Bye Bye S&P: Regulators Seek to End Banks’ Reliance on Ratings

Proposed rules aimed at reducing ratings firms’ influence in financial markets would require the largest U.S. banks to stop using credit ratings to evaluate the risk of assets they hold in their trading accounts. The Federal Deposit Insurance Corp., Federal Reserve, and Office of the Comptroller of the Currency unveiled the proposal on Wednesday.

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Banks currently are required to use credit ratings to assess the risk of assets such as mortgage-backed securities and other forms of debt when calculating how much capital they must hold against potential losses. But the credit raters’ poor track record on evaluating mortgage debt in the run-up to the 2008 financial crisis spurred lawmakers to mandate that federal regulators remove references to credit ratings from their rules.

Since the mandate was issued last year, bank regulators have struggled to find a workable alternative to credit ratings, which have become entwined in both the domestic and international financial-regulatory structure.

Wednesday’s proposal seeks to replace the use of credit ratings in a set of rules for a number of large banks, but has broader implications in that regulators will likely use a similar framework in forthcoming rules that will apply to all banks, including smaller ones.

Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings have all said they welcome the mood, though analysts say it could reduce demand for their services.

“When you remove them from government regulations, you diminish their overall significance in the financial system,” said Jaret Seiberg, a Washington analyst with Guggenheim Securities. At the same time, evidence is mounting that investors are already paying less attention to ratings, he said, pointing to the lack of market reaction this week when Standard & Poor’s warned that it might downgrade the government debt of Germany, France, and 13 other euro nations, as well as other European entities, including banks.

However, other analysts think the move won’t have much of an impact. Big issuers of securities backed by mortgages and other debt will still be expected to get the firms’ stamp of approval. Many state-level pension funds and private mutual funds still require investment decisions to e based on letter grades assigned by ratings agencies.

If approved, the proposed rules would apply to the 30 largest banks and bank-holding companies in the United States, all of which have at least $1 billion in trading assets. Banks and others will have until February 3 to weigh in with comments, after which regulators will consider making changes to the proposal before moving forward and putting it to a vote.

In its current form, the proposal would require banks to replace ratings by calculating the riskiness of numerous forms of debt, with the riskiest debt carrying the largest capital charge. Government, corporate, municipal and other forms of debt such as mortgage-backed securities, would carry varying risk weightings.

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When it comes to sovereign debt, the regulators would rely on risk classifications developed by the Organization for Economic Cooperation and Development. Corporate debt would be evaluated based on companies’ finances and stock-market volatility. Banks would have to hold the most capital for the riskiest pieces of securities backed by assets like mortgages.