Bank of Canada severs mechanical link to external ratings

It has taken many years of work, significant investment and a change in culture, but the Bank of Canada is now poised to fully end its mechanistic reliance on external credit ratings.

Philippe Muller, senior director of the Financial Risk Office at the central bank, has overseen efforts to develop a system of internal credit risk assessments, allowing the bank to make its own judgements on the riskiness of its main counterparties. “I would argue we are well positioned to completely end mechanistic use of credit ratings,” he tells Central Banking.

A team of eight is tasked with assessing the credit risk of around 80 counterparties, and their work now forms a critical input for the management of Canada’s reserves, which stood at $84.6 billion on July 23. The bank’s investment team does still use external credit ratings, but they are treated “not so much as a source, but as a validation”, Muller says.

The work began after the Financial Stability Board (FSB) recommended central banks cut their reliance on external ratings, as part of a set of principles published in 2010.

Philippe Muller was appointed senior director of the Financial Risk Office of the Bank of Canada’s Funds Management and Banking Department in March 2014. He now oversees the credit ratings, middle office and reporting, and risk modelling groups.

Since joining the central bank in 1997 he has held a range of positions across the monetary policy, financial stability and funds management functions, advancing from analyst positions to his current role as director. He holds a master’s degree in finance from HEC Montreal.

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Cutting reliance on external ratings can bring various benefits. A key concern for the FSB was reducing the global instability caused by herding and cliff effects, but there are also narrower benefits for reserve managers. Better insights into the exposure of counterparties can give them an edge when investing, potentially generating higher returns.

The act of performing the analysis has proven valuable in itself, Muller notes: “It provides a forum to discuss relevant credit risk developments, and in that sense it actually augments the management ownership of credit risk considerations.

“Credit risk assessments over time will prove very valuable to best position those making investment decisions in the face of potentially important changes in the credit quality of some counterparties.”

Challenging process

Implementing the internal credit risk assessment framework has taken a lot of work. One challenge was building up, and retaining, the expertise necessary to perform the work, though Muller believes central banks are “well positioned to tackle technical questions of this sort”.

Muller notes “we do have turnover from time to time”, as skills on the team are in high demand elsewhere – a perennial problem for central banks. “We have been successful in continuing to develop our capabilities overall,” he adds.

Another challenge has been cultural change. “Most central banks around the world have, for the past 20 years or so, outsourced credit risk assessments. The development of internal credit risk assessments is really a big change in culture, as it requires taking on responsibility and accountability,” Muller says. Adjusting culture takes time, but senior officials at the bank support the effort, which is helping to drive change.

A major consideration when launching the project was its cost. The Bank of Canada was very conscious it was spending public funds and needed to put them to good use, but Muller points out even marginal improvements can pay for the initial investment “quite quickly”. “When you look at the sheer size of foreign exchange reserves and you calculate some form of management expense ratio, the investment in a few resources is a very small cost in relation to the reserves and the exposures faced.”

Spreading the benefits

Other central banks have expressed an interest, and Muller now regularly gives presentations and other advice to those seeking to emulate the Bank of Canada’s work. The central bank published the methodology behind its sovereign ratings in May, with the aim of allowing others to benefit from its investment.

An important prerequisite for those looking to develop internal capabilities is the governance structure. “Think about setting up a governance structure internally that will be strong: a relatively strong independence of those doing credit ratings from those making investment decisions; and senior management support for the development of credit risk assessment capabilities,” Muller says.

He also recommends starting small and building from there: “Focus on the areas where exposures are deemed to be greatest, and develop capabilities in those asset classes first.”

Next steps for the Bank of Canada include continuing to spread the benefits of the internal credit risk assessment capabilities, making sure other departments are aware of, and make use of, the insights that are being generated. For example, the team now contributes analysis to the Financial System Review.

There are also certain references to external ratings that still need to be replaced. “One of the next steps we would like to accomplish is to complete the modernisation of certain credit risk management policies,” says Muller. “Some of our policies still speak to external ratings.”