As deadline looms, US agencies are stumped over replacing ratings in regulation. New market risk rules less conservative than Basel version

By Melvyn Westlake

US bank regulators are said to be stumped over how to meet the Dodd-Frank Act requirement that they find an alternative to the use of credit ratings in financial regulation. And the clock is ticking. Washington regulatory agencies have until July 21 to come up with an answer to a conundrum that has implications for America’s adoption of the internationally-agreed Basel risk capital and liquidity rules for banks.

“Nobody has put forward any really satisfactory ideas,” admits a Federal Reserve regulator. Already, the absence of a practical alternative to credit ratings has begun to impair new rulemaking in Washington. A notice of proposed rulemaking (NPR), aimed at revising market risk regulation for banks, and jointly drafted late last year by the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), specifically had to exclude some elements dealing with securitisation because of the ratings question.

Use of ratings in regulation is pervasive, but particularly pivotal in determining risk capital adequacy for many banks. However, this must now change because of a 24-line section of the 848-page Dodd-Frank Wall Street Reform and Consumer Protection Act, which became US law last July. Section 939A instructs regulatory agencies to review their regulations that require the use of an assessment of creditworthiness of a security or money market instrument, or have requirements regarding credit ratings. Agencies must then modify their regulations to remove any such reference, or requirements, or reliance on, credit ratings, and substitute in their place other standards of creditworthiness that the agencies determine to be appropriate. The Act gives each agency one year to report to Congress on the actions it has taken.

An advanced notice of proposed rulemaking (ANPR), issued jointly by the agencies last August, asking the public for ideas on alternatives to relying on ratings in regulation, produced nothing very helpful.

There is, however, widespread agreement that the methodologies of credit rating agencies performed poorly in the years prior to the financial crisis, particularly in relation to securitised financial products. They are held at least partly responsible for the subsequent seizing up of the markets and large bank losses.

The inability to find a solution and the looming deadline is “a source of a great deal of concern,” says Karen Petrou, executive director of Federal Financial Analytics, a Washington consultancy on regulation. “The agencies are informally admitting that they are stumped. But the deadline is only six months away, so something has got to happen. The law is very clear. It says there may be no reference to ratings,” she adds. “We are going to have a hell of a time with the Basel III rules because of the way ratings are still embedded in them,” Petrou reckons, referring to the capital and liquidity standards hammered out by Basel Committee regulators last year, and published in mid-December (see page 4).

No easy task

Finding an alternative to ratings “is not proving an easy task,” confirms Nancy Hunt, associate director for capital markets in the FDIC’s supervision and consumer protection division. “We are looking at several approaches, some more mathematical than others, and trying to backtest them to see if they perform better than rating agencies,” she says. “It’s a very complex and involved process. But we have a law, and we have to figure out how to do this.”

One approach that has been considered by the agencies is using probability of default (PD) and loss given default (LGD) calculations. Another is obliging banks to use 100% risk weights for corporate debtors; and the risk weights compiled by the Organisation for Economic Cooperation and Development in Paris, for sovereign debt. But there are objections to most of these ideas. Who estimates the PDs, for example? What stress tests should be used, and is there sufficient historical data?

The standardised approach to measuring risk and capital requirements under the Basel II regulatory framework (the approach used by smaller, less sophisticated banks) relies totally on external credit ratings. Although the advanced approach involves internal modeling of risk, instead, it does also use external ratings for securitisations. The Basel II framework was not adopted in the US when many other countries were implementing it, three of four years ago. But America is planning to adopt it as soon as possible, along with the new, Basel III (which builds on the earlier framework).

This latest set of rules embodies the use of credit ratings, too, both in the liquidity and counterpart credit risk requirements.

Difficulties of rule-making have been highlighted by the joint agency NPR requesting comment on a proposal to revise their market risk capital rules and prevent the kind of build up of risky positions that resulted in large bank losses during the crisis. This NPR incorporates the higher capital requirements for banks’ trading book exposures that are part of Basel III, along with earlier market risk rules issued by the Basel Committee in 2005, but not yet adopted in the US.

Among its provisions is an incremental risk capital requirement to capture default and credit quality migration; and a stressed Value-at-Risk capital requirement.

But, significantly, the market risk proposal does not include the methodologies adopted by the Basel Committee for calculating the specific risk capital requirements for debt and securitisation positions because of their reliance on credit ratings, which is impermissible under the Dodd-Frank Act. So instead the NPR proposal “retains the current specific risk treatment for these positions,” the NPR says, “until the agencies develop alternatives standards of creditworthiness as required by the Act.”

At the FDIC open meeting in mid-December that approved the NPR, both chairwoman Sheila Bair and vice chairman Martin Gruenberg, expressed their concern that this made the market risk rules significantly less conservative than they would have liked. “Not using external ratings, in this instance, will result in the US having lower capital requirements than would otherwise have been the case,” noted Gruenberg. This underscores the importance of addressing the issue of finding an alternative to ratings, he said, because otherwise “we are not utilising the full potential of the market risk rules.”

Because these rules will involve some bigger banks in developing complex new models, the FDIC wanted to issue the NPR now, even while staff worked on “coming up with an alternative to credit ratings that gives us the same capital charge as the Basel III’s use of rating does,” says Nancy Hunt. “And the FDIC does not intend to have a lower capital charge” for US banks than applies elsewhere.