Treasury’s Office of Financial Research has released a brief entitled “Credit Ratings in Financial Regulation: What’s Changed Since the Dodd-Frank Act?” The introductory statement notes “The use of credit ratings in financial regulation created perverse incentives for market participants and contributed to the financial crisis. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress called for eliminating credit ratings in financial regulation. Regulatory agencies, in turn, introduced alternative means for evaluating credit. But these alternatives have their own challenges. This brief reviews how credit ratings have been used in financial regulation, the incentives they created, and how they were replaced after the Dodd-Frank Act.”
The brief highlights three methods used to replace reliance on credit ratings after Dodd-Frank:
- Defining creditworthiness for certain securities is the most widely used alternative to credit ratings in financial regulation since the Dodd-Frank Act. This approach has three key features. First, regulated entities must determine the securities they hold meet the new regulatory definitions. Prudential regulators have the discretion to accept or reject these justifications. Second, regulators provide guidance about factors they will consider in reviewing firms’ determinations. Third, credit ratings still can be used, but regulated entities must justify their use.
- In the second approach, bank regulators give companies models to use in place of credit ratings. For example, federal bank regulators use two models to replace credit ratings in setting capital requirements for securitized products.
- In the third approach, regulators use third parties other than rating agencies to set credit standards. For example, federal bank regulators now use country risk assessments provided by the Organization for Economic Co-operation and Development (OECD) to set capital requirements for sovereign and depository institution debt.
The brief then discusses how the three alternative approaches to credit ratings bring potential challenges and concerns.