New regulations on credit ratings due diligence could prove challenging  for investors and asset managers alike, according to Nina Roehrbein

Following two recently amended EU directives, the German regulator BaFin has called on pension funds to undertake their own credit risk assessments in an attempt to tackle over-reliance on ratings agencies.

While BaFin says pension funds will not need to undertake their own in-house rating exercises, they should not exclusively or automatically rely on external  ratings in their assessment of companies or financial instruments. This replaces a BaFin directive of 2012.

“The suggestions by BaFin on ratings have caused bewilderment and confusion among investors,” says Marcus Burkert, head of institutional consultancy at FERI. “The problem is that the current rules do not state what they will have to do instead of using rating agencies. While pension funds generally did not exclusively rely on rating agencies in their assessment of investment opportunities before, the question is now what depth their new analysis will have to have. Employees of Versorgungswerke [first pillar funds for professionals] might also be wondering whether they will have a liability risk if they conduct the analysis themselves. Interest groups and professional bodies are likely to try to consult with BaFin on this, as this has to be addressed and resolved.”

The EU directives have, in fact, led to a U-turn, as BaFin previously required life insurance companies and pension funds to use external ratings and distrusted internal assessments.

“Many pension funds have told us that BaFin is still trying to find the right balance between internal and external rating requirements,” says Michael Schütze, head of corporates Germany at Allianz Global Investors and managing director at Allianz Corporate Pension Advisors. “Smaller institutions are concerned with how they will be able to cope with heightened internal rating requirements, especially with regard to sovereign or financial issuer risks.”

Michael Fuss, co-head of asset management for Germany at Deutsche Asset & Wealth Management (DeAWM) adds: “The ratings issue is a hot topic for German pension funds. Pension funds will have to decide whether they have the resources to create their own rating or whether they need other providers, particularly for niche asset classes. They could potentially work together on a collective basis but this remains to be seen. If they try to get a rating from their asset manager it creates a liability issue for managers like ourselves.”

Large pension institutions are likely to create a rating themselves in their own departments, while the smaller ones, because it is hoped they will be allowed to outsource the internal rating function as part of the investment value chain, are expected to buy expertise from specialists.

Outsourcing could take place either through the use of rating providers, or by taking a different approach to investing. Pension funds can, for example, invest through funds where only the asset manager has the governance and the capabilities to undertake the rating of these entities instead of on a single-name basis.

“One ramification of the rules could be that we see more investments being outsourced to external management because they only apply to direct investments,” says Nigel Cresswell, head of investment consulting at Towers Watson in Frankfurt. “In a fund, the requirement is on the manager to assess the underlying instruments.”

Schütze notes further issues: “Quite a large number of asset managers will be responsible for outsourced internal ratings because of the mandates issued to them,” he says. “If we have a Spezialfonds mandate…. and if we, as an asset manager, undertake the rating, this is an outsourced-but-internal rating from a regulatory standpoint of view. With directly held assets, the question arises as to how they can come under a single asset management roof if they are to be rated internally by an external asset manager.”

In many parts of insurance and pension fund regulation, a principle of proportionality already applies, particularly to smaller market participants. This means that smaller Pensionskassen, for example, do not have to provide the same organisational structure as life insurers who have 500 employees working on asset and risk management.”

Schütze hopes that BaFin will make use of this proportionality clause with regard to ratings, too.

Cresswell agrees: “The principle of proportionality should be applied here because it is just not feasible for small pension funds. Even large pension funds will struggle to set up their own costly credit analysis department. The challenge for the regulator is to come up with a solution that respects the principle of proportionality but also complies with the EU directives. BaFin is trying to implement something that ensures investors invested directly in single securities have an understanding of the underlying risks which they are taking but they cannot create this machinery where small pension schemes have to have their own credit rating department to facilitate that. It is just not practical. A balance needs to be drawn and a proportional solution found.”

Organisations that undertake some ratings in-house today have had inquiries already, including AllianzGI and FERI.

Union Investment also undertakes country ratings in-house.

“The European ratings regulations will not come into force until 2014,” says Thomas Fleck, managing director institutional at Union Investment. “This offers an additional opportunity for asset managers to become real sparring partners to their investors rather than being just one component in the value chain.”

BaFin is awaiting jumbo guidelines from the EU’s European Securities and Markets Authority (ESMA) before taking further steps.