U.S. Regulators Embrace Plan to End Reliance on Credit Ratings Firms

U.S. regulators are embracing a plan devised by the Paris-based Organization for Economic Co-operation and Development that would assign zero risk to most European government debt.

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Required by Congress to remove credit ratings from banking rules, regulators from the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency proposed rules last month that would set bank capital levels using classifications made by the OECD.

The OECD, two-thirds of whose members are European Union countries, considers most EU sovereign bonds to be risk-free, including those of Greece and Portugal.

But the proposal undermines the intent of the 2010 Dodd-Frank Act, which sought to eliminate the use of ratings by companies paid by the entities they rate. Because the OECD represents its member governments, there is an inherent bias in its dealings.

Still, to find an alternative to credit ratings where there are no conflicts of any kind is almost impossible, says Luigi De Ghengi, a partner at law firm Davis Polk & Wardwell LLP in New York, who believes regulators are only replacing one set of conflicts with another.

The Basel Committee on Banking Supervision in 2009 laid out new global capital rules that would increase the amount banks are required to keep on hand in order to back mortgage-linked securities and other complicated products at the heart of the 2008 financial crisis. The December 7 proposal is part of the U.S. effort to implement those rules.

The so-called market-risk rules were supposed to be in place by the end of 2011 — an EU version went into effect on December 31 — but Dodd-Frank’s credit-ratings ban slowed the process in the U.S., where regulators ultimately devised a plan that would bar ratings from firms like Moody’s Investors Service and Standard & Poor’s.

The U.S. proposal would allow regulators to increase risk weightings for nations that have defaulted on their debt within the past five years. Voluntary restructurings would be considered as default, resulting in a jump in risk weighting, but until then would stay at zero.

U.S. regulators, recognizing the weakness of the OECD’s proposed ratings, added the debt-restructuring provision and suggested using market indicators such as bond yields and credit-default swap spreads to complement them. However, such market indicators strip out short-term volatility, making it unlikely they would capture increasing risk before it was too late.

The December 7 proposal also contains formulas for determining the riskiness of securitizations, correlating risk weightings with the hierarchy of tranches: If a bond is lower in the order of receiving payments and among the first to get hit by losses when loans in the package start defaulting, it would be assigned a higher risk, just as was the case under the Moody’s and S&P methodologies.

Basel III rules also rely on credit ratings for calculating how much capital banks must keep on hand to protect against losses on securities and bonds on their balance sheets. The Fed, FDIC, and OCC, which are trying to devise a proposal by the end of March for how to implement Basel III, will have to find an approach that avoids relying on credit rating firms.

Unless regulators object, the new Basel rules, like the current ones, will continue to allow the largest banks to use their own internal models to assign risk to assets, including Greek bonds. The U.S. never implemented the earlier framework, known as Basel II, which was adopted by the EU in 2006. Basel III rules are supposed to go into effect globally starting in 2013.

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To contact the reporter on this story: Emily Knapp at staff.writers@wallstcheatsheet.com

To contact the editor responsible for this story: Damien Hoffman at editors@wallstcheatsheet.com