External Credit Assessment Institutions
From Wikipedia, the free encyclopedia
Under the Basel II Accord framework for international banking regulation (developed by the Basel Committee on Banking Supervision), banks are permitted to choose between two broad methodologies for calculating their capital requirements for credit risk (that is, how much money they must set aside to balance the risk carried by their financial portfolio). One of these methodologies measures credit risk in a standardized manner, supported by "external credit assessments" made by certain qualifying credit rating agencies, referred to as "External Credit Assessment Institutions" (ECAIs). (The second methodology allowed under the Basel II Accord, which is subject to the explicit approval of the bank’s supervisor, would allow banks to use their internal rating systems for assessing credit risk.)
According to Part 2, Section II, Part B of the Basel II Accord, banking regulators must determine whether a given credit rating agency meets certain criteria before that CRA's ratings may be used for external credit assessments. These criteria (listed in Paragraph 91 of the Accord) include:
-
- Objectivity: The methodology for assigning credit assessments must be rigorous, systematic, and subject to some form of validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. Before being recognised by supervisors, an assessment methodology for each market segment, including rigorous backtesting, must have been established for at least one year and preferably three years.
- Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. The assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest.
-
- International access/Transparency: The individual assessments should be available to both domestic and foreign institutions with legitimate interests and at equivalent terms. In addition, the general methodology used by the ECAI should be publicly available.
-
- Disclosure: An ECAI should disclose the following information: its assessment methodologies, including the definition of default, the time horizon, and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the assessments, e.g. the likelihood of AA ratings becoming A over time.
-
- Resources: An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments. Such assessments should be based on methodologies combining qualitative and quantitative approaches.
-
- Credibility: To some extent, credibility is derived from the criteria above. In addition, the reliance on an ECAI’s external credit assessments by independent parties (investors, insurers, trading partners) is evidence of the credibility of the assessments of an ECAI. The credibility of an ECAI is also underpinned by the existence of internal procedures to prevent the misuse of confidential information. In order to be eligible for recognition, an ECAI does not have to assess firms in more than one country.
Paragraph 90 also states that banking regulators should ensure that supervisory process for recognising ECAIs should be made public to avoid unnecessary barriers to entry.
