of 
default (PD) models 

For a group of borrowers with 
similar characteristics, predicts the 
number of borrowers that are 
likely to default over a specific 
time horizon e.g. one year 

Underlying data 

Based on borrower 
characteristics 

Loss given default 
(LGD) models 

Attempts to predict the amount of 
loss in a credit in the event of 
default 

Based on the characteristics 
of facility e.g. collateral 
covenants 

Exposure at default 
(EAD models) 

Amount outstanding with the 
obligor at the time of default 

Based on the characteristics 
of facility  and borrower 
behaviour 

Credit institutions use portfolio credit models (which quantify risk across portfolios of 
loans), generally in combination with other credit risk models (to assess risk of specific 
counterparties or lending decisions).  Portfolio credit models serve a variety of 
purposes: 

(cid:121)  Benchmarking total capital and general provisioning levels; 

(cid:121)  Capital allocation (including by business unit, geography, product, distribution 

channel, customer and individual transaction); 

(cid:121)  Risk-adjusted profitability measurement (using risk-adjusted return on capital 

and shareholder value added concepts); 

(cid:121)  Performance-based remuneration; 

(cid:121)  Risk-based pricing; 

(cid:121)  Internal risk reporting; and 

(cid:121)  Setting credit risk concentration limits. 

Scope and sophistication of internal credit risk assessment approaches is a function of 
the size of the market player (larger credit institutions typically have more 
sophisticated internal approaches), available resources and regulatory context (Basel 
II and Solvency II can be regarded as driving external ratings’ usage under the 
standardised approach / standard formula, but also as allowing the use of internally 
generated ratings where such models have been validated by regulators). 

Most market participants also differentiate their approach to credit risk assessment 
according to product type.  

(cid:121)  For instance, for sovereign bonds, the use of third party assessments is 

typically more prevalent and internal analysis lighter than for other classes. 
Building one’s internal model for that asset class was seen as too costly 
considering the amount of information which needs to be analysed, for little 
added value, especially since it is accepted by the regulators to rely on ratings 
for sovereigns. In the few cases where companies reported doing a proper 
internal analysis on the sovereign debt, it was reported that the judgmental 
part in the analysis process is even more important than for other asset 
classes. 

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Study on the Feasibility of Alternatives to Credit Ratings 

(cid:121)  For corporates, internal analysis was generally described as more thorough 

than for sovereigns. That said, one interviewee highlighted that the added value 
of the ratings was particularly important for that asset class – because of the 
insider information CRAs have in case of solicited ratings. 

(cid:121)  For structured finance, for those companies where this type of investments are 

material, internal assessment can go further than for other asset classes 
because there is a need to understand the quality of the underlying assets, the 
structure of the transaction and the different levels of subordination. Internal 
assessment of such products is typically model based. It was reported that 
market participants not in a position to internally assess these products have 
not maintained their positions in that area after the crisis. 

The differences in assessment processes can also be a function of ratings coverage. 
For many corporates and certain emerging countries, external ratings simply do not 
exist, which means that the investor has to rely on own analysis.  

Generally, the following principle applies: the riskier the investment, the deeper the 
analysis. Beyond the asset class, ex ante credit quality can influence a party’s 
approach to credit risk assessment. One company reported that for high yield/ unrated 
assets, own internal analysis is a prerequisite while for high credit quality, investment 
can be made prior to a formal internal assessment being made. 

3.2.1  Strengths  

Actual take up is high. Internal credit risk assessment was the most frequently cited 
alternative to external credit ratings in interviews and surveys conducted as part of 
this study. Internal approaches are already being widely used by market participants. 

Incorporation of additional information in the assessment. An internal credit analysis 
can better reflect the risk profile of a specific borrower or security. The rationale is 
that a market participant has better knowledge of the specific characteristics and risk 
parameters of a particular borrower or security due to his/her experience and 
proximity with the sector and/or relations with the counterparty (e.g. internal 
approaches allow a bank to use its knowledge of its customers) . Such sector or 
counterparty specific information may not necessarily be adequately considered in the 
standard methodologies of external credit rating agencies.  

Greater coverage. A vast majority of corporates (and SMEs in particular) are not rated 
by CRAs and any investment/ lending decisions involving these are  subject to internal 
credit risk assessments by investors/ lenders. 

Reliability and accuracy. Investors would have a strong incentive in conducting a 
robust own due diligence and therefore, internal credit risk assessments should 
typically generate accurate and reliable results. For regulatory purposes however, 
internal credit rating models may be designed to minimise capital requirements and as 
such, could potentially under-estimate the risks associated with certain portfolios of 
debt. 

Acceptability to regulators. Since the introduction of Basel II, the use of internal credit 
risk models has been allowed in the banking sector for regulatory purposes (i.e. to 
calculate capital charges), provided that the models are approved ex-ante by the 
supervisor. A similar development is taking place in the insurance sector with Solvency 
II. Regulatory acceptability of internal ratings based approaches is a strong incentive 
for their take-up by market participants. 

Increased risk sensitivity for regulatory purposes. Capital requirements based on 
internal ratings are tied to actual asset risk, meaning the higher the risk as captured 
by the parameters in a bank’s internal risk model, the higher the capital charges. 
Capital requirements are therefore more risk sensitive compared to the standardised 
approach based on external ratings.  

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Study on the Feasibility of Alternatives to Credit Ratings 

Lower risk of herding behaviour and lower systemic risk. The take up of internal 
ratings contributes to a diversity of assessments by market participants, thus reducing 
the risk of herd behaviour and financial instability. 

Adabtability. Internal credit risk assessment approaches can be customised to reflect 
the specific requirements of an investor/ lender (e.g. asset class focus, geographic 
focus, sectoral focus etc.)  

Relative advantages of vendor solutions 

Cost compared to a fully-fledged proprietary model. For smaller entities it is probably 
cheaper than building a fully-fledged internal model.  

Ease of use.  The output of many vendor products includes not only the  modelling 
results, but also other information to support interpretation and use, such as key 
factors that determine the final result, benchmarks for comparison or mapping 
between different risk scales (such as between ratings or scores and default 
probabilities).35 

3.2.2  Weaknesses 

Costs to market participants. Internal credit risk assessments can be relatively costly 
as compared to external measures or ratings. The costs involved include: 

(cid:121)  Cost of collecting and/or acquiring data; 

(cid:121)  Cost of developing analytical tools such as computational models; 

(cid:121)  Cost of employing trained credit risk analysts; 

(cid:121)  Cost of validation and quality control of internal models. 

Both, interviewed regulators and market participants (in particular insurance 
companies, but also representatives of banks and asset management industry) 
pointed to costs as an important concern, especially for smaller market participants 
who cannot justify the expense for significant internal resources and expertise.   The 
cost issue might explain why, in practice, a minority of the credit institutions (in terms 
of number of institutions – the picture might be different in terms of market share) 
have obtained an approval for the use of the Foundation Internal Ratings Based 
approach (FIRB) or of the Advanced Internal Ratings Based approach (AIRB) – see the 
recent ESMA technical report36. 

Costs to regulators. Internal credit analysis also requires more resources from 
regulators as it shifts the emphasis from a “tick-the-box” delegation approach where 
regulators / supervisors rely largely on CRA -ratings toward a more resource 
consuming “examination-and-supervision” process. 

Lack of availability of data and the expertise to analyse that data. The data and 
expertise required to conduct internal credit risk assessment may not be readily 
available to certain market players for certain asset classes such as structured 
products. Although initiatives such as simple standardised securitisation (STS) and the 
European Data Warehouse would improve data availability, market participants may 
lack the expertise or capabilities to analyse this data. Moreover, participants at the 
workshop organised in the context of this study made the point that making the data 
available is a step in the right direction, but is not sufficient. The data needs to be 
standardised, organised and structured to make it useful. Access to data, was also 
mentioned as a constraint to rate corporates, especially SMEs. Most SMEs in the EU do 

35 BIS (2010) Vendor models for credit risk measurement and management  - Observations 
from a review of selected models, Working paper 17, February 2010 
36 ESMA. 2015. Technical Advice on reducing sole and mechanistic reliance on external credit 
ratings. Available at: https://www.esma.europa.eu/system/files/esma-2015-
1471_technical_advice_on_reducing_sole_and_mechanistic_reliance_on_external_credit_ratings
.pdf  

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Study on the Feasibility of Alternatives to Credit Ratings 

not have to file financial statements and of those that do, many contain only abridged 
data. Enterprises have to file public financial statements only if required to do so by 
law. The 4th Company Law Directive37 defines the types of enterprises which need to 
file statements. These types of enterprise vary by Member State but are typically 
enterprises with limited liability. Normally, enterprises without limited liability (most 
micro enterprises) do not file financial statements. Estimates by CSES showed that 
only around a quarter of enterprises are of a legal form that is covered by the 4th 
Company Law Directive, although there are significant differences between Member 
States. For instance, only 17% of enterprises in Italy (and 18% in Germany) have to 
file financial statements compared to 66% in Luxembourg. Even if an enterprise is of a 
legal form covered by the 4th Company Law Directive (“a company”), it may be a 
small company which is required to file only an abridged balance sheet and not a 
detailed profit and loss account. Abridged statements do not provide sufficient data for 
financial analysis. This small company exemption covers most companies and the 
CSES report estimated that only about a quarter of companies exceeded the small 
companies’ exemption limits. In some countries there are additional obligations, e.g. 
in France there is an obligation for all companies to publish their financial information 
and make it available to the commercial court.  Overall, it is estimated that less than 
10% of European enterprises have to file detailed financial statements38.  

Lack of applicability in certain types of financial contracts. Interviewees (particularly 
asset managers) highlighted that when it comes to various types of contractual 
arrangements with asset owners, internal credit ratings do not offer the comparability 
provided by external ratings. According to them, asset owners often prefer an 
independent third-party to carry out a credit risk assessment and to use ratings as a 
control tool, to make sure managers respect their investment mandate. References to 
CRA ratings are seen by asset managers and asset owners as a simple, objective and 
clear way of defining the acceptable level of risk.  

Potential conflict of interest. Where credit assessment is performed by the same team 
of professionals who are making investment decisions within a financial institution, 
there might also be an inherent conflict of interest between the desired “objectivity” of 
the credit assessment and the interest of the professional in pursuing higher returns 
through less creditworthy investments. Although this conflict of interest is believed to 
be manageable through the use of adequate internal procedures. 

Table 8. 

Feasibility assessment: internal credit risk assessment 

Criteria  

Assessment 

Applicability  

Can be applied to all asset classes, namely 

(cid:121)  Sovereign/ sub-sovereign debt 

(cid:121)  Corporate debt 

(cid:121)  Structured products 

Can be applied to individual loans/ bond issues as well as across 
portfolios 

Coverage 

Market participants develop the scope and coverage of internal 
approaches based on their requirements. 

A vast majority of corporate debt is not rated by CRAs and hence, 
internally assessed by market participants 

37  Fourth  Council  Directive  78/660/EEC  of  25  July  1978.  Available  at:  http://eur-
lex.europa.eu/legal-content/SK/ALL/?uri=URISERV:l26009  
38  CSES  (2014)  Evaluation  of  Market  Practices  and  Policies  on  SME  Rating  -  Final 
report 

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Study on the Feasibility of Alternatives to Credit Ratings 

Criteria  

Assessment 

A functioning 
alternative 
according to market 
participants 

Reliability & 
accuracy of the 
approach in 
signalling the credit 
quality of the 
instrument / of the 
counterparty 

Ability to compare 
and rank different 
instruments 
/counterparties 
according to their 
credit risk 

Yes  

Internal approaches pre-date external ratings  

High 

The method used to produce internal ratings should logically be sound. If 
the internal rating system is to be used for regulatory purposes, the 
reliability actually needs to be verified ex-ante by the supervisor. 

With regards specifically to reliability and accuracy in the context of 
usage for capital requirements purposes: 

The capital requirement differences across systems should not come to a 
large extent from non-risk factors. Recent EBA works39 show that about 
half of the differences in capital requirements can easily be explained, 
while the origin of remaining differences is still to be explored.  

In terms of knowing whether there are incentives to get the internal 
models right, there could be diverging perspectives within the same 
institutions (and therefore the need for internal system of check and 
balance). For example, while banks certainly have incentives to make 
the right investment decisions, they could at the same time be focussing 
on lowering regulatory capital requirements. The academic literature40 
indeed suggests that the use of internal models for regulatory purposes 
can undermine the validity of such internal ratings. The paper illustrates 
how with internal ratings, the capital requirements for banks tend to be 
lower, while risks and losses increase, and the accuracy of the interest 
rate charged suggests the banks were aware of the actual riskiness of 
their positions. 

High within the same internal system 

Low across systems, because of the heterogeneity of the rating systems 
across market players  

39 EBA (2013) Summary report on the comparability and pro-cyclicality of capital requirements 
under the Internal Ratings Based Approach in accordance with Article 502 of the Capital 
Requirements Regulation. Available at: 
https://www.eba.europa.eu/documents/10180/15947/20131217+Summary+report+on+compa
rability+and+pro-cyclicality+of+the+IRB+Approach.pdf; and EBA(2013) Interim results of the 
EBA review of the consistency of risk-weighted assets. Top-down assessment of the banking 
book. Available at: https://www.eba.europa.eu/documents/10180/15947/Interim-results-EBA-
review-consistency-RWAs_1.pdf 
40  Behn,  Markus  and  Haselmann,  Rainer  F.  H.  and  Vig,  Vikrant,  The  Limits  of  Model-Based 
Regulation  (November  30,  2014).  SAFE  Working  Paper  No.  75.  Available  at  SSRN: 
http://ssrn.com/abstract=2523383 or http://dx.doi.org/10.2139/ssrn.2523383  

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Criteria  

Assessment 

Limitation of 
negative effects 
such as  pro-
cyclicality 

Transparency 

High. 

Different internal models come with different conclusions. Therefore, by 
definition, if all players look at different measures, the risk of herding 
behaviour as well as the risk of overreliance on one single measure is 
lowered. 

Internal models however are not necessarily designed to produce 
through the cycle ratings. Internal systems can e.g. define grades 
strictly in terms of their one-year probability of default, as opposed to 
taking a wider range of information into account, and thus produce 
ratings which vary over the course of a business cycle. Should those 
ratings be used for determining regulatory capital charges, it could affect 
the market player’s behaviour and have pro-cyclical effects. 

Low to the outsider: internal models are not publicly available. This 
would not be possible to be fully transparent either as in many cases, 
the ratings are not based purely on quantitative models. Generally 
speaking, subjective risk factors and business judgments are important 
considerations in internal risk assessment approaches and these cannot 
be codified or shared externally (unless regulatory standards make it 
necessary to stick with the approved model). 

Medium to the supervisor: when used for regulatory purposes, internal 
models need to be approved ex ante by the regulator. 

Suitability for 
regulatory purposes 

High. Internal approaches are accepted for determining regulatory 
capital requirements in the banking sector. Solvency II allows internal 
approaches in the insurance sector as well 

Acceptability  

High for regulatory purposes  

High for investment decisions 

Cost of using the 
alternative for 
supervisors 

Cost of using the 
alternative for 
market participants

Low in financial contracts – particularly in the asset management sector 

High- supervisors have to approve internal approaches 

High – duplication of efforts across participants 

High costs of collecting and analysing data 

3.3  External measures and ratings 

3.3.1  Market implied ratings 

Market-based measures encompass: 

(cid:121)  Credit default swap (CDS) spreads. A CDS is an insurance contract against a 
default by a particular corporate or sovereign entity. CDS spreads is the cost 
per year of protection against a default by a particular entity. The higher the 
risk of default, the higher the spread.  

(cid:121)  Bond pricing information/ bond spreads.  

(cid:121)  Equity pricing information.   

Market based measures are typically analysed as follows to determine risk:  

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(cid:121)  Calculating bond spreads i.e. the difference between the yield to maturity of a 
particular bond and the yield to maturity of a government bond of similar 
structure and maturity (US or German bonds are typically used); 

(cid:121)  Mapping of spreads of instruments with a given ratings to identify a range of 

spreads, which then determines a market implied rating based on the observed 
spread; 

(cid:121)  Comparing the size of issuer bond spreads to the yields of some objective 

market index, such as the Markit CDX series of indices. The larger the spread, 
the higher the risk weightings assigned to the debt;  

(cid:121)  Comparing the size of issuer bond spreads with spreads of comparable 

securities (“peer group”);  

(cid:121)  Measuring the volatility or standard deviation of stock prices; 

(cid:121)  Model based analysis of spreads data e.g. correlations/ regressions to identify 

relations between spread, recovery and ratings.  

3.3.1.1  Strengths 

Timeliness (compared with accounting based measures or external ratings). A key 
feature of market-based measures is that they reflect available information in a 
timelier manner. It has been demonstrated that during the financial crisis, CDS 
responded to events quicker than external credit rating agencies, and reflected rising 
systemic and institutional risks41. 

Data availability.  Market data on CDS, bonds and equity prices are readily available 
from a variety of sources e.g. Bloomberg, Reuter etc. 

Easy to analyse and interpret. It is quite easy to analyse bond pricing or CDS data by 
calculating spreads (although interpretation needs to be nuanced to reflect the 
structural features of bonds such as callability and amortization). 

Low cost involved. The costs involved in collecting, analysing and interpreting market 
data are much lower as compared to the costs of internal approaches or CRA ratings. 

Moreover, market based measures are objective, forward-looking, and allowing for 
specific risk weightings to be assigned to a given asset. 

3.3.1.2  Weaknesses 

Volatility. Most commonly mentioned weakness was market measures’ volatility. Prices 
typically reflects the market sentiment or simply changes in the demand and supply. 
Yet, those may capture vast type of signals with some having very little or no relation 
to the actual default risk of a given asset. Current market sentiment can be overly 
pessimistic or overly optimistic, depending on market conditions. In extreme cases, 
market measures can be strongly affected even by one particular news story, or 
become highly skewed because of the particularly high risk appetite / aversion of a 
major player.  

Risk of moral hazard. Market participants could potentially trade strategically, i.e. 
attempt to influence the prices in order to generate and benefit from a regulatory 
consequence.  

It is however, argued that lagged measures such as 30 or 90 day rolling averages can 
be constructed to smooth out volatility. Rolling averages would also reduce moral 

41 See for instance: Mark J. Flannery , Joel F. Houston and Frank Partnoy, Credit Default Swap 
Spreads as Viable Substitutes for Credit Ratings, University of Pennsylvania Law Review, Vol. 
158, 2010, San Diego Legal Studies Paper No. 10-031 
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1666350 

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hazard by making it more difficult for market participants to trade strategically to 
influence a bond price in an advantageous manner. 

Pro-cyclicality. A few interviewees pointed also to the highly pro-cyclical character of 
market based measures and the negative implications if used in regulations in 
replacement external ratings.    

Encompasses information beyond the fundamentals. Market prices reflect not only the 
fundamentals, but also, inter alia, time-varying risk and liquidity premiums.  According 
to an interviewee the interpretation of market measures is vulnerable to issues 
including those caused by opaque markets, investor herding, varied investing 
strategies, illiquidity and asymmetrical information flows.   Both CDS spreads and 
bond pricing information are therefore, not easy to interpret.  

Potential incoherent signals from various market measures. Although CDS spreads and 
bond spreads measure equivalent credit risk, there are many factors which can cause 
their prices to diverge such as: documentation, convertible issuance and the market’s 
expectation of debt buybacks, as well as macro factors such as liquidity differences 
and segmentation between markets, low bond market supply and structured credit 
flows.  

Narrow focus. Market-based measures have a rather narrow focus and, in contrast to 
external ratings, do not capture vast types of other relevant information.  

For the above reasons, market based measures are typically used as an early warning 
or surveillance tool. They are rarely used in isolation to make investment / lending 
decisions. 

Specific weaknesses of CDS spreads 

Applicability limited to highly liquid instruments. High liquidity is a pre-condition for 
robust usage of CDS spreads. A recent Wall Street Journal article based on proprietary 
research indicated that CDS markets are thinly traded and therefore may not be the 
best indicators of actual default risk42. Low liquidity of some CDS spreads or simply 
their absence for some assets (e.g. thinly traded corporations) is a highly limiting 
feature in terms of their usefulness. Some empirical research suggests that the risk of 
pricing errors increases substantially for illiquid markets. For instance, value of insight 
derived from the CDS spread of thinly traded corporate bonds may be highly reduced 
because less frequent trading typically translates into higher spreads, sometimes 
irrespective of the actual default risk.   

Low availability of CDS spreads in some geographical markets. In some geographical 
areas, e.g. Central and Eastern Europe, CDS spreads are scarce and therefore the 
replacement of external ratings by CDS spreads would be very problematic.   

Non availability on primary markets. Another specific drawback of CDS spreads is that 
these are not available on primary markets and the applicability to different products 
is therefore restricted. 

Undue correlation within industries. Because spreads reflect the current market 
assessment that may lack more nuanced distinction, some interviewees pointed to 
high correlation of spreads between particular names within certain class of assets 
such as corporations from the same industry. Though, this correlation may occur 
despite the fact that the fundamentals and actual default risk may remain very 
different. The correlation can also stem from chains of OTC derivative contracts. 
Although this problem has been reduced due to the much reduced market of OTC 
derivatives after the crisis, it is still a fact that if institutions are tied up to each other 
through chains of OTC derivative contracts, a fall in one institution can substantially 

42 Mollenkamp, Carrick and  NG, Serena (2011) A Fear Gauge Comes Up Short, 28 September 
2011, Wall Street Journal 

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raise CDS spreads on another. This can make it difficult for investors to separate the 
credit risk of the debtor from the credit risk of the CDS counterparty risk.  

Not a good indicator of default risk. Representative from one large European insurance 
company quoted the company’s own research that showed low correlation of spread 
experience with default experience over a range of time horizons e.g. 1 yr/3yr/5yr43. 
For instance, while substantial spikes in CDS spreads were observed in 2008, the 
default rate was only slightly above the average, even when taking into account rolling 
default losses. From that perspective, CDS spreads are an indicator of supply and 
demand and not of the fundamentals and therefore not of default risk.  

Table 9.  Detailed feasibility assessment – market based measures 

Criteria  

Applicability  

Assessment 

(cid:121)  Sovereign debt 

(cid:121)  Corporate debt (for highly liquid instruments) 

(cid:121)  Structured products (for highly liquid instruments) 

Coverage 

Limited coverage: instruments that are traded at a sufficiently wide 
scale (especially sovereigns and large corporations) 

A functioning alternative 
according to market 
participants 

Reliability & accuracy of 
the alternative in 
signalling the credit 
quality of the instrument / 
of the counterparty 

Ability to compare and 
rank different instruments 
/counterparties according 
to their credit risk 

Limited coverage is an issue for the securities which are not covered but 
also because it would imply the use of multiple assessment systems and 
methodologies, depending on data availability. 

No. 

It is rather a complementary source of information. Examining market 
based measures serves a different purpose than looking at external or 
internal ratings. A different type of information is reflected in market 
based measures. 

Market based measures are rather point in time indications, while 
external or internal rating systems tend to assign the rating across the 
cycle. The fact that ratings are valid throughout the duration of the 
instrument / through the cycle is valued by investors and issuers – as 
many investors primarily intend to hold the security up to maturity to 
match their liability. In that sense, the lack of responsiveness is a 
positive point.  

Low – high levels of volatility 

Market movements give a notice, but as those movements are not 
necessarily linked to credit quality, this is not a good basis on which to 
make a decision. 

Medium 

By nature, spreads are comparison tools. That said, because of limited 
coverage and correlation, their ability to compare and rank different 
instruments is limited. 

43 Using POINT data for historical spread movements and Moody’s data on default experience.  

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Criteria  

Assessment 

Limitation of negative effects 
such as  pro-cyclicality 

Low 

For regulatory purposes, replacing reliance on external ratings with 
another single measure would not serve the intended purpose: the aim 
is not to align the opinions of all market participants but rather to 
maintain a diversity of opinions. 

Relying on market based measures entails pro-cyclical effects: in case 
some nervousness in the market make bond prices fall, investors could 
all start selling despite the fact that these movements are not 
necessarily linked to fundamentals. This would accelerate the downward 
trend. 

Transparency 

High 

Transparency is high as the data is available publicly or easily accessible 
from market data providers but ease of interpretation, from a credit risk 
assessment perspective, less so as there is a need to filter out irrelevant 
movements. 

Suitability of the alternative 
for supervisory purposes  

Medium 

Acceptability  

Low for regulatory purposes 

Low for investment decisions 

Low in contracts 

The high volatility would require constant updates and the type of 
information provide does not serve the appropriate information needs. 

Cost of using the alternative 
for supervisors 

Low - data is available publicly or easily accessible from market data 
providers 

Cost of using the alternative 
for market participants 

Low - data is available publicly or easily accessible from market data 
providers 

3.3.2  Accounting-based measures  

Accounting-based measures refer to financial ratios calculated based on (often publicly 
available)  financial  statements.  Examples  of  such  ratios  include  liquidity  ratios, 
profitability ratios, leverage ratios and efficiency, activity or turnover ratios.  

Accounting based measures are sometimes combined with market based measures to 
compute the following ‘hybrid’ measures: 

(cid:121)  Leverage or total liabilities ÷ market value of assets. 

(cid:121)  Cash flow or EBITDA ÷ market value of assets 

3.3.2.1  Strengths 

One  key  element  of  the  traditional  financial  analysis.  Traditional  financial  analysis 
typically relies on the successive examination of financial ratios and their comparison 
with industry benchmarks. 

Can  be  used  as  (one  of  the)  predictor(s)  of  probability  of  default.  Statistical  scoring 
models  can  be  built  based  on  accounting  measures  and  tailored  to  best  discriminate 
between  healthy  and  sick  firms.  Accounting-based  measures  and  market-based  data 
are often used in combination and aggregated into indexes. 

Widespread  use  of  financial  ratio  covenants:  Financial  ratios  are  widely  used  in 
covenants,  especially  in  certain  types  of  contracts  (e.g.  syndicated  loans).  In  a 

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database  of  syndicated  private  loan  agreements  from  US  firms,  close  to  80%  of  the 
deals  include  a  financial  covenant44.  The  five  types  of  most  common  financial  ratio 
covenants are: (i) Minimum Coverage (earnings / periodic debt-related expense); (ii) 
Maximum Debt to Cash Flow (total debt / earnings); (iii) Minimum Net Worth (assets – 
liabilities  =  shareholders’  equity); (iv)  Maximum  Leverage  (total  debt  /  total  assets); 
(v) Minimum Current (current assets / current liabilities).  

In contracts, the lender and the borrower can agree on the financial ratio(s) which are 
the best predictor of credit risk based on the current situation of the firm (for instance 
for  loss  firms,  ratios  related  to  earnings  are  not  good  predictors,  net  worth  ratio  is 
better suited). 

Reliability.  In  a  recent  academic  working  paper,  credit  ratings  by  Standard  &  Poor’s 
dating  back  to  1986  are  outperformed  by  a  simple  model  in  predicting  corporate 
default45.  Components  of  the  model  measure  profitability,  leverage,  past  returns, 
volatility  of  past  returns,  firm  size,  firm  cash  holdings,  and  firm  valuation.  This 
approach  has  the  benefit  that  each  of  these  measures  is  readily  available  and  easily 
calculated.  

3.3.2.2  Weaknesses 

instance,  profitability  ratios  or 

Requires skilled analysts with sectoral expertise. Interpretation requires an element of 
judgement.  For 
turnover  ratios  may  differ 
fundamentally  between  corporations  reflecting  specific  characteristics  of  their  sectors 
(i.e. manufacturing versus high-tech sector) and hence may be hardly comparable. In 
addition, ratios for the same firm may be discordant (e.g. a poor profitability ratio but 
an  above-average  liquidity  ratio),  which  may  lead  to  divergence  of  opinions  across 
analysts.  Interpretation  of  ratios  without  sufficient  contextual  knowledge  by  less 
experienced market participants may therefore difficult.  

Backward looking. Unlike market-based methods, accounting-based measures are not 
forward looking.  

Access  to  information.  Although  many  interviewees  have  observed  a  meaningful 
increase  in  transparency  and  availability  of  various  types  of  data  over  recent  years, 
the access to financial data can be still problematic. Accounting-based measures may 
in  some  countries  still  not  be  easily  available  for  non-listed  companies  (i.e.  due  to 
lower reporting standards/obligations). 

Limited  applicability.  While  accounting-based  measures  are  typically  suitable  for 
corporations,  they  are  not  suitable  for  sovereign  debt  and  for  many  structured 
products.  In  addition,  they  are  based  on  historical  data  and  are  thus  not  really 
applicable to new entrants.  

Narrow focus. Financial ratios have a rather narrow focus and, in contrast to external 
ratings, do not capture vast types of other relevant information.  

Not  suitable  for  regulatory  purposes.  Financial  ratios  have  limited  value  for  the 
calculation  of  capital  requirements.  As  financial  ratios  may  often  reflect  distinctive 
features  of  countries,  sectors  or  asset  classes,  having  a  consistent  framework  would 
be difficult in practice and would probably require some arbitrary policy choices. 

44 Peter R. W. Demerjian (2007) Financial Ratios and Credit Risk: The Selection of Financial 
Ratio Covenants in Debt Contracts. Available at: 
https://www.gsb.stanford.edu/sites/default/files/documents/Demerjian_Financial.pdf. 
45  Hilscher, Jens and Wilson, Mungo (2013) Credit Ratings and Credit Risk  

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Table 10.  Detailed feasibility assessment – corporate debt 

Criteria  

Applicability  

Coverage 

Assessment 

(cid:121)  Corporate debt 

All corporates (provided access to information) 

A functioning alternative 
according to market 
participants 

Reliability & accuracy of the 
alternative in signalling the 
credit quality of the 
instrument / of the 
counterparty 

Ability to compare and rank 
different instruments 
/counterparties according to 
their credit risk 

Limitation of negative effects 
such as  pro-cyclicality 

Transparency 

No (only in specific cases e.g. loan covenant) 

Medium to High (a sophisticated approach combining several measures 
has proven to be demonstrably superior) 

Financial ratios are informative of credit risk. Financial ratios can e.g. 
measure earnings and operating performance, leverage and short-term 
liquidity of the firm. These indicators are linked to the probability to 
default on debt obligations and to the availability of assets to make 
payments.  

Financial ratios are one of the indicators used by credit rating agencies, 
but they make up only part of the information which is examined as 
other factors play a role as well. 

Medium 

Needs financial skills to compare across sectors 

Low across countries (different accounting rules) 

Medium 

Because of potential divergence of opinions when interpreting the same 
financial ratios, the risk of herding behaviour is limited. 

There are however around whether accounting rules themselves could be 
pro-cyclical. It is e.g. said that with market value accounting, increases 
in asset prices during economic booms means stronger capital for 
financial institutions, which, in turn, fuels demand for these assets and a 
further increase in their prices46. 

Medium – providing data is available publicly, financial ratios can easily 
be calculated. There is however a need to be aware of the underlying 
accounting rules. 

Suitability of the alternative 
for supervisory purposes  

Low – difficulty to have a consistent framework across sectors and 
countries 

Acceptability  

Low for regulatory purposes  

Low for investment decisions 

High in contracts 

Cost of using the alternative 
for supervisors 

Medium - data is often available publicly but requires skills for 
interpretation 

Cost of using the alternative 
for market participants 

Medium - data is often available publicly but requires skills for 
interpretation 

46 Jean-Pierre Landau, Deputy Governor of the Bank of France (2009), Remarks at the 
Bank  of  Spain's  conference  on  Procyclicality  and  the  Role  of  Financial  Regulation; 
Madrid, 4 May 2009. http://www.bis.org/review/r090805d.pdf 

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3.3.3  Third part assessments (non-commercial): OECD Country Risk 

Classifications  

OECD Country Risk Classifications were developed by the OECD in an effort to align 
premiums charged by different export credit agencies for the same country, and avoid 
subsidisation. There are eight categories (from the least risky 0 to the riskiest 7). A 
given country is reviewed “whenever a fundamental change is observed and at least 
once a year”.   

However, country risk classifications cannot be interpreted in the same way as 
sovereign risk classifications. OECD Country Risk Classifications are based on two 
dimensions47: 

(cid:121)  Transfer and convertibility risk (i.e. the risk that a government will impose 
capital or exchange controls that prevent an entity from converting local 
currency into foreign currency and/or transferring funds to creditors located 
outside the country); and, 

(cid:121)  Cases of force majeure (e.g. war, expropriation, revolution, civil disturbance, 

floods, and earthquakes). 

OECD country risk classifications are based on a much narrower criteria than the 
sovereign ratings produced by CRAs. With its strong emphasis on political risk and risk 
related to capitals and exchange controls being imposed by the sovereign authorities, 
which would affect the private agent to convert local currency into foreign currency 
and/or transfer to non-resident creditors, they are more like transfer and convertibility 
risk indicators rather than default risk indicator. And indeed, the OECD clearly states 
that: “The country risk classifications are not sovereign risk classifications and should 
not, therefore, be compared with the sovereign risk classifications of private credit 
rating agencies (CRAs). Conceptually, they are more similar to the "country ceilings" 
that are produced by some of the major CRAs.”  

3.3.3.1  Strengths 

Expertise of the OECD. The OECD possesses high country expertise and often has 
unique access to national authorities.  As such the OECD is very well placed to gather 
and analyse wide range of data and qualitative information, which may not be 
available to CRAs or investors.  

Current acceptability for regulatory purposes. Under CRR, banks have the possibility to 
use OECD country classifications (or the credit assessment of an Export Credit Agency 
provided this agency subscribes to the OECD agreed methodology, its assessment is 
published and can be translated into one of the eight OECD categories) to derive risk 
weights (see article 137 (2) CRR). A similar approach is in place in the US. 

Overall good country coverage. OECD Country Risk Classifications currently cover 140 
countries48 (against 132 by S&P49).  

3.3.3.2  Weaknesses 

Not a measure of sovereign credit risk. OECD country risk classification does not 
intend to take into account the risks associated with the fiscal situation of the 
government (i.e. the risk of default); it measures purely the country risk. While for 
some countries, country risk and sovereign credit risk are broadly equivalent, in other 
countries, the difference coming from the assessment of the fiscal situation can be 
quite large. 

47 http://www.oecd.org/tad/xcred/crc.htm 
48 http://www.oecd.org/tad/xcred/cre-crc-current-english.pdf 
49 https://www.standardandpoors.com/en_US/web/guest/entity-browse 

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Potential political pressure. Assessments performed by an international institution like 
the OECD is perceived as potentially being subject to political pressure exercised by 
the members of the organisation while issuing ratings of sovereign bonds.  

Application limited to sovereign debt. The OECD is relatively well placed to assess 
country risk but it would be outside its mandate to assess risk of municipal, structured 
products or corporate debt orphaning those credit buyers.  

Not covering High Income OECD and High Income Euro Area countries since 2013. 
Prior to that date, high Income OECD and High Income Euro Area countries were 
automatically assigned to the Country Risk Category Zero, without the Country Risk 
Classification Methodology being applied to them. As the methodology was not 
regarded as being applicable to them (not designed for reserve currency countries), 
this automatic classification was terminated to avoid create any confusion, especially 
in a context where the country risk classification continues to be used as an indicator 
of sovereign credit risk50. 

Table 11.  Detailed feasibility assessment – OECD country risk classification 

Criteria  

Applicability  

Coverage 

A functioning alternative 
according to market 
participants 

Reliability & accuracy of the 
alternative in signalling the 
credit quality of the 
instrument / of the 
counterparty 

Ability to compare and rank 
different instruments 
/counterparties according to 
their credit risk 

Limitation of negative effects 
such as  pro-cyclicality 

Assessment 

Sovereign debt 

Many countries with the  exception of High Income OECD and High 
Income Euro Area countries  

Yes (with some limitations however), especially by public sphere players 

Market participants were less prone to use OECD country risk 
classification / have an opinion on that matter 

No the large limitation is that the OECD country risk classification, by 
definition, does not take into account the risks associated with the fiscal 
situation of the government:  it is not intended to measure the sovereign 
credit risk but rather the country credit risk 

High to compare and rank country credit risk 

Low to compare and rank sovereign credit risk 

Medium 

For regulatory purposes, replacing reliance on external ratings with 
another single measure would not serve the intended purpose: the aim is 
not to align the opinions of all market participants but rather to maintain 
a diversity of opinions. 

The results of a research report by RATINGPLATFORM, an initiative 
supported by the European Association of Credit Rating Agencies 
(“EACRA”)51 tend to suggest that the OECD country classification and the 
CRA ratings exhibit similar transition rates (i.e. changes of assessments 
across the business cycle).  

50 For more information, see http://www.oecd.org/tad/xcred/cat0.htm 
51  RATINGPLATFORM  (2014)  "Sovereign  Assessments:  Comparison  between  the  Sovereign 
Ratings  of  12  CRAs  and  the  OECD  Country  Risk  Classification  -  ECAI  rules  and  Risk  Weights 
analysis" 

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Criteria  

Transparency 

Assessment 

Medium. The methodology behind the OECD country risk classification is 
explained in much detail in the document called the Arrangement (see 
article 25)52. However the OECD publishes the results of the classification 
without any accompanying reports. The deliberations of the group of 
country risk experts assigning the ratings remain confidential. 

Suitability of the alternative 
for supervisory purposes  

High 

Acceptability  

High for regulatory purposes (CRR and US experience) 

Cost of using the alternative 
for supervisors 

Cost of using the alternative 
for market participants 

Medium for investment decisions 

Medium in contracts 

Low (check the box approach) 

Low (publically available free of charge) 

3.3.4  Third party assessments (non-commercial): Scoring / assessment by 

Central Banks 

Central credit registers (CCRs) and central financial statements databases (CFSDs) are 
central databases owned or managed by central banks collecting, processing and 
analysing credit exposure (in case of CCRs) and credit quality of counterparties to 
which banks are exposed (in case of CFSDs) respectively.  

They work under a more or less compulsory regime by which contributors must abide. 
Input data are based on primary information from creditors for CCR and public 
information in the case of CFSD. They are used mostly for corporate debt products. 
Central banks produce ratings based on the information collected in analysis process 
combining human thinking (judgmental rating) and computer processing (automated 
rating). As they allow / advise, these should be primarily used to determine eligibility/ 
non-eligibility status to trade bills and other corporate debt instruments. In some 
countries, the usage is wider and includes the prudential review of banking portfolios 
or additional input for the creditworthiness analysis conducted by credit institutions. 
Both are typically updated on a monthly basis. 

3.3.4.1  Strengths 

Expertise and credibility of the CBs. The central banks have high credit analysis 
expertise and credibility. 

3.3.4.2  Weaknesses 

Limited country coverage. Not all countries have fully operational CCRs and CFDS53. 
The ECB is working towards establishing a Euro area level central credit register by 
the end of 2017, the so-called analytical credit dataset or AnaCredit54.  

Limited asset coverage. They are also limited in application to corporate debt, and in 
some countries there is only negligible coverage of non-financial corporations.  

52 
http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?doclanguage=en&cote=tad/
pg(2015)7 
53 For an overview of European credit reporting systems, see Nicola Jentzsch* (2007) Do we 
need a European Directive for Credit Reporting? Available at: 
http://www.ecri.eu/new/system/files/55+CESIFO_Reportdicereport2007.pdf (Table 1) 
54 ECB(2015) Financial Integration in Europe. Available at: 
https://www.ecb.europa.eu/pub/pdf/other/financialintegrationineurope201504.en.pdf 

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Limited access to the data. Sometimes significant data protection obligations in 
respect of corporate/personal information held on the CCRs and CFSDs may also 
constrain the access to the data. In fact, the CFSDs and CCRs remain unavailable to 
many market participants in many countries.  These findings from interviews have 
been confirmed by a recent fact-finding mission concluding the o CCR raw data often 
remains restricted for supervisory purposes55. The FIBEN56, the French Central Credit 
Register provided by the Bank of France, has only recently expanded its access to 
non-banking institutions and insurers.  

Possible competition with the private sector. Private vendors sometimes provide 
similar services to CFSDs (e.g. Dun & Bradstreet). 

Limited cross-country comparability. The CCRs and CFSDs may still differ substantially 
from country to country due to different reporting populations, partial coverage (i.e. 
interbank lending, collateral, currency, and maturity), non-harmonised concepts and 
definitions (i.e. concept of exposure, definition of maturity) or different thresholds for 
reporting (between EUR 0 and EUR 1.5 million) used by many European central banks. 
Consequently, it makes the latter unlikely to be very useful in assessing the 
creditworthiness of smaller entities handling smaller transactions (i.e. SMEs).  

Assignment of a rating only in a few cases. Finally, while the classification of the risk 
of default used by CRAs (AAA, BBB, etc.) and its common understanding is an 
undisputable advantage of external credit ratings, CCRs very rarely provide a similar 
feature. One of the exceptions is the French CCR (FIBEN) which also assigns the credit 
ratings with a simple and easily understandable rating scale57. The EIB is also said to 
be involved in the development of a common methodology for the credit scoring of 
midcaps and SMEs, building on the information which will be available following EU 
level initiatives. The idea is to produce a scoring which would limit the sovereign risk 
bias across borders to focus on the fundamentals of the rated companies and grant 
access to key corporate and credit data on SMEs58.  

Table 12.  Detailed feasibility assessment: Scoring / assessment by CB 

Criteria 

Applicability  

Coverage 

A functioning alternative 
according to market 
participants 

Reliability & accuracy of the 
alternative in signalling the 
credit quality of the 
instrument / of the 
counterparty 

Assessment 

(cid:121)  Corporate debt 

Varies from country-to-country, not for smaller entities because of too 
high thresholds in some countries 

Expected to improve as from 2018 with AnaCredit 

Yes where available and accessible 

This is considered as viable alternative especially by public sphere 
players as market participants were less prone to have access to it yet.

Having a European version of those systems which exist in some 
countries is planned for end 2017.  

Medium 

Data is considered as highly reliable. Some further analysis by the user 
is encouraged. 

55 Violetta Damia and Jean-Marc Israël (n.d.) Standardised granular credit and credit risk data. 
Available at: http://www.bis.org/ifc/events/7ifcconf_damia_israel.pdf (page 4) 
56 http://www.fiben.fr/  
57 From 3++,3+,3 ,4+,4 ,5+,5 ,6 ,8 to 9 where 3++ stands for 0.00% default and failure rate 
and 9 for default  

58 Eurofi (2014) Stimulating EU corporate bond and equity markets. Available at: 
http://www.eurofi.net/wp-content/uploads/2014/09/Stimulating-EU-corporate-bond-Web.pdf 

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Ability to compare and rank 
different instruments 
/counterparties according to 
their credit risk 

Limitation of negative effects 
such as  pro-cyclicality 

High within one system, low across countries 

Expected to be high with AnaCredit 

Medium 

Can be considered as one input to the internal rating system 

Transparency 

Suitability of the alternative 
for supervisory purposes  

Medium 

Medium 

Acceptability  

Medium for regulatory purposes 

Medium for investment decisions 

Medium in contracts 

Cost of using the alternative 
for supervisors 

Cost of using the alternative 
for market participants 

Low 

Low 

3.3.5  Third party assessments (commercial): Automated scorings based on 

computational models 

Other third party scorings include those produced e.g. by D&B or new players such as 
BIPE. Unlike external ratings, third party scorings are based purely on computational 
models and therefore cheaper to produce. Unlike the vendor solutions mentioned 
above, they consist of buying a rating, the output of an assessment process, and not 
the tool to produce the rating itself. 

3.3.5.1  Strength 

Important for ESIs / SMEs in the context of their greater access to the financial 
markets. The importance of having such scorings available is currently seen as critical 
in the context of an increasing number of ESIs / SMEs in Europe needing to access the 
financial markets and the development of Euro PP. 

Quality dependent on scope of input data, increasing with the inclusion of sectoral 
data. The quality of the scoring necessarily depends on the input data on which it is 
based. One important criteria seems to include information on the sector in which the 
scored SMEs are active, since compared to larger companies, SMEs are typically more 
dependent on the sector in which they are active. 

3.3.5.2  Weaknesses 

More backward looking and entirely based on quantitative data. One downside which 
was raised is that they are backward looking and do not take into account qualitative 
information. They can predict default but not long before it happens and were 
therefore seen as more adequate for short term investors. Long term investors, on the 
other hand, need ratings which look five years ahead like the external ratings.Credit 
scorings of such types are useful / have a purpose to serve e.g. for short term 
investors. However, for long term investments, the indication they provide are not 
very helpful; good at picking up default just before it happens but that it is irrelevant 
for longer term investors who need to predict five years ahead. 

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Table 13.  Detailed feasibility assessment: Other third party scoring 

Criteria \ Alternative 

Other  third party scoring 

Applicability  

(cid:121)  Corporate debt 

Coverage 

(cid:121) 

Focus on small and mid caps, to be an alternative to external ratings 
where these are not available / too expensive 

A functioning alternative 
according to market 
participants 

Reliability & accuracy of the 
alternative in signalling the 
credit quality of the 
instrument / of the 
counterparty 

Ability to compare and rank 
different instruments 
/counterparties according to 
their credit risk 

Limitation of negative effects 
such as  pro-cyclicality 

No (except for small and mid caps) 

Medium 

Varies across providers 

Based only on quantitative information 

Medium (only among small and mid caps) 

Medium 

For regulatory purposes, replacing reliance on external ratings with 
another single measure would not serve the intended purpose: the aim is 
not to align the opinions of all market participants but rather to maintain 
a diversity of opinions. 

Transparency 

Suitability of the alternative 
for supervisory purposes  

Medium 

Medium 

Acceptability  

Low for regulatory purposes 

Low for investment decisions (large caps), medium for investment 
decisions (small and mid caps)  

Medium in contracts 

Cost of using the alternative 
for supervisors 

Low 

Cost of using the alternative 
for market participants 

Low 

3.3.6  Third party assessments (commercial): ratings produced by registered 

and certified credit rating agencies as recognized by ESMA 

CRAs issue creditworthiness opinions to help overcome the information asymmetry 
between those issuing debt instruments and those investing in these instruments. 
They carry out analyses and issue opinions on the probability of default or expected 
losses of companies ("corporate credit ratings") and governments ("sovereign credit 

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ratings59"). They also rate more complex financial products, including structured 
finance products60.  

All of the major CRAs use an alphabet based rating scale, the highest and safest being 
AAA, with lower grades moving to double and then single letters (AA or A) and down 
the alphabet from there (B, C and D). Although grading between the CRAs may differ 
slightly (i.e. Ba1 in Moody’s corresponds to BB+ in S&P and Fitch), in general the 
symbols and associated definitions are very similar, for the sake of simplicity, 
comparability and transparency61.  

A credit rating is a relative measure of risk, i.e. BB is a higher risk than A, but lower 
than BBB. It is not intended to be an absolute measure of risk; therefore, it does not 
mean that a specific rating, e.g. BBB, which for structured finance securities has had 
an average default rate of 0.18 per cent between 1987 and 2007, is a mathematical 
prediction of the future probability of default62. 

3.3.6.1  Strengths 

Independence and objectivity. In theory, CRAs provide the market with an objective 
and independent evaluation of a borrower or security’s creditworthiness. However, the 
impartiality of CRAs came under sharp scrutiny during the financial crisis as it became 
apparent that the issuer-pays model was resulting in conflict of interest and thus, 
undermining rating independence – see the sub-section on disadvantages below. 

Comparability. CRAs measure risk in a consistent way, across geographic and product 
segments. This makes it easy for investors to compare different potential investments.  
The common language function was cited as one of the most important benefit of CRA 
ratings by various market participants interviewed.  It is also the main reason, why 
references to CRA ratings are widespread in financial contracts, particularly 
investment mandates. For some agents, even the inclusion of contractual references 
to external ratings is seen as rational, either driven by client demands (for 
transparency purposes); or demands by industry players, i.e. asset manager, external 
manager / portfolio managers, who want to secure access to accurate information.   

Transparency. Ratings are publicly available. Moreover, the underlying rating 
methodologies are also typically publicly available. Since the financial crisis, CRAs 
have undertaken additional measures to enhance transparency such as organising 
meetings with companies and investors to explain their methodology, providing more 
information and supporting research/ narrative so market participants can see the 
underlying analysis and justification behind a particular rating, making more 
methodological documentation available on their websites  

Cost effectiveness. CRAs benefit from economies of scale when evaluating credit risk. 
This benefit was mentioned often by small insurance and asset management 
companies who do not have the resources or the expertise to invest in internal 
approaches. 

Reliability. It was suggested by market participants that CRAs have access to more 
and better data, in particular more access to the management of the rated entities. A 
few interviewees even indicated that the rating agencies assessments are more 
credible as compared to other approaches. CRAs typically publish regular (quarterly 
and/or annual) reports providing data on accuracy and stability of their ratings. This 
contributes to building trust and confidence in CRA ratings.  

59 Sovereign ratings include ratings of countries, regions and municipalities. 
60  European  Commission  (2009)  Commission  Staff  Working  Paper  -  Impact  Assessment  
SEC(2011) 1354 
61  System  of  grading  used  by  CRAs  has  been  sometimes  criticised  for  too  simplistic  approach 
which does leave enough room for nuanced categorisation.   
62 ESME (2008) Role of Credit Rating Agencies, ESME’s Report to the European Commission 

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Added value offered by CRAs. Market participants explained that they value the 
analysis provided by CRAs and see this as a key component of their added value.  

Regulatory acceptability. As previously mentioned in section 2, there remain 
references to CRA ratings in key European regulations, particularly CRR / CRD IV and 
Solvency II.  These references de facto assign a quasi-regulatory status to CRA 
ratings. CRA ratings thus, have a high level of regulatory acceptability. 

Disadvantages 

Conflict of interest. The financial crisis highlighted the conflict of interest inherent in an 
issuer-paid model (before 1974 the rating agencies were paid by the investors). By 
accepting payment from an issuer, a rating agency potentially sacrifices its 
independence as it has a vested interest in the success of a bond/ debt offering and in 
the welfare of the issuer. CRAs argue that preservation of their reputational capital 
prevent them from issuing high ratings in order to secure business.  And that rating 
decisions are made by committees, not individual analysts, and that employees are 
not compensated based on their ratings. 

Ratings through the cycle. One of the biggest criticisms of rating agencies is that they 
are reluctant to make rating changes based on cyclical considerations even though the 
number of default rises during recessions. At the same time, a switch in approach 
would reinforce pro-cyclicality. 

Sluggishness. A related criticism is that CRAs often lag behind events. This may be 
reflective of the fact that ratings do agencies do not offer frequent monitoring of each 
issuer. While the agencies will look at a company once or twice a year, a credit analyst 
at a financial intermediary will monitor daily developments at each company s/he 
covers 

Credibility issues. Trust and confidence in CRAs has been significantly dented since the 
2008-09 financial crisis as structured finance products, which were initially rated 
investment grade were sharply downgraded later on. In the US, the scale, magnitude 
and timing of the downgrade of these mortgage backed securities were extraordinary. 
In the third quarter of 2007, CRAs downgraded US$ 85 billion ‘worth’ of mortgage 
backed securities, followed by US$ 237 billion in the fourth quarter, an additional US$ 
739 billion in the first quarter of 2008 and US$ 841 billion in the second quarter of 
2008. Overall, US$ 2 trillion ‘worth’ of previously top-tier ‘AAA’ rated mortgage backed 
securities were downgraded to a ‘subprime’ or ‘junk’ status in a short span of 12 
months63. In 2007, as US housing prices began to tumble, Moody's alone downgraded 
83 percent of the US$ 869 billion in mortgage backed securities it had rated at the 
AAA level in 200664. 

Pro-cyclicality of CRA ratings. Since CRA ratings are used for regulatory purposes and 
embedded in capital requirement legislation, rating agencies’ widespread downgrades 
in recessions raise capital requirements, creating a negative spiral. Procyclical effects 
are also generated by having references to external credit ratings in contracts, which 
brings inflexibility and entails systemic risk. 

Contagion effect of ratings. It has been empirically proven that rating agencies’ 
opinions independently affect market spreads. As argued by Grande and Presley65, 
downgrades of sovereign rating in one country may result in repercussions in another. 

63 Barnet-Hart, K. (2009) The story of the CDOs Market Meltdown: an empirical 
analysis. Available at: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-
CDOmeltdown.pdf 
64 Segoviano, M., Jones, B., Lindner, P. and Blankenheim, J. (2013) Securitization: 
Lessons Learned and the Road Ahead, IMF working paper, WP/13/255. Available at: 
http://www.imf.org/external/pubs/ft/wp/2013/wp13255.pdf 
65 Gande, A., and D.C. Parsley, 2005. News spillovers in the sovereign debt market, Journal of 
Financial Economics, 75, 691–734. P. 12  

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An event study analysis by Cantor and Packer66 shows that the announcements of 
changes in the agencies’ sovereign risk opinions are followed by statistically significant 
bond yield movements in the expected direction. In other words, ratings’ downgrades 
have a direct effect on access to credit and borrowing costs.   

More recent studies by the International Monetary Fund67 or the European Central 
Bank68 confirm the above. The IMF study found that sovereign rating downgrades 
have statistically and economically significant spillover effects both across countries 
and financial markets. In other words, rating agencies downgrades were found to have 
fuelled financial instability during the European debt crisis. In addition, the ECB study 
specifically examined the issue of causality between ratings changes and yields/CDS 
spread over the short-term and concluded that there is “two-way causality”. This tend 
to illustrate that although rating agencies are lagging behind markets in their 
judgment regarding sovereign bonds, they still amplify negative spirals 

Costs. SMEs are not willing to pay for a rating by the CRAs as it is too expensive 
compared to the size of their issuance. 

Anglosaxon view and restricted focus on financial parameters only. A Nordic financial 
association argues that the Anglosaxon view of companies of CRA is also a problem. 
Their ratings focuses on credit risk only and do not look at other parameters like 
business model, job creation, environmental criteria, long term value that the 
company creates for society and different stakeholders: many big investors – such as 
labour market pension funds – look for more diverse information from a company, in 
particular on their environmental and societal approach. 

Table 14.  Detailed feasibility assessment: ratings produced by registered and 
certified credit rating agencies  as recognized by ESMA 

Criteria \ Alternative 

Assessment 

Applicability  

Coverage 

(cid:121) 

(cid:121) 

(cid:121) 

(cid:121) 

Sovereign debt 

Corporate debt (of large companies) 

Structured products 

Wide coverage but for corporates- mainly cover big companies 

66 Cantor, R. and Packer, F. 1996, Determinants and Impact of Sovereign Credit 
Ratings. Federal Reserve Bank of New York. Economic Policy Review / October 1996 
67 Arezki, R. Candelon, B. & Sy, A. (2011), Sovereign Rating News and Financial 
Markets Spillovers: Evidence from the European Debt Crisis. IMF Working Paper. 
WP/11/68. Available at: https://www.imf.org/external/pubs/ft/wp/2011/wp1168.pdf  
68 Afonso, A., Furceri, D. and Gomes, P. (2011) Sovereign Credit Ratings And Financial 
Markets Linkages Application to European Data. ECB Working Paper Series No 1347 / 
June 2011 

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Criteria \ Alternative 

Assessment 

A functioning alternative 
according to market 
participants 

N/A 

Reliability & accuracy of the 
alternative in signalling the 
credit quality of the 
instrument / of the 
counterparty 

High for corporates69 

Low/ Medium for sovereigns70 and structured finance71 

The referenced literature shows how sovereign ratings repeatedly failed 
to anticipate sovereign crisis. It also showed ratings for structured 
finance performed badly for structured finance during the last financial 
crisis, while performance for corporates remained high. 

Prior to the 2007/08 subprime market turmoil and resulting financial 
crisis, the confidence in the reliability of external ratings was higher. 

The confidence in CRA ratings remains higher for corporate ratings 
(compared to sovereigns and structured finance). Corporate ratings are 
perceived as traditional business segment of CRAs, where they have 
more experience and methodological expertise. 

Ability to compare and rank 
different instruments 
/counterparties according to 
their credit risk 

Perceived as high by market participants. This is especially true that 
CRAs use the same rating scale across asset classes. This is however 
challenged by the academic literature72, which highlights that structured 
products typically receive more generous ratings. 

Limitation of negative effects 
such as  pro-cyclicality 

Low 

CRAs have designed their methodology to produce through the cycle 
ratings. This should in theory limit pro-cyclical effects. 

The pro-cyclical effects of external ratings mainly comes from their 
embeddedness into legislation and contracts. It forces market 
participants to rely on one single measure and suppresses the diversity 
of opinions. 

Transparency 

High 

The methodology of CRAs is available to users and CRA ratings are 
accompanied by a detailed research report. 

Suitability of the alternative 
for supervisory purposes  

High 

CRA ratings have largely been embedded into legislation across 
jurisdictions. 

Acceptability  

High for regulatory purposes  

High for investment decisions 

High in contracts 

69 See for instance: Efraim Benmelech, Jennifer Dlugosz (2010) The Credit Rating Crisis. 
Available at: http://www.nber.org/chapters/c11794.pdf 
70 See for instance: Bhatia AV (2002). Sovereign Credit Ratings Methodology: an Evaluation. 
IMF Working Paper 02/170, IMF. Available at: 
https://www.imf.org/external/pubs/ft/wp/2002/wp02170.pdf 
71 See for instance: Committee on the Global Financial System (2008), CGFS Papers No 32 
Ratings in structured finance: what went wrong and what can be done to address shortcomings? 
Available at: http://www.bis.org/publ/cgfs32.pdf 
72 See for instance: Cornaggia, Jess and Cornaggia, Kimberly Rodgers and Hund, John, Credit 
Ratings across Asset Classes: A Long-Term Perspective (November 10, 2015). Available at 
SSRN: http://ssrn.com/abstract=1909091 or http://dx.doi.org/10.2139/ssrn.1909091  

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Criteria \ Alternative 

Assessment 

Cost of using the alternative 
for supervisors 

Low 

Cost of using the alternative 
for market participants 

Low (with the limitation that users are typically expected to pay for 
subscriptions) 

3.4  Summary overview 

The table below provides summarises the above discussion with respect to the relative 
strengths and weaknesses of CRA ratings and alternative approaches. 

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Table 15.  Summary of the relative strengths and weaknesses of different approaches to credit risk assessment 

Criteria  

Alternative approaches 

 CRA ratings 

In house analysis 

Market based measures Accounting based 

Applicability to 
different asset 
classes 

Coverage 

High - can be applied to all 
asset classes 

(cid:121)  Sovereign/ sub-
sovereign debt 

(cid:121)  Corporate debt 

(cid:121)  Structured finance 

products 

Investors/ financial 
institutions’ can adapt 
coverage to their needs 

High - can be applied to all 
asset classes, although 
there are some limitations 

Suitable for highly liquid 
instruments (corporate 
debt, structured finance 
products)  

Instruments that are traded
on the markets 

measures 

Limited – applicable to 
corporate / sub-
sovereign debt 
(although similar ratios 
can be calculated at a 
sovereign level e.g. 
debt to GDP ratio) 

High 

Databases such as 
Amadeus cover a vast 
majority of EU 
enterprises 

Sovereign/ sub-
sovereign  data is 
typically available 
publicly (national 

OECD country 
risk 

Central Credit 
Registers 

Limited – 
applicable to 
sovereign debt only

Limited –  
applicable to 
corporate debt only

High - can be applied 
to all asset classes 

Many countries 
except High 
Income countries 

Limited - very few 
Member States 
have such registers

Expected to 
improve as of 2018 
with AnaCredit 

High – sovereign/ 
structured finance  

Limited coverage of 
sub-sovereign 

Limited coverage of 
corporate debt – 
CRAs mainly cover 
large companies and 
those accessing 
capital markets via 
public issues 

N/A 

A functioning 
alternative to CRA 
ratings according to 
market participants 

Yes 

No (seen as a 
complementary measure) 

No (only in specific 
cases e.g. loan 
covenants) 

Yes  (with some 
limitations) 

Yes, where 
available and 
accessible 

(EU level version 
planned for end 
2017) 

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Criteria  

Alternative approaches 

 CRA ratings 

In house analysis 

Market based measures Accounting based 

Reliability & accuracy  Empirical data is not 

available to independently 
determine reliability and 
accuracy, but logically 
speaking it should be high 

Perceived to be low due to 
high levels of volatility 

High within the same 
internal system 

High 

Medium across systems 

measures 

Accounting measures 
in isolation would be 
insufficient to predict 
default 

Medium 

Low across countries 

Ability to compare 
and rank different 
instruments 
/counterparties 
according to their 
credit risk 

Limitation of negative 
effects such as  pro-
cyclicality 

High – as  internal 
approaches would most 
likely yield different results 
across investors/ financial 
institutions and there will 
also be differences in 
interpretation of data 

 Low – due to risk of herding 
behaviour 

Medium– as there will 
be differences in 
interpretation of data 

Transparency 

Low to the outsider, 

High 

Medium 

Medium to the supervisor 

Suitability of the 
alternative for 
supervisory purposes 

High 

Medium 

Low 

OECD country 
risk 

Central Credit 
Registers 

A measure of 
country risk; not 
sovereign risk 

Not possible to 
make a judgement 
on basis of available 
information 

High for corporates 
and sovereigns  

Low for structured 
finance 

High within one 
system, low across 
countries 

Expected to be high 
with AnaCredit 

Low within one 
country; but high  

Perceived as high by 
market participants, 
but challenged by the 
academic literature73 

Low – the financial 
crisis provided 
evidence of herding 
behaviour and cliff 
effects if ratings are 
used in a mechanistic 
way 

High - country 
credit risk 

Low - sovereign 
credit risk 

Medium– as there 
will be differences in 
interpretation of 
data (OCED shows 
country risk; 
investors will have 
to draw their own 
conclusions as to the 
extent to which it 
corresponds to 
sovereign risk) 

High 

High 

Medium 

High 

High 

High 

73  See  for  instance:  Cornaggia,  Jess  and  Cornaggia,  Kimberly  Rodgers  and  Hund,  John,  Credit  Ratings  across  Asset  Classes:  A  Long-Term 
Perspective (November 10, 2015). Available at SSRN: http://ssrn.com/abstract=1909091 or http://dx.doi.org/10.2139/ssrn.1909091  

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Criteria  

Alternative approaches 

 CRA ratings 

In house analysis 

Market based measures Accounting based 

Acceptability  

High for regulatory 
purposes  

High for making investment 
decisions 

Medium in contracts 

Low for regulatory purposes 

Low for investment 
decisions 

Low in contracts 

measures 

Low for regulatory 
purposes  

Low for investment 
decisions 

High in contracts 

OECD country 
risk 

Central Credit 
Registers 

High for regulatory 
purposes (CRR and 
US experience) 

Medium for 
investment 
decisions 

Medium in 
contracts 

Medium for 
regulatory purposes

High for regulatory 
purposes  

Medium for 
investment 
decisions 

Medium in contracts

High for investment 
decisions 

High in contracts 

Cost of using the 
alternative for 
supervisors 

High- supervisors have to 
approve internal 
approaches 

Low 

Low 

Low 

Low 

Low 

Cost of using the 
alternative for 
market participants 

High for investors/ lenders 
(although there are some 
less costly options such as 
vendor solutions) 

Low for borrowers 

Low for all market 
participants 

Low for all market 
participants 

Low for all market 
participants 

Low for all market 
participants 

High for issuer 

Low to medium for 
investor/ lender – 
ratings are freely 
available, but market 
participants have to 
obtain paid 
subscriptions in order 
to use   

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4 

The US experience 

In 2010, the Dodd Frank Act was passed, which requires all U.S. agencies to remove 
references to external credit ratings in their legislation. This section describes the U.S. 
experience of implementing the Dodd-Frank Act with the aim of drawing lessons for 
Europe. 

4.1  The Dodd-Frank Act 

4.1.1  The key provision of the Dodd Franck Act related to external credit 

ratings 

In the US, the foundation legislation strengthening financial regulatory rules in the 
aftermath of the financial crisis is the Dodd-Frank Wall Street Reform and Consumer 
Protection Act74, which was signed in July 2010.  Section 939A of the Dodd-Frank Act 
was intended to reduce regulatory overreliance on external ratings. It instructed all 
Federal Government agencies to review all regulations that required the “the use of an 
assessment of the creditworthiness of a security or money market instrument” and to 
modify such regulations so as “to remove any reference to or requirement of reliance 
on credit ratings (…)”. The statutory date for action was one year after the date of 
enactment (i.e. July 21, 2011). 

The regulation aims to reduce the influence of the three largest CRAs in determining 
which securities could and could not be bought (invested in) by prudentially regulated 
institutions.  The main federal agencies that are affected by this mandate are the Fed, 
the OCC, the FDIC, the NCUA, the SEC, the CFTC, and the DOL. 

Table 16 summarises the market segments for which these federal agencies have 
regulatory and/or supervisory responsibilities. 

Table 16.  Overview of federal supervision of key financial services sectors 

Market segment 

Responsible federal agency 

Banks 

The Federal Reserve Board (Fed), the Federal Deposit Insurance 

Corporation (FDIC) and the Office of the Comptroller of the 
Currency (OCC) collectively have responsibility for regulating 
and supervising the activities of the banking sector. 

National Credit Union Administration (NCUA) is also involved. 

Securities and Exchange Commission (SEC) 

Commodities Futures Trading Commission (CFTC)  

Investment firms, 
investment managers, 
broker-dealers, money
market mutual funds 

Occupational pensions  The Department of Labor (DOL) 

Insurance / 
reinsurance 

The insurance industry is regulated at a state rather than 
federal level, and so exempt from Article 939A of the Dodd-
Frank Act.  However, there is support for a reduction in reliance 
on CRAs, and state-level regulatory review is coordinated by the 
National Association of Insurance Commissioners (NAIC)75 

Central counterparties  The Securities and Exchange Commission (SEC) and the 

Commodities Futures Trading Commission (CFTC)  

Other 

The Federal Housing Finance Agency 

74 Available at: http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf  
75  Whilst  the  insurance  industry  is  regulated  at  a  state  level  in  the  US,  NAIC  provides 
coordination functions in terms of standard-setting and regulatory support 

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4.1.2  Regulatory developments prior to the enactment of the Dodd-Frank Act 

Prior to the enactment of the Dodd Franck, most federal agencies were using CRA 
ratings in their investment rules and, to some extent, capital rules (although the 
reference to rating in capital rules -typically the largest set of regulation for the 
banking regulation - were not as embedded in US regulation as in Europe).  

Beginning with banks in 1936, and expanding since then, the major CRAs’ ratings 
started being woven into government prudential regulation of US financial institutions  
In 1936, federal bank regulators mandated that commercial banks—if they wanted to 
invest in bonds—could invest only in investment grade bonds; they could not invest in 
speculative (i.e., high-risk) bonds. The determination of what constituted “investment 
grade” was specified with reference to “recognised rating manuals” or in simple words, 
CRA ratings. 

This decision by federal bank regulators is understandable. A central regulatory 
function of bank regulation is “prudential regulation”: the regulatory effort to keep 
banks solvent. If a bank were to invest in bonds, the prudential regulator would want 
the bonds to be “safe”. Apparently, the federal regulators believed that the major 
CRAs’ ratings were reliable and could accurately distinguish between investment grade 
and speculative bonds. In this context, “outsourcing” this safety determination to the 
CRAs made sense and probably economized on the regulators’ own resources, because 
these determinations wouldn’t have to be made in-house by the regulators 

During the following decades, the state regulators of insurance companies also began 
to incorporate the major CRA ratings into their prudential regulation of their respective 
insurance companies. In 1975, the SEC revised its “net capital” rule for broker-dealers 
(i.e., securities firms); this was, essentially, prudential regulation of these firms. The 
capital levels that the SEC required broker-dealers to maintain were linked to the 
safety of the assets in the broker-dealers’ portfolios as determined by CRAs’ ratings: 
Higher-rated securities were considered to be safer and therefore required less capital. 

Similarly,  in 1991 the SEC mandated that bonds and other debt instrument that were 
held as assets by money market mutual funds (MMMFs) had to have a CRA rating of 
AAA/Aaa or AA+/Aa1.  And the DOL, in its regulation of pension funds, has imposed 
similar suitability restrictions. 

Thus, as a general matter, this regulatory reliance meant that prudential regulators 
were effectively relying on the CRAs’ ratings for prudential regulatory purposes. This 
reliance provided an easy “tick-the-box” way for the banks to demonstrate that they 
were meeting this safety requirement and for the prudential regulators to ascertain 
that the banks were meeting the requirement. But this reliance also meant an 
assumption that the CRAs’ judgments were generally correct.   

With respect to securitisation, there were no direct regulatory requirements that 
involved ratings. However, getting high ratings was very important for the profitability 
of the issuers/packagers in the securitisation process and regulation of many bond 
buyers (through capital requirements, and suitability) influenced the demand for the 
bonds and thus the issuers'/packagers' profitability (see Box 2). 

Box 2: The case of securitisation  

The importance of the ratings for profitability of the issuers/packagers in the 
securitization process prior to Dodd Franck is illustrated below 

a) The issuers'/packagers' profit came from the difference between the price that they 
paid for the mortgages and the price that they received for the packaged bonds/securities 
that they sold.  Other things being equal, higher rated bonds could be sold at a higher 
price. 

b) Because of lower regulatory capital requirements on higher-rated bonds, regulated 
bond buyers were willing to pay higher prices for higher-rated bonds. 

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c) Because of regulatory suitability requirements, higher ratings meant that more 
regulated entities would be eligible to buy. 

d) Because of internal guidelines as well as marketing/promotional positioning for some 
institutions, such as bond mutual funds ("We invest only in AAA bonds!"), higher rated 
bonds would be more attractive to some institutions that were not regulated with respect 
to their capital or with respect to suitability. 

Accordingly, ratings were at "the center of the world" for the securitization process, even 
though there were no regulatory requirements that directly involved ratings for 
securitization. 

4.1.3  Implications of the Dodd Frank Act 

In an important sense, the Dodd-Frank requirement that the prudential regulators 
move away from the mandated uses of ratings for the determination of suitability is 
relatively easy.  For instance, banks make a wide variety of loans that do not involve 
CRAs’ ratings.  These categories include: residential mortgage loans, credit card loans, 
loans to small and medium-sized business, etc. Instead of relying on the “external” 
CRA ratings (which don’t exist) for judgments about the suitability of these kinds of 
loans, the banks typically collect information about the borrower and make internal 
assessments as to whether to grant the loan: i.e., whether the loan is “suitable” for 
the bank.  The information that is used may be generated internally or a bank may 
make use of information about the borrower that has been obtained from third parties 
(e.g., credit scores).  And prudential regulation in this context involves an examination 
of the bank’s “rulebook” for the origination of these kinds of loans and some sampling 
of actual loans that have been made to check whether they do indeed conform to the 
rulebook. 

Prudential regulatory scrutiny is necessary, of course, because the bank might be 
inclined to have a riskier standard for “suitability”, since (under a legal system of 
limited liability for the owners of a corporation) the bank’s owners get all of the 
“upside” from risk-taking, whereas they are limited (because of limited liability) in 
their exposure to the downside consequences.  The bank prudential regulator’s 
standard for suitability should be taking into account the full downside consequences, 
including any systemic effects. 

In this context, the effort to move away from regulatory reliance for the purposes of 
determining the suitability of bonds for a bank’s portfolio is not all that radical.  In 
essence, it is asking the banks to do for bonds what they have already been doing for 
other (unrated) loans that they make:  Use their internal data gathering and 
assessment processes – perhaps supplemented by some externally supplied 
information (for bonds, this could be CRAs’ ratings) – to make their suitability 
decisions with respect to the bonds that they choose to hold in their portfolios.  And 
prudential regulation similarly should involve checking the “rulebook” that the bank 
develops for the suitability of bonds and sampling some bonds to determine whether 
they conform to the rulebook.  In addition, the prudential regulator should be asking 
the bank to justify its choice of external supplier of information. 

The “leap” may be a bit greater for MMMFs, which have tended to invest only in short-
term rated debt securities.  But, in principle, the senior management of any MMMF 
should have been using the CRA ratings of a debt security only as an input into the 
decision as to whether any specific debt security was suitable for that MMMF.  Under 
the new regime, the primary focus for senior management will have to be on 
suitability (not “tick the box”); and, again, external ratings can be an input into that 
decision. 

The same kind of leap may be present for securities firms and other kinds of regulated 
institutions (e.g., by the CFTC or the SEC), where issues such as suitable collateral for 

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transactions were previously being specified in terms of the CRAs’ ratings and now will 
have to be specified in terms of more nuanced assessments.  But, again, the CRAs’ 
ratings can continue to be an input into that suitability assessment; but, also again, 
the primary focus for senior management decisions (and for regulators’ assessments 
of those decisions) will have to be on suitability and not on “tick the box”. 

Since regulators (and their regulated institutions) had been using ratings for decades 
prior to the Dodd-Frank mandate to cease the tick-the-box reliance on ratings, there is 
likely to be a transition period – which could extend for years, since long-standing 
“culture” will have to be modified – during which the institutions and the regulators 
will have to figure out how to ascertain suitability in a way that is more nuanced than 
just “tick-the-box”.  During this transition period there will surely be various 
suggestions for the kinds of inputs – internal and external – that should enter the 
suitability decision.  Among the external sources of information, in addition to external 
ratings, can be credit spreads, reports by debt analysts (e.g., who are employed at 
securities firms), etc.  There may well be a “trial-and-error” process whereby various 
ideas for ascertaining suitability are suggested – and some succeed, while others fall 
by the wayside. 

The important thing is that a prudentially regulated financial institution should have a 
reasoned basis for its suitability decision process, including its choice of the kind of 
information that is used as an input into that decision process and its choice of the 
specific source for that information; and the prudential regulator should have a 
reasoned basis for its oversight of those decisions and choices. 

In principle, the same considerations apply to the issue of the use of ratings for the 
determination of banks’ capital requirements.  In an important sense, capital 
requirements are just a more nuanced version of suitability.  A suitability requirement 
establishes a lower bound on what is appropriate for a bank to hold.  But, above this 
lower bound, there can be gradations in the riskiness of “suitable” assets that capital 
requirements should be taking into account.  

If prudential regulatory capital requirements for banks are to steer clear of any 
mandated use of ratings, then there are two possible tracks that could be followed: a) 
The regulator develops for all banks a “standardized” model of assets and their 
riskiness (including the cross-correlations of risk across assets) and specifies the 
appropriate capital levels that accompany those assets (again, including their cross-
correlations); information that would be used to ascertain riskiness could include 
external ratings; or b) In addition to the standardized model, larger, more 
sophisticated banks might be able to provide their own models – subject, of course, to 
regulatory scrutiny. 

Again, a crucial concept is that the bank has to have a reasoned basis for its 
determination of its capital requirements; and the regulator has to have a reasoned 
basis for its review of those capital levels.  And, also again, because of limited liability, 
the bank’s owners will tend to favor skimpier capital levels than should a prudential 
regulator that is taking into account the full consequences of adverse outcomes for a 
bank. 

And, finally, just as will be true for the transition to suitability standards that are not 
mandated by ratings, the transition to capital requirements that do not involve 
regulatory reliance on ratings will involve changes in culture and will require time; and 
a “trial-and-error” process is likely to be involved. 

However, an extra complication is that the BCBS wants to continue its use of ratings in 
the determination of banks’ capital requirements for the prospective “Basel III” 
prudential regulatory framework.  And U.S. prudential regulators are supposed to be 
in conformance with the BCBS – but also in conformance with the Dodd-Frank 
mandate to eliminate regulatory reliance on ratings (see also section Table 6). 

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4.2  Implementation of Article 939A of the Dodd-Frank Act 

Study findings confirm that by end 2015, the federal agencies have largely met the 
Dodd-Franck obligation to remove regulatory the implementation of Article 939A of the 
Dodd-Frank Act. The timing initially foreseen by the Dodd-Frank Act, extremely 
ambitious, was not respected, rulemaking deadlines have often been met with delays 
(after 2011), but after five years spam, most rules have now been finalised. 

The latest changes relate to the SEC's recent elimination of references to NRSROs in 
the regulation of money market mutual funds (MMMFs).  This was considered as one 
of the major areas where a federal government regulatory agency was "dragging its 
feet".   

The U.S. Department of Labor (DOL), as the regulator of pension funds, now remains 
as the sole large federal area where such references have not been withdrawn.  The 
rule remains in the proposal stage since 2013. 

Table 6 presents an overview of the implementation of Article 939A of the Dodd-Frank 
Act. A complementary annex goes into the details of each identified rule 

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Table 17.  Summary of federal regulatory changes implementing Article 939A of the Dodd-Frank Act 

Regulation by 

Related piece of legislation 

Final 
rule 

Proposed 
rule 

Summary  

The Office of the 
Comptroller of the 
Currency (OCC) 

Alternatives to the Use of External Credit 
Ratings in the Regulations of the OCC, 
Final rule, Federal Register / Vol. 77, No. 
114 (June 13, 2012) 

Securities and 
Exchange 
Commission (SEC) 

Security Ratings Release No. 33–9245; 
34–64975; File No. S7–18–08 (September 
2, 2011) 

Securities and 
Exchange 
Commission (SEC) 

Removal of certain references to credit 
ratings under the Securities Exchange Act 
Of 1934. Release No. 34-71194 (Jan. 8,  
2014) 

(cid:57) 

(cid:57) 

(cid:57) 

(cid:121)  Banks need to make their own assessments of a 

security’s creditworthiness 

(cid:121)  Guidance note published to assist the banks in 

their due diligence process 

(cid:121)  The risk is to be determined by the credit quality, 
the complexity of the structure and the size of the 
investment 

(cid:121)  Replace security ratings with alternative 

requirements for securities offering or issuer 
disclosure rules 

(cid:121)  Forms S–3 and F– 3 will no longer refer to 

security ratings by an NRSRO 

(cid:121)  Relates to the minimum regulatory capital 
requirements applicable to broker-dealers 

(cid:121)  The eligibility of asset classes for haircuts are no 

longer based on credit ratings 

(cid:121)  Non-exhaustive and non-mutually exclusive list of 

alternatives:  

-  Credit spreads  

-  Securities-related research  

- 

Internal or external credit risk assessments  

-  Default statistics  

- 

Inclusion on an index  

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Regulation by 

Related piece of legislation 

Final 
rule 

Proposed 
rule 

Summary  

Securities and 
Exchange 
Commission (SEC) 

Removal of Certain References to Credit 
Ratings Under the Investment Company 
Act Release Nos. 33–9506; IC–30847 
(February 7, 2014) 

Securities and 
Exchange 
Commission (SEC) 

Removal of Certain References to Credit 
Ratings and Amendment to the Issuer 
Diversification Requirement in the Money 
Market Fund Rule. Release No. IC-31828 
(Sept. 16, 2015) 

-  Priorities and enhancements  

-  Price, yield, and/or volume  

-  Asset class-specific factors  

(cid:57) 

(cid:121)  Replaces reference to required NRSRO credit 

ratings in rule 5b–3 for certain held by funds as 
collateral for repurchase agreements with an 
alternative standard that is designed to retain a 
similar degree of credit quality 

(cid:121)  Eliminates the use of NRSRO in Forms N–1A, N–

2, and N–3  

(cid:121)  Adopts a credit quality standard  

(cid:57) 

(cid:121)  Addressed to Money Market Fund 

(cid:121)  Provisions which would remove references to 
credit ratings and establish the eligibility of a 
security as one that has been determined to have 
minimal risk 

(cid:121)  Any money market fund which invests in 

securities subject to a guarantee will carry a 10% 
diversification requirement on the part of the 
guarantor as well as a 5% diversification 
requirement for the issuer. 

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Regulation by 

Related piece of legislation 

Final 
rule 

Proposed 
rule 

Summary  

The Commodity 
Futures Trading 
Commission (CFTC) 

Investment of Customer Funds and Funds 
Held in an Account for Foreign Futures 
and Foreign Options Transactions, 76 FR 
78776 (Dec. 19, 2011)  

Removing any reference to or reliance on 
Credit Ratings in Commission Regulations; 
Proposing alternatives to the use of credit 
ratings, 76 FR 44262 (July 25, 2011)  

The National Credit 
Union 
Administration 
(NCUA) 

Alternatives to the Use of Credit Ratings, 
77 FR 74103 (Dec. 13, 2012)  

(cid:57) 

(cid:57) 

(cid:57) 

The Federal Housing 
Finance Agency 
(FHFA) 

Removal of References to Credit Ratings 
in Certain Regulations Governing the 
Federal Home Loan Banks, 78 FR 30784 
(May 23, 2013)  

(cid:121)  Changes to the list of permitted investments  

(cid:121)  Clarification of the liquidity requirement  

(cid:121)  Removal of rating requirements 

(cid:121)  Expansion of concentration limits including asset-

based, issuer-based, and counterparty 
concentration restrictions 

(cid:121)  Federal agencies should establish “uniform 

standards of credit worthiness” for use by the 
respective agencies 

(cid:121) 

Implements alternatives and appropriate 
standards of determining credit worthiness 

(cid:121)  Credit institutions should conduct and document 

internal and external credit analyses to determine 
that an issuer of financial instruments holds a 
certain capacity to meet its financial requirements 

(cid:121)  Credit union may consider any of the following 
factors: credit spreads, securities related 
research, default statistics, inclusion of an index, 
priorities and enhancements, price, yield, and 
volume, as well as asset class-specific factors 

(cid:57) 

(cid:121)  Removes a number of references and 

requirements affecting the Federal Home Loan 
Banks and adopts new provisions that require 
Banks to apply internal analytic standards and 
criteria to determine creditworthiness of a 
security or obligation  

(cid:121)  Removes references and requirement related to 
credit rating agencies contained in the capital 

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Regulation by 

Related piece of legislation 

Final 
rule 

Proposed 
rule 

Summary  

Office of the 
Comptroller of the 
Currency (OCC) and 
Board of Governors 
of the Federal 
Reserve System 
(FED) 

Regulatory Capital Rules: Regulatory 
Capital, Implementation of Basel III, 
Capital Adequacy, Transition Provisions, 
Prompt Corrective Action, Standardized 
Approach for Riskweighted Assets, Market 
Discipline and Disclosure Requirements, 
Advanced Approaches Risk-Based Capital 
Rule, and Market Risk Capital Rule. Final 
Rule. Federal Register / Vol. 78, No. 198 
(October 11, 2013) 

regulations applicable to the Banks 

(cid:121)  Banks determine that a security has a level of 

credit risk that is equivalent to or less than that 
of outstanding consolidated obligations before the 
security can be used to fulfil the negative pledge 
requirement 

(cid:121)  Use of credit standards collectively developed by 
the Banks in consultation with the Office of 
Finance. 

(cid:121)  Requires Bank to maintain a rating of at least the 

second highest from an NRSRO 

(cid:57) 

(cid:121)  Revise their risk-based and leverage capital 
requirements for banking organizations 

(cid:121)  Country Risk Classifications (CRC) as a basis for 
new risk-based capital requirements, instead of 
sovereign ratings 

(cid:121)  Zero percent risk weight to exposures for certain 

Supranational Entities and Multilateral 
Development Banks 

(cid:121)  The percentage risk weight for different financial 

asset was determined 

(cid:121)  Alternatives to credit rating  were considered for 

corporates but seen as having significant 
drawbacks, such as operational complexity, or 
insufficient development 

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Regulation by 

Related piece of legislation 

Final 
rule 

Proposed 
rule 

Summary  

The Federal Deposit 
Insurance  

Corporation (FDIC) 

Permissible Investments for Federal and 
State Savings Associations: Corporate 
Debt Securities Federal Register /Vol. 77, 
No. 142 (July 24, 2012) 

The Federal Deposit 
Insurance  

Corporation (FDIC) 

The Department of 
Labor (DOL) 

Regulatory Capital Rules: Regulatory 
Capital, Implementation of Basel III, 
Capital Adequacy, Transition Provisions, 
Prompt Corrective Action, Standardized 
Approach for Risk-weighted Assets, 
Market Discipline and Disclosure 
Requirements, Advanced Approaches 
Risk-Based Capital Rule, and Market Risk 
Capital Rule, FIL-18-2014 (April 25, 2014)

Proposed Amendments to Class Prohibited 
Transaction Exemptions to Remove Credit 
Ratings Pursuant to the Dodd-Frank Wall 
Street Reform and Consumer Protection 
Act, 78 FR 37572 (June 21, 2013)  

(cid:57) 

(cid:57) 

(cid:121)  Prohibits insured savings associations from 

acquiring or retaining a corporate debt security 
unless the issuer has adequate capacity to meet 
all financial commitments  

(cid:121)  Federal and state savings associations are 

allowed to invest only in corporate debt securities 
that meet creditworthiness standards established 
by the FDIC 

(cid:121)  External credit assessment must be 

supplemented with due diligence processes and 
analyses 

(cid:121)  Relates to the risk-based and leverage capital 
requirements for FDIC-supervised institutions 

(cid:121)  Changes are technical revisions designed to 

ensure that the rule conforms to the final rules 
issued by the FED and the OCC 

(cid:57) 

(cid:121)  Requires the Department to remove any 

references to or requirements of reliance on 
credit ratings and use appropriate alternatives to 
determine creditworthiness 

(cid:121)  Affects the employee benefit plans including 
participants and beneficiaries, fiduciaries, 
financial institutions that engage in transactions 
with, or provide services or products to, the plans 

(cid:121)  Numerous factors should be considered when 

conducting when assessing the creditworthiness 

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Regulation by 

Related piece of legislation 

Final 
rule 

Proposed 
rule 

Summary  

National Association 
of Insurance 
Commissioners 
(NAIC)# 

Source: list compiled by ICF 

Note # not a federal agency but provides national coordination of state-level insurance regulation 

of a financial instruments or establishments 

(cid:121)  Alternatives to consider follow the 
recommendations of the SEC 

(cid:121)  Established a Rating Agency Working Group 

evaluate state-level regulatory use of the credit 
ratings76.   

(cid:121)  NAIC reports that it has eliminated a reliance on 
credit ratings provided by rating agencies for 
residential and commercial mortgage-backed 
securities but still continues to rely on rating 
agencies for other asset classes. (see box The 
case of the insurance sector in the US) 

76 http://www.naic.org/cipr_topics/topic_rating_agencies.htm  

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4.3  Analysis of the proposed alternatives in the US context 

The table below summarises the formulations and alternatives which have been 
adopted by the federal agencies to actually remove the regulatory references to 
external ratings. 

Table 18.  Overview of alternatives 

Alternative proposed 

Description 

Vague formulation, 
including vague 
formulations referring to 
the situation existing prior 
the removal of references 
to external credit ratings  

(cid:121) 

(cid:121) 

“use of appropriate alternatives to 
determine creditworthiness” 

investing only in “a security 
determined to have minimal risk”  

(cid:121)  use of “an alternative standard that 

is designed to retain a similar 
degree of credit quality”  

(cid:121)  need to have a reasonable belief that it 

would have been eligible according to 
the rules in existence prior to the new 
rules 

Comments 

Quite subjective 

Reference to a benchmark 

(cid:121)  a security which has a “level of credit 

Quite subjective 

Promotion of internal 
analyses and guidance on 
how to conduct sound 
internal assessment 
processes  

risk that is equivalent to or less than 
that of outstanding consolidated 
obligations”  

(cid:121)  Example of list of factors to 

consider: 
-  Credit spreads  
-  Securities-related research  
- 

Internal or external credit risk 
assessments  
-  Default statistics  
- 
-  Priorities and enhancements  
-  Price, yield, and/or volume  
-  Asset class-specific factors  

Inclusion on an index  

Refresher of due 
diligence best 
practices, capacity 
building 

OECD Country Risk 
Classifications (CRC) 

A 100 percent risk weight 
for all 

(cid:121)  Guidance available in 

documentation, publications, 
articles, videos produced by the 
federal agencies 

for new risk-based capital 
requirements (US implementation of 
Basel III) 

Instead of sovereign ratings, for non-
US sovereigns 

for new risk-based capital 
requirements (US implementation of 
Basel III) 

For corporate exposure 

US Simplified Supervisory 
Formula Approach (US 
SSFA)  

for new risk-based capital 
requirements (US implementation of 
Basel III) 

Lack of frequent 
update 

Limited coverage 

May overstate the 
credit risk 
associated with 
some high-quality 
bonds. 

No risk sensitivity. 

Not compliant with 
Basel III 

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For securitisation exposure, use of 
standardised risk weights and actual 
delinquency rates of the underlying 
asset pool. 

(cid:121)  Note: for example of outreach and guidance documents, see for instance the material 

produced by the FDIC : 

(cid:121)  Video on Evaluation of Municipal Securities:  

https://www.fdic.gov/regulations/resources/director/technical/municipal.html  

(cid:121)  Supervisory Insights Journal Article on credit risk analysis and Chapter on 

Investment Securities in Examination manual:  
https://www.fdic.gov/regulations/capital/investments/resources.html  

(cid:121)  FDIC Guidance from 2009 on risk management of structured credit products:  

https://www.fdic.gov/news/news/financial/2009/fil09020.html  
(cid:121)  1998 Interagency Guidance on Securities and End-User Derivatives:  

https://www.fdic.gov/news/news/financial/1998/fil9845.html   

4.4  The US approach and the international standards 

Following the Dodd Franck Act, new rules issued do not promote sole and 
mechanistic reliance, even when implementing international standards that do 
heavily refer to ratings. For example, an OCC, FED and FDIC regulation, 
namely Liquidity Coverage Ratio: Liquidity Risk Measurement Standards 
Federal Register Vol. 79, No. 197 (October 10, 2014), implements a 
quantitative liquidity requirement consistent with the liquidity coverage ratio 
standard established by the BCBS, but without references to ratings as a 
standard of creditworthiness, or a standard to distinguish hiqh-quality liquid 
assets.  

Although U.S. regulators have made efforts to demonstrate that their non-
ratings-based approach to capital requirements is the rough equivalent of the 
ratings-based Basel III framework, it is far from clear as to how this conflict 
will eventually be worked out. 

The Basel III regulatory consistency assessment for the US77 indicates that 
there is some data, albeit limited, suggesting that on average the US 
alternatives produce higher risk weights - and therefore higher capital 
requirements - than the Basel ratings-based approaches. In one area however, 
namely securitisation, the US agencies have been judged as materially non-
compliant with the Basel framework. 

4.5  Remaining regulatory references to ratings in the US 

The DOL is the federal agency which is not in conformity with Article 939A of 
the Dodd-Frank Act by end 2015. Beyond that, there remains some scattered 
references to ratings in some remaining federal bank and securities regulations 
but they merely specify that ratings can be one potential source of information 
amongst others and mention there should not be any sole and mechanistic 
reliance.  

More worryingly, references to ratings remain within State level rules, which 
were not covered by the Dodd Franck Act and which govern several important 
areas such as investment by public funds as well as state banking regulations, 

77 Available at: http://www.bis.org/bcbs/implementation/l2_us.pdf 

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as listed under the recent ESMA technical advice report78. The insurance sector 
is another example regulated by state rules where references to ratings 
remain. Plans which were initiated to reduce overreliance on credit ratings in 
the insurance sector have only been partially implemented (see Box 2). 

Box 3: The case of the insurance sector in the US 

Insurance in the United States historically has been and currently is regulated 
at the state level. There can be an element of federal regulation (because 
some agencies like the SEC promulgate rules for certain financial transactions 
no matter what kind of institution engages in it and because of the potential 
systemic risks), but it remains so far tangential. State regulators coordinate 
through the National Association of Insurance Commissioners (NAIC), a 
voluntary not for profit association of the insurance commissioners of the 50 
states, the District of Columbia, and the U.S. territories.  

The situation of the insurance sector in the US is fairly unique as for decades, 
there has been functioning public entity emitting credit rating for the sector. 
The Securities Valuation Office (SVO), an organization within the NAIC created 
in 1907, has been charged with assessing the credit risk of insurance company 
investments. The SVO maintains its own ratings called designations. The SVO 
is remunerated via a fee charged to the insurance companies on their 
issuances. Insurance companies have to use the designation in reporting back 
to regulators.  

Little by little over the last decades however, regulators opted for underusing 
the existing rating capability the NAIC had and increased reliance on credit 
ratings. This is notably illustrated in the 2004 "filing exempt" rule (FE Rule), 
authorising, for certain securities, the mechanic conversion of a CRA rating 
(produced by a recognised agency called NRSRO in the US) into a SVO 
designation.  

The main types of assets which are rated by the SVO nowadays are those 
which are not rated by external credit agencies (unrated corporate bonds, 
unrated municipal/ state debt). 

Following the crisis, regulators re-broadened the mandate NAIC to move away 
from ratings as far as structured financed securities are concerned. In 2009, 
the NAIC initiated its Structured Securities Project, which aimed at developing 
a new methodology to determine RBC requirements for the residential (RMBS) 
and commercial (CMBS) mortgage-backed securities held by insurers. The 
chosen approach to implement this project is an “outsource and oversight 
model”, whereby vendor which provides the assessment from which 
designations are derived, with the NAIC in charge of the quality assurance and 
oversight.  

Insurance regulators thus continue to rely on rating agencies for many asset 
classes (except for those unrated securities by the SVO, and RMBS and CMBS) 

More ambitious calls for reforms made in the aftermath of crisis to reinforce 
the capacities of the SVO/ expand its mandate or transform it into an NAIC-
run / state regulated rating entity (which would have applied for the NRSRO 
recognition) were later abandoned. 

Additionally, in the insurance sector, several pieces of legislation still drive the 

78 ESMA. 2015. Technical Advice on reducing sole and mechanistic reliance on external credit 
ratings. Available at: https://www.esma.europa.eu/system/files/esma-2015-
1471_technical_advice_on_reducing_sole_and_mechanistic_reliance_on_external_credit_ratings
.pdf  

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use of external ratings, including:  

- State investment laws that impose limits on types of assets investors can 
invest in and define investment grade securities in terms of external ratings 

- NAIC and state capital requirements which foresee higher capital charges on 
lower rated assets. 

- Credit for reinsurance laws which indicate that for lower rated, more 
collateral is required. 

4.6  Changes in market practices and impact of the Dodd Frank Act 

US interviewees were generally of the opinion that the regulatory changes 
made following the Dodd Franck Act had limited impact on the market 
participants. It was not its primary objective either. 

Similar to the picture painted in the EU, it was claimed that many market 
participants were already doing their own assessment even prior to the 
regulatory changes and that they were making a sensible use of ratings.  

Some interviewees however recognised that Dodd Franck act was a wake-up 
call for some players who, despite being already supposed to make their own 
due diligence, were not meeting their obligations prior to the crisis. 

Another finding is that the impact of the regulatory changes are different 
depending on the size of the financial institutions. Schematically, the impacts 
are as follows: 

(cid:121)  W.r.t. to their investment portfolio, smaller banks have an incentive to shift 
to safe assets – treasury bonds or local securities which are backed by a 
guarantor.  

(cid:121)  Intermediate players opt for outsource their credit risk assessment to 

specialist firms. 

(cid:121)  Larger banks do their own analysis and pay additional efforts to 

documenting their processes, with most of the changes made in the 
securitisation business. 

In terms of contractual references to ratings, this was not an area which was 
targeted by Dodd Franck and not an area over which regulators can have 
control, according to the message conveyed by interviewees. Some 
interviewees acknowledged these references could potentially lead to liquidity 
problems, while others did not find supportive evidence for risks of cliff effects 
and herding behaviours. It is recognised that contractual references to ratings 
are used e.g. by asset owners to define the investment universe or in 
reinsurance contracts saying e.g. that if the reinsurer is downgraded below a 
certain level, there is a need for full collateralisation. Quoted mitigating factors 
were similar to ones in the EU (see section 3). 

Generally the feeling in the US is the same than in the EU: building up internal 
credit risk assessment processes is the natural alternative to reliance on credit 
ratings and beyond that, there are not many alternatives. This relative lack of 
alternatives is said to lead, to some extent, to a switch in regulatory focus, 
from looking for alternatives to reforming the NRSRO market. 

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5  Main findings and conclusions 

The scale and scope of application of external credit ratings 

External credit ratings (mainly CRA ratings) are used extensively by market 
participants for a range of purposes, most notably:  

(cid:131) 

Investment and risk management 

o  Making investment and lending decisions; 

o  Assessing and monitoring credit /counterparty risk; 

o  Signalling creditworthiness (bond issuers, borrowers); 

o  Determining collateral eligibility, haircuts and margins (Central 

Banks and CCPs); 

o  Communicating and reporting of risk; 

(cid:131)  Regulatory purposes (e.g. determining capital requirements, monitoring 

systemic risk); 

(cid:131)  Contractual purposes (see the section below on contractual references 

to external ratings). 

The use of external credit ratings for investment and risk management 

External credit ratings – by providing independent, objective and comparable  
assessment of credit/ counterparty risk – play an important role in reducing  
information asymmetries between borrowers and lenders/ investors, but they 
are rarely used in isolation by market participants when making investment or 
lending decisions.  The weight placed on external ratings depends on the 
sector, size and sophistication of the market participant and the types of 
products that they invest in.  

  Sector  

External ratings do not play an important role in credit institutions’ lending 
business as many of their clients are not externally rated.  External ratings 
however, are used to varying degrees in their investment or security deposit 
businesses. 

In the insurance sector - where credit risk assessment is not the core purpose 
of these undertakings - the use of external ratings is relatively common as it is 
not considered feasible for insurance/ reinsurance undertakings (except 
perhaps for the larger ones) to invest in internal credit risk analysis.  

Similarly, the use of external ratings is quite common within the asset 
management sector – particularly among smaller players and those investing in   
‘plain vanilla’ products. 

CCPs tend to conduct their own internal analysis to determine counterparty 
creditworthiness and collateral eligibility. External ratings are used by them for 
comparison and quality assurance. 

Size 

Larger financial market participants typically conduct their own internal credit 
risk assessment, using external ratings as an input into or as a reference point 
for complementing/ cross-checking their own analysis; whereas smaller, less 
sophisticated players tend to rely more heavily on external credit ratings due to 
lack of resources and expertise to invest in internal approaches. 

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Asset class 

The use of external ratings is typically more prevalent in the case of sovereign 
bonds and structured finance products (although for latter, reliance on external 
ratings has reduced since the financial crisis). 

Regulatory and contractual references to external ratings 

References to external credit ratings continue to be embedded in a number of 
regulatory and contractual provisions throughout the financial system: 

(cid:121)  References to external ratings still remain within key  EU sectoral 

legislation, namely CRR/ CRD IV (banking sector) and the forthcoming 
Solvency II Directive (insurance/ re-insurance sector), although measures 
have been introduced to reduce sole and mechanistic reliance on ratings. 

(cid:121)  Outside of EU legislation, references to external ratings can be found in: 

─  The Eurosystem Credit Assessment Framework and the collateral 

assessment framework of several national central banks; 
─  Private contracts such as such as investment guidelines and 
mandates, bond documentation, prospectuses, collateral 
agreements, credit agreements and loan covenants. 

The extent to which the use of external ratings is driven by regulatory 
references or market practices varies by sector. For example: 

(cid:121)  For banks and insurers, the main drivers for using external  are to comply 

with regulatory requirements (most notably, capital requirement 
calculations) and for accessing finance from capital markets; 

(cid:121)  Within the asset management sector, the use of external ratings is driven 
by market practice and contractual references as investors/ asset owners 
prefer the common language function of external ratings. 

Alternatives to external credit ratings 

There exist a wide range of alternative approaches and measures to CRA 
ratings:  

(cid:121)  Internal measures and ratings (purely model based or incorporating 

human judgement); 
(cid:121)  Market implied ratings; 
(cid:121)  Accountancy-based measures;  
(cid:121)  Third party assessments conducted by non-commercial entities such as 

the OECD and Central Banks as an alternative to CRA ratings. 

The table below summarises the main findings of this study with respect to the 
current scale and scope of application of each of these alternatives. It also 
provides a high level assessment of the feasibility of using a particular 
alternative as a substitute for CRA ratings. 

Table 19.  Mapping and feasibility assessment of alternatives 

Alternative 

Current scale and scope of 
application 

Feasibility of replacing CRA 
ratings with the alternative 

Internal 
measures and 
ratings 

(cid:121)  Widely used by market 

participants (particularly in 
the banking sector) in 
assessing credit risk of 
counterparties and 

High, although following issues 
need to be taken into 
consideration 

(cid:121)  Costs – costs may not be 

justified for small investors 

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Alternative 

Current scale and scope of 
application 

securities 

(cid:121)  Can be applied to all asset 

classes 

(cid:121)  CRR/ CRD IV and Solvency 
II allow the use of internal 
rating based approaches 

(cid:121)  Internal ratings and 

measures are also already 
being used in financial 
contracts, albeit to a limited 
extent  

Feasibility of replacing CRA 
ratings with the alternative 
or those investing in plain 
vanilla products 

(cid:121)  Regulatory barriers – 

banking and insurance 
regulation disincentivises 
participants from using 
internal measures and 
ratings for regulatory 
purposes 

(cid:121)  Market practices – 

investors’ preferences for 
using external ratings in 
financial contracts 

Market implied 
ratings 

Accountancy-
based measures 

(cid:121)  Limited application- 

essentially used as an early 
warning signal / monitoring 
tool by market participants.

(cid:121)  The study did not find any 
examples of application in 
financial contracts 

(cid:121)  Not very suitable for 

regulatory purposes such as 
determining capital 
requirements 

Application is also limited to 
certain instruments – liquid 
bonds and securities 

These are complementary 
measures 

Market based measures are not 
seen as substitutes to external 
credit ratings, for various reasons 
including reflection of information 
beyond credit risks, pro-
cyclicality, risk of moral hazard, 
short term nature, volatility, 
limited coverage and need to 
consider other types of 
information. Rolling averages are 
not considered as a way to 
mitigate all those downsides 

(cid:121)  Are already being used as 
an input – particularly by 
banks – in assessing credit/ 
counterparty risk 

(cid:121)  Application limited to 

corporate debt and sub-
sovereign entities 

(cid:121)  There are examples of use 
of accountancy based 
measures in financial 
contracts (instead of CRA 
ratings) 

These can be used as 
supplementary information for 
investment and risk management 
purposes as new corporate 
issuers may not have historical 
data to enable informed decisions

Can be used as alternatives to 
CRA ratings in financial contracts

Not very suitable for regulatory 
purposes 

OECD country 
risk classification

(cid:121)  Application is limited to 

sovereign debt 

(cid:121)  Even so, current usage is  

very limited 

Central Credit 
Registers 

(cid:121)  Application limited to 

Can be used as a complementary 
source of information for 
sovereign debt, rather than an 
alternative as it does not 
measure default risk 

This is considered as viable 
alternative if market participants can 

  December 2015 

83

 
 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

Alternative 

Current scale and scope of 
application 

corporate debt 

Feasibility of replacing CRA 
ratings with the alternative 
be provided access 

(cid:121)  Very limited use as these 
exist in only a handful of 
Member States 

Having a European version of those 
systems is planned for end 2017 

The overriding conclusion of this study is that there are a range of alternatives 
that are currently being used by market participants, either as complementary 
tools or as substitutes for CRA ratings. The range of available approaches 
means that CRA ratings need not be the default choice of regulators or market 
participants.  Each approach –including CRA ratings – has certain strengths and 
weaknesses in specific contexts and applications. Both, regulators and market 
participants should therefore, be encouraged to adopt the most suitable tool or 
combination of tools based on a consideration of their needs and circumstances, 
as well as the relative strengths and weaknesses of available approaches. 

  December 2015 

84

 
 
 
Study on the Feasibility of Alternatives to Credit Ratings 

doi:10.2874/370060 

ISBN: 978-92-79-50590-4