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Saturday, April 2, 2011

ISO 10674 standard for credit rating agencies

International Organization for Standardization has recently published a new ISO standard that targets rating agencies directly. ISO announced this release on the 30th of March 2011 and is classifying the program as the Credit Rating Agency Standard; which will be a unique set of requirements to assist with improving the way credit rating agencies operate and report ratings.

In this article we are briefly going to look at labelled ISO 10674, what this standard aims to achieve, why it has come into existence and how it could be a game changer for the credit rating agencies.

ISO Risk Management Standards
There are many regulations across the planet for various types of industries. However, when it comes to banking or insurance, the ISO Standards Board holds the largest non-industry specific published standards that banks can refer to. Some of the more popular ISO standards which have been broadly accepted and which target risk, would include some of the following:

It is also worth noting that if one was to search for risk on the ISO standards website alone, at least nine pages of standards are returned, that itemize everything you could imagine on risk. The are even standards on the risk of biological contamination from the re-entry of space craft through the atmosphere.

Rating Agencies In Focus
The cause of the credit crisis has been blamed on many different commercial and non-commercial groups including banks, risk departments, regulators, governments and of course in the context of this article, rating agencies.

In reality each individual entity had its own unique hand in driving or dispersing risky assets across alternate banking communities. The credit rating agencies were implicated in several ways but mostly fell under criticism for the manner in which they rated SPV structures and Collateralized Debt Obligations (CDO). The CDO derivative was used to transfer entire toxic loan portfolios off a lenders banking book and into the broader market, this happened with ease when the securities were highly rated. In effect, a top grade CDO was able to increase the contamination factor of poorly originated loans and it did this for a huge array of investors across the planet.

There have been several backlashes towards the rating agencies for their role in the credit crisis, the first serious mandate was the Dodd-Frank Wall Street Reform Act. This ruling aims at prohibiting conflicts of interest for rating agencies and financial firms by prohibiting where ratings can be disclosed when banks sell investments. 

In addition to the Frank Dodd Wall street reform act, limits for a credit rating agencies reach and scope in the market is going to be impacted by Basel III rulings.  In Basel III, banks are going to become less reliant on rating agencies and banks will have to build their own internal assessment models. However, there are also some additional key hurdles ahead for rating agencies in the context of Basel III including some of the following:

[1] Banks need to develop internal models to internally assess credit exposure of borrowers.
[2] Even if ratings are available for borrowers, banks need to carry out their own assessment in addition to the external credit assessment.
[3] External Credit Rating Agencies need to meet a specific eligibility criteria before their ratings are allowed to be used by banks.
[4] The key elements for assessing a counterparty must be made public on a non-selective basis and that assessment should be free of charge.

ISO 10674
ISO 10674 aims to improve the transparency of rating agencies assessments further by stipulating common terms and definitions. It also steps a layer below this propaganda interface and into the specific process requirements that need to be in place for the standardization of the assessment of counterparty creditworthiness.
Extending credit to companies is a common component of business today. However, for small and medium-sized enterprises (SMEs) in particular, the decision to extend credit can involve numerous financial concerns.  These concerns need to be answered beforehand to avoid a host of problems afterward - which begs the question "is a credit assessment reliable?"
ISO 10674 | ISO Standards Board
There are six major components to the ISO 10674 standard which fall into the following clear delineations:

[1] Scope, Terms, Definitions, Responsibilities
[2] Quality and integrity of the assessment process
[3] How an assessment is monitored and updated
[4] Credit assessment procedures and policies
[5] Credit rating - Committee Based Approach using scales, symbols, assessment actions, process and validation

Dr Olivier Everling, the chair of the project committee that developed ISO/TS 10674:2011, stated; "In the aftermath of the financial crisis, rating agencies and credit bureaus needed to simplify and provide broader market access to rating criteria, underlying models and their analytic tools"
ISO/TS 10674:2011, rating services - Assessment of creditworthiness of non-listed entities, was prepared by ISO/PC 235, rating services.  It costs 66 Swiss francs and is available from ISO nation member institutes and from the ISO central secretariat 
ISO 10674 | ISO Standards Board
The Dodd-Frank reform act and Basel III are without any fact going to be major hurdles for the business model that make rating agencies tick. They restrict how central a rating agency can be for credit assessments and how external ratings can be used to justify investment decisions. The ISO 10674 however could be game changing for all rating agencies globally depending on its acceptance.

ISO Standards can be taken seriously which has occurred with other protocols such as the ISO 9001 quality standard or the ISO 31000 risk standardization program.
For credit rating agencies, the ISO 10674 standard leaves no stone un-turned, we just have to wait and see if the market catches on.
In ISO 10674, credit rating agencies may be held accountable for their credit assessments, they may also have to disclose their models at a detailed level and that might just give the game away. If banks couple Basel III together with ISO 10674, then the rating agencies might be in for trouble and if we think this through, what bank would work with a credit rating agency that is not ISO 10674 certified.
More information can be found at the ISO Standards Site

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