Guidelines

Introduction

1. Authorised deposit-taking institutions (ADIs) and insurers use credit assessments provided by External Credit Assessment Institutions (ECAIs) recognised by APRA to determine the risk-based capital on their publicly rated credit exposures (including securitisation exposures).
2. APRA is responsible for determining whether an ECAI meets eligibility criteria for recognition, so that ADIs and insurers can use an ECAI’s risk assessment for the calculation of regulatory capital requirements.
3. These Guidelines set out the eligibility criteria APRA will use to assess an ECAI’s request for recognition, the application requirements, APRA’s mapping process and APRA’s ongoing review processes for direct recognition.
4. APRA notes that its recognition process is not prudential regulation and does not constitute licensing of ECAIs.
5. An ECAI wishing to discuss or seek recognition under these Guidelines should contact APRA at licensing@apra.gov.au.

Recognition

6. Recognition can occur in two ways:
   1. direct recognition, where APRA carries out its own assessment of an ECAI’s compliance with the eligibility criteria, or
   2. indirect recognition, where APRA recognises an ECAI without carrying out its own recognition process, relying instead on the (direct) recognition by another national supervisor.
7. An ECAI will need to seek direct or indirect recognition according to the arrangements outlined below.
8. For direct recognition, APRA will carry out its own assessment of an ECAI’s compliance with the eligibility criteria in Attachment 1 to these Guidelines.
9. For indirect recognition, while APRA will not carry out its own assessment of an ECAI’s compliance with eligibility criteria, it will look to ensure that a national supervisor applies robust recognition criteria and processes similar to those applied by APRA. Where APRA reaches the view that the eligibility criteria of the national supervisor are not sufficiently similar to APRA’s recognition criteria, the ECAI will need to seek direct recognition under these Guidelines.
10. Where an ADI or insurer intends to use the ratings produced by an Australian subsidiary/branch of an overseas-based ECAI that does not adhere to the processes and methodologies that are set by the directly recognised overseas entity, the local subsidiary/branch of the ECAI will need to seek direct recognition by APRA.
11. Where an ADI or insurer has an exposure domiciled in a G20 or EMEAP country1, it will be able to use the credit assessment of an ECAI recognised by the national supervisor in that country (applying the mapping of the ECAI’s ratings as determined by the national supervisor to the exposure in question).
12. ECAIs can be recognised by APRA at a group or subsidiary level. Where an ECAI can demonstrate that its subsidiary operations comply with practices and procedures at a group-wide level, it may be eligible for group recognition. Group recognition is needed for each market segment for which an ECAI is applying – see below. Group-level recognition does not, however, extend to joint ventures or affiliates.
13. ECAIs may be recognised on a limited basis (for example, by type of claims rated). ECAIs generally categorise rated institutions into three broad classes or market segments: structured finance (including securitisation); public finance (including sovereign and municipalities); and commercial entities (corporates and financial institutions). APRA does not require separate applications for recognition be made for each market segment unless processes and methodologies differ between them.
14. An ECAI seeking recognition must meet the application requirements in Attachment 2.
15. APRA expects an ECAI that it has recognised directly will continue to meet the eligibility criteria and that its methodologies and credit assessments remain appropriate over different periods of time and through changes in market conditions as set out in Attachment 3.

Mapping

16. The Basel Framework2 (Framework) requires national supervisors to assign an eligible ECAI’s assessments to the risk-weights under the standardised approach to credit risk. This mapping process should be objective and result in a risk-weight assignment that is consistent with the level of credit risk. For insurance, APRA will use the mapping process outlined here should an insurer seek to use the ratings of a rating agency not recognised by APRA and for which recognition is sought.
17. The Framework proposes a method for mapping in which supervisors evaluate the cumulative default rate (CDR) associated with all issues assigned the same credit rating. APRA has based its mapping on this method and the CDRs set out in the Framework. These provide an appropriate measure of the predictive power of credit assessments. While this means the mapping process is based on quantitative data, it also takes account of qualitative factors that influence comparability of CDRs across ECAIs.
18. While securitisation fits broadly within the mapping criteria set out in the Framework, adjustments need to be made. Specifically, CDRs may not be available or be the most appropriate reference for benchmarking securitisation assessments. As with the mapping of credit assessments, mapping of securitisation assessments should largely be based on quantitative data. APRA will consider data relating to default/impairment rates for different credit assessments and will work with an ECAI applicant to fully understand its approach.
19. Where relevant, APRA will publish its mappings in Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk and Prudential Standard CPS 001 Defined terms. Attachment 4 provides details on APRA’s mapping process.

Attachment 1 – Recognition criteria

1. The key purpose of the recognition criteria is to identify ECAIs that produce credit assessments of sufficiently high quality, consistency and robustness to be used by ADIs and insurers for regulatory capital purposes. APRA expects all criteria to be satisfied by an ECAI.
2. These recognition criteria apply for the purposes of both direct and indirect recognition. For indirect recognition purposes, APRA will consider whether the national supervisor that has recognised an ECAI applies similar recognition criteria and may, in addition, require an ECAI to explicitly demonstrate how it meets certain recognition criteria.

Objectivity

3. An ECAI should have a rigorous and systematic credit assessment methodology that is subject to internal validation. Assessments should be subject to ongoing review and be responsive to changes in financial condition. An assessment methodology for each market segment (including rigorous back-testing3) should have been established for at least one year, and preferably for three years, prior to recognition.
4. An ECAI should demonstrate that its methodology incorporates factors known to be relevant in determining an entity’s creditworthiness. This should be supported by statistical evidence that the methodology has produced accurate credit assessments in the past.
5. An ECAI should implement procedures which ensure its credit assessment methodology is applied consistently in the determination of all credit assessments for a particular market segment.
6. An ECAI should be able to demonstrate:
   1. it has quantitative evidence of the discriminatory power of its credit assessment methodology. This should include evidence from statistical techniques such as default studies and transition matrices which demonstrate the strength and predictive power of its credit assessment methodology
   2. it has processes to assess factors driving creditworthiness and to ensure these factors are incorporated into its credit assessment methodology, and
   3. it has procedures which ensure its credit assessment methodology is applied consistently in the determination of all credit assessments.
7. Quantitative evidence of consistency and predictive power will be considered an indicator of the objectivity of an ECAI’s credit assessment methodology. A proven track record is a good indication that methodological processes are sufficiently objective for the purposes of determining capital requirements under APRA’s prudential standards.
8. Where there is insufficient quantitative evidence to support the objectivity of an ECAI’s credit assessments, APRA will undertake further review of the credit assessment methodology process in order to be satisfied it is sufficiently objective.
9. APRA will verify that an ECAI validates its methodologies based on historical experience. The ECAI should demonstrate that the methods it uses in its quantitative assessment confirm the discriminatory power and consistency of its credit assessments over time and across market segments. The ECAI should also demonstrate that procedures are in place to ensure that systematic ratings errors highlighted by back-testing are incorporated into credit assessment methodologies and corrected.
10. An ECAI should have policies and procedures to ensure that its credit assessments remain appropriate over time and in different market conditions. The ECAI should be able to demonstrate that its processes:
    1. reliably detect changes in a rated entity that are large enough to potentially change its assignment to a credit risk rating category, and
    2. ensure that a credit assessment is revised when the change in an entity’s operating conditions is large enough to warrant a revision.
11. An ECAI should demonstrate it reviews each credit assessment at least annually.
12. An ECAI should be able to demonstrate at least one year of back-testing of its credit assessments has been undertaken. Back-testing should be undertaken for each market segment for which the ECAI is seeking recognition.

Independence

13. An ECAI should be independent and not be subject to political or economic pressures that may influence a credit assessment. 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 entity seeking a credit assessment may be perceived as creating a conflict of interest.
14. An ECAI should demonstrate it has:
    1. adequate safeguards to ensure its independence from ownership and to prevent external pressure or constraints from influencing the objectivity of a credit assessment
    2. an organisational structure that separates its credit assessment business from any other business (e.g. consultancy services)
    3. adequate safeguards to ensure independence from key customers and issuers
    4. an independent internal audit function or similar, and
    5. adequate written internal procedures, corporate governance rules, fee policies and, where relevant, an internal code of conduct.
15. An ECAI should demonstrate it has adopted, monitored and successfully applied internal procedures to ensure all credit assessments are determined consistently and objectively, particularly where conflicts of interest may arise.
16. An ECAI should also demonstrate it has mechanisms in place to identify actual and potential conflicts of interest and take reasonable measures to prevent, manage and eliminate such conflicts.

International access/Transparency

17. An ECAI’s credit assessment should be available to both Australian wholesale clients4 and foreign entities with a legitimate interest and at equivalent terms. In general, the procedures, methodologies and assumptions for assessments used by the ECAI should also be available to Australian wholesale clients and foreign entities. The individual assessments, the key elements underlining the assessments and whether the issuer participated in the assessment process should be available to Australian wholesale clients and foreign entities on a non-selective basis, unless they are private assessments.
18. An entity will be considered to have a legitimate interest in a credit assessment where it intends to use the credit assessments of a particular ECAI for determining its regulatory capital requirement. There should be no undue price discrimination restricting access to credit assessments.
19. An ECAI that does not charge subscribers for access to its credit assessments should ensure the complete range of credit assessments is available, and the list is updated whenever a new credit assessment is issued or an existing credit assessment is revised.
20. An ECAI that only permits paying subscribers to access its credit assessments should ensure the complete range of credit assessments is available to all subscribing entities and the list is updated whenever a new credit assessment is issued or an existing credit assessment is revised.
21. Where an ADI wishes to rely on an ECAI credit assessment for the purposes of calculating regulatory capital for credit risk under Prudential Standard APS 120 Securitisation (APS 120) in respect of a securitisation exposure, the credit assessment must be available to wholesale clients on a non-selective basis and free of charge.

Disclosure

22. An ECAI should disclose the following information:
    1. its code of conduct and the general nature of its compensation arrangements with assessed entities
    2. its credit assessment methodologies, including the definition of default, time horizon and the meaning of each rating, and
    3. the actual default rates experienced in each category and the transitions of assessments (for example, the likelihood of AA ratings becoming A ratings over time).

23. An ECAI applying for recognition of its credit assessments for the purposes of APS 120 should ensure its credit assessments for structured finance are available to wholesale clients on a non-selective basis and free of charge.

Resources

24. 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 a rated entity. APRA expects a credit assessment would be based on a combination of qualitative and quantitative approaches.
25. An ECAI’s staff should have sufficient skills and experience to conduct credit assessments. There should also be sufficient resources to carry out consistent credit assessments and have frequent contact with rated companies.

Credibility

26. The reliance on an ECAI’s credit assessments by independent parties can provide evidence of the credibility of assessments of the ECAI. The credibility of an ECAI is also underpinned by the existence of internal procedures to prevent the misuse of confidential information.
27. In considering an ECAI’s credibility, APRA will consider:
    1. the market profile of the ECAI, including its market share
    2. the adequacy of financial resources of the ECAI, and
    3. whether there is any pricing determined on the basis of the rating outcome.
28. Evidence of the degree of market acceptance of the credit assessments in the Australian market will provide APRA with a degree of confidence regarding the appropriateness of an ECAI’s credit assessments.

Attachment 2 – Application requirements

1. An ECAI applying to APRA for recognition as an eligible ECAI on a direct basis is to provide the information set out below in its written application. APRA may request additional information during the application process.
2. In the case of an ECAI applying for recognition as an eligible ECAI on an indirect basis - APRA will determine on a case-by-case basis what information the ECAI is to provide in its written application; such an ECAI will need to provide evidence of recognition on a direct basis in a suitable jurisdiction.

General information

3. An applicant should provide APRA with general information that provides an overview of its business. This should include:
   1. the market segments for which the applicant is seeking recognition
   2. the level of recognition the applicant is seeking (group or subsidiary level)
   3. the type of credit assessments provided
   4. the countries where the applicant is active, and
   5. an overview of the legal structure of the applicant and the group to which it belongs: including ownership, major subsidiaries, ancillary or other services provided etc. The information on ownership should include a list of major shareholders.
4. An applicant should also provide APRA with details of its Australian operations, including:
   1. the legal structure of the ECAI
   2. the expertise of staff and the total number of full-time employees
   3. the total number and percentage of revenues from major customers and/or subscribers, and
   4. financial information demonstrating the financial soundness of the applicant, including its financial statements for the past three years and forecasts for the next three years where applicable. Alternatively, a subsidiary applicant may provide a letter of support from its parent entity.
5. An applicant should also provide APRA with a statement of compliance with the International Organisation of Securities Commissions’ Code of Conduct Fundamentals for Credit Rating Agencies or similar market-accepted standards.

Objectivity

6. To demonstrate its compliance with the objectivity criteria set out in Attachment 1, an applicant should provide:
   1. a description of the core ratings process for each market segment. The applicant should clearly indicate where criteria differ from one market segment to another
   2. a high-level description of the credit assessment methodology and processes and how the methodology is determined, implemented and changed. This description should include an overview of the processes in place to ensure the consistent application of the assessment methodologies across all credit assessments; in particular, the role of ratings committees and guidelines governing them and the extent of input from rated entities
   3. for each of the market segments within which a core methodology is applied consistently, a high-level description of quantitative inputs including key variables, data sources, assumptions and quantitative techniques used
   4. for each of the market segments within which a core methodology is applied consistently, a high-level description of qualitative inputs, including the scope of qualitative judgement regarding the strategy and business plans of the rated entities
   5. a summary by geographical area of the major differences in the core methodologies
   6. a description of the methodology used to verify the accuracy, consistency and discriminatory power of the ratings systems, with details on the results and conclusions generated by such analysis
   7. a description of the internal compliance mechanism to ensure the consistent application of ratings methodologies
   8. an overview of the ratings reviews process, including information such as main characteristics, scope, frequency, teams involved, main phases of the monitoring process, data updates, information from rated entities taken into account, automatic warning systems and mechanisms that allow systematic errors in credit assessments to feed back into potential changes in ratings methods
   9. evidence that a back-testing system is in place and has been up and running for at least one year, and
   10. an outline of the extent of contacts with the senior management of the rated entities.

Independence

7. To demonstrate its compliance with the criteria for independence in Attachment 1, an applicant should provide:
   1. a description of the procedures aimed at ensuring fair and objective credit assessments, including mechanisms to identify, prevent, manage and eliminate actual or potential conflicts of interest
   2. a detailed description of the safeguards in place when shareholders, subsidiaries or other entities belonging to the group are rated
   3. an overview of the internal audit function, including reporting lines and/or that there are means to ensure that internal procedures are implemented effectively
   4. an overview of the remuneration policy, demonstrating remuneration of the staff involved in credit assessment does not affect the production of independent and objective credit assessments
   5. details of the applicant’s fee policy, and
   6. confirmation that the staff involved in the credit assessment process are not engaged in any business relationships with rated entities which could hinder the issuance of independent and high-quality credit assessments.

Transparency and disclosure

8. To demonstrate compliance with the transparency and disclosure criteria in Attachment 1, an applicant should provide:
   1. a summary of its disclosure policy and provide evidence that the principles of the methodology employed for the determination of its credit assessments are available to all interested parties
   2. a summary of the ways methodologies are made publicly available and of the terms of access to the credit assessments by all potential users
   3. a description of the transparency policy with regard to the types of credit assessment, and
   4. a high-level description of the disclosure procedures in place.

Credibility

9. To demonstrate the credibility of its ratings, an applicant should provide evidence of market reliance on its credit assessments. This could take the form of market share, number of issuers, how long the applicant has been active in the particular market segment, the revenues generated by the ratings activities and any other relevant evidence.

Mapping

10. To facilitate the mapping of a successful applicant’s ratings categories, the applicant should provide:
    1. its definition of default
    2. the CDR over a three-year period for each credit assessment category and at least the two most recent CDRs. This should continue to be provided annually if the applicant is recognised as an eligible ECAI
    3. the ten-year average of the three-year CDR
    4. if a target probability of default is used, the target probability of default for each ratings category
    5. a description of the methodology to calculate the CDRs:
       1. selection of pool (static versus dynamic/adjusted)
       2. definition of default, and
       3. aggregation of defaults (weighting mechanism)
    6. the statistical significance of default rates
    7. dynamic characteristics of the ratings methodology (point in time or through the cycle)
    8. the meaning of the ratings categories
    9. the range of credit assessments that the applicant assigns
    10. the time horizon of the credit assessment
    11. transition matrices, and
    12. geographic coverage.

Attachment 3 – APRA’s ongoing review

Direct recognition

1. APRA’s approach to the ongoing review of its direct recognition of an ECAI includes:
   1. APRA will verify an ECAI has procedures to ensure its credit assessments remain appropriate over different time periods and market conditions, including that: ratings are reviewed at least annually, and revised in response to changes in financial conditions and ratings are subject to back-testing on an annual basis.
   2. APRA will require an ECAI to inform APRA promptly of any material changes in the methodology used to assign ratings, including changes that alter a significant number of ratings or potentially prompt the need for a change in mapping, as well as any significant changes in other recognition criteria (e.g. change of ownership or internal structure and major deterioration in financial positions).
   3. APRA will review the continuing reliability of an ECAI if there is a deterioration in the performance or market acceptance of the ECAI.
   4. APRA will withdraw the recognition of an eligible ECAI that ceases to comply with the recognition criteria, having regard to the impact of such a decision on APRA-regulated institutions and the relevant considerations and decisions of other regulatory authorities that have also recognised the ECAI for the purposes of their capital adequacy regimes. Before a decision of derecognition is made, APRA will notify the ECAI in writing of its intention to withdraw recognition as well as the eligibility criteria in respect of which APRA is considering non-compliance by the ECAI. The ECAI will be able to make written representations to APRA within a reasonable period of time after notification. Where representations are made by the ECAI, APRA will take them into account in deciding whether to derecognise the ECAI.
   5. Further to these measures, APRA may require an ECAI to provide, annually, its default rates for each rating category, allowing APRA to monitor the mapping of ratings to ratings categories.

Indirect recognition

2. Under indirect recognition, the responsibility for checking the ongoing eligibility of an ECAI rests with the relevant national supervisor. However, an ADI or insurer using the credit assessments of an ECAI that is indirectly recognised by APRA will be responsible for confirming the ECAI’s ongoing status as a directly recognised entity by the relevant national supervisor.

Attachment 4 – APRA’s mapping process

1. APRA will assign an eligible ECAI’s credit assessments to the credit rating grades under the relevant prudential standards. As part of the mapping process, APRA will review:
   1. the size and scope of the pool of issuers the ECAI covers
   2. the range and meaning of the credit assessments that it assigns
   3. the statistical significance of the ECAI’s default rates, and
   4. the definition of default used by the ECAI.
2. In addition to the qualitative factors outlined above, APRA will consider other factors such as:
   1. the variable used to weight default events
   2. geographical coverage, and
   3. dynamic properties and characteristics of the ratings system or methodology.
3. The use of three-year CDRs is considered an appropriate measure of the predictive power of credit assessments in relation to creditworthiness.
4. APRA will evaluate the CDR associated with all issues assigned to the ratings category.
5. Where significant quantitative data are available they will form the basis of the mapping process. However, the mapping process will also consider qualitative factors that influence the comparability of ECAIs’ credit assessments’ CDRs with the benchmark CDRs.
6. Where significant quantitative data are not available, APRA will reach its own view for mapping purposes based on the quantitative information available and an assessment of the meaning of an ECAI’s ratings scale in comparison with the benchmark.

Comparing an ECAI’s long-run average three-year CDR to a long-run reference CDR

7. APRA will evaluate the ten-year average of the three-year CDR where available. If an ECAI has less than ten years of default data, APRA may consider the ECAI’s projected ten-year average of the three-year CDR for each ratings category. In this case, an ECAI will be accountable for its estimate.
8. Each of the CDR measures will be compared to reference and benchmark values of CDRs.
9. For each step in an ECAI’s ratings scale, a ten-year average of the three-year CDR will be compared to a long-run reference three-year CDR that represents a sense of the long-run international default experience of risk assessments.
10. APRA has adopted the long-run reference three-year CDRs proposed in the Framework, as shown in Table 1.

Table 1

Comparing an ECAI’s most recent three-year CDR to CDR benchmarks

11. APRA will also consider the most recent three-year CDR associated with each ratings category. For each step in an ECAI’s ratings scale, the two most recent three-year CDRs will be compared to benchmarks for CDRs.
12. Two benchmarks have been set to determine whether a CDR falls into an acceptable range for a ratings category to qualify for a particular risk-weight:
    1. a monitoring level benchmark, and
    2. a trigger level.
13. Where an ECAI exceeds the monitoring level benchmark, this implies its current default experience for a particular ratings category is markedly higher than international default experience. Although such assessments are still eligible for the associated risk-weights, the ECAI would be expected to explain why its default experience appears to be significantly worse.
14. Where APRA determines the higher default experience is attributable to weaker standards in assessing credit risk, it will assign a less favourable ratings category to the ECAI’s credit risk assessment.
15. Where an ECAI exceeds the trigger level, this implies its default experience is considerably above the international historical default experience for a particular assessment grade. The ECAI’s credit assessment methodology is either too weak or not applied appropriately.
16. If the observed three-year CDR exceeds the trigger level in two consecutive years, APRA will likely move the credit risk assessment into a less favourable ratings category. APRA may retain the original ratings category where the higher observed CDR is not attributable to weaker credit assessment standards.
17. APRA may assign an increased ratings category where the ECAI is able to demonstrate that its three-year CDR falls and remains below the monitoring level for two years.
18. APRA will map an ECAI’s credit assessments according to the three-year CDR benchmarks proposed in the Framework, as shown in Table 2.

Table 2

Securitisation

19. While there will be similarities between mapping credit assessments for APS 112 and APS 120, there will also be important differences. Mapping of securitisation credit assessments must be mapped to risk ratings as set out in APS 120.
20. In mapping securitisation credit assessments, APRA will consider data relating to the default/impairment rates associated with different credit assessments. APRA will work with an ECAI applicant to fully understand the definition of default for the purposes of data analysis.
21. APRA will consider loss/recovery rate data in relation to different ECAIs' ratings.

Short-term credit assessments

22. The mapping of short-term credit assessments will be based on the mapping of long-term credit assessments as outlined above and will take into consideration any internal mapping undertaken by an ECAI.