Banks have, since 1985, been subject to a risk-based capital regime under which the amount of capital each is to maintain is to be based upon a rough calculation of the amount of risk in the assets on its balance sheet. One way in which bank regulatory rules have historically appraised that risk is to look to credit ratings by Nationally Recognized Statistical Rating Organizations (NRSROs; such as Moody’s, Standard & Poor’s and Fitch; of assets; such as corporate securities and securities representing interests in securitized assets; held by banks on their balance sheets.1 In some cases, rules have prohibited a national bank’s investment in certain classes of securities unless the securities carried a certain credit rating.2 Also, currently deposit insurance assessments on large banks are a function of long-term debt credit ratings, although, last April, the FDIC proposed elimination of credit ratings from its deposit insurance assessment rule. In addition, bank examiners have regularly used credit ratings as a basis to criticize the quality of investment securities held by banks.
Even before the recent financial crisis subjected the credit rating agencies to criticism, bank regulators informally questioned the wisdom of bankers supplanting their own credit judgments with those of third parties such as the rating agencies. Nonetheless, the bank regulators, in 2008, issued a notice of proposed rulemaking on a so-called “standardized approach” to bank capital under the Basel Accord that relied heavily on credit ratings to assign risk weights to various exposures.3 The standardized approach is a version of Basel II that, despite its reliance on credit ratings, is currently in effect in many countries, albeit not in the U.S. yet.
Of course, the financial crisis, with its attendant collapse of values of highly rated securities, has caused some to question the reliability of such ratings.
In 2009, the Basel Committee of bank regulators from the G-20 countries responded to the financial crisis by issuing a paper entitled “Enhancements to the Basel II Framework” containing operational criteria that would require banking organizations to undertake independent analyses of the credit-worthiness of their securitization exposures.
Concerns that banks have been relying too heavily on credit ratings as a substitute for due diligence and that banks have essentially outsourced risk assessment have now led to enactment of Section 939A of the Dodd-Frank Act, the comprehensive 2,319 page financial regulatory reform legislation signed by the president on July 21.4
Section 939A of that Act requires each federal bank regulatory agency, by July 21, 2011, to review its regulations requiring use of an assessment of the credit-worthiness of a security or money market instrument and to review any reference to credit ratings in such regulations.
Each agency is then to remove any reference to credit ratings and to substitute another standard of credit-worthiness.
On August 10, less than three weeks after the president signed the new law, the bank regulatory agencies issued an Advance Notice of Proposed Rulemaking (ANPR) soliciting thoughts on alternatives to the use of credit ratings in risk-based capital guidelines. This notice does not propose specific rules, but rather asks questions to help the regulators later to come up with rules to propose. One effect of the ANPR is to put the eventual adoption of the credit rating-dependent standardized approach proposed in 2008 on indefinite hold.
The ANPR considers standards of credit-worthiness other than credit ratings that might be used for assessing risk under the riskbased capital standards. The regulators recognize that alternatives would involve trade-offs and cite the example that, while greater refinement in measuring risk might provide the benefit of more accurate tracking of capital to risk, that benefit would come at the expense of greater burden. The ANPR mentions six factors the regulators will consider in deciding upon alternatives to credit ratings:
1. Does an alternative distinguish credit risk associated with a particular exposure within an asset class?
2. Is the alternative transparent enough to allow banking organizations to reach consistent assessments and to allow supervisors to review them?
3. Does the alternative provide for timely and accurate measurement of changes?
4. Does the alternative minimize regulatory capital arbitrage?
5. Will the alternative add undue burden?
6. Will the alternative foster prudent risk management?
The regulators are willing to entertain other factors and to hear thoughts on these.
One alternative being considered by the regulators is simply to delete references to credit ratings, but maintain the current Basel I rules; thus, most non-securitization exposures would receive a 100 percent risk weighting except, sovereign exposure would carry a zero percent risk weighing and bank exposure would carry a 20 percent risk weighting.
Another alternative would be for the regulators to provide a wider range of risk-weight categories than those currently available under Basel I. Metrics might include credit spreads or even data specific to the obligor, such as debt-to-equity ratios.
A more complex alternative that sounds somewhat like Basel II would permit a banking organization to assign an asset to one of a limited number of risk-weight categories based on the banking organization’s assessment of probability of default or estimated loss. Under that alternative, the banking organization might be permitted to contract with third-party service providers to obtain data. The regulators worry, however, that this could lead to inconsistency.
Yet another alternative is one followed by the National Association of Insurance Commissioners (NAIC). A third party financial assessor (which sounds functionally like an NRSRO) would advise the banking agencies on the amount of risk associated with a given security. The NAIC selected PIMCO Advisory as a third-party financial modeler for valuation of more than 20,000 issues of non-agency residential mortgage-backed securities held by insurers. The bank regulators worry, however, that this might place too much reliance on one firm’s judgment.
Today, the general risk-based capital rules assign a 20 percent risk weight to obligations of U.S. and other OECD banks. The proposed standardized approach contemplated risk weighting bank counter-parties based on their credit ratings, which, in light of Section 939A, will no longer work.
One option here is to retain the 20 percent risk weighting.
Another option mentioned by the regulators in the ANPR is to use financial ratios, such as the ratio of core deposits to total liabilities or the ratio of non-performing assets to total assets or both. If the bank’s securities were publicly traded, this could be supplemented by the spread between the price of the bank’s unsecured bonds and comparable Treasuries.
General risk-based capital rules currently, of course, risk-weight corporate exposures (except for those of certain qualifying securities firms) at 100 percent; the standardized proposal would have permitted use of credit ratings, again a practice that would violate new Section 939A.
Again, one option going forward is to continue the current broad risk-weighting category of 100 percent.
Another option mentioned by the regulators would be to consider financial and economic measures of the borrower based on balance sheet or cash flow ratios of the borrower, such as the borrower’s current ratio, debt to equity ratio, or debt service coverage.
Yet another option the regulators mention would be, in the case of publicly traded firms, to consider credit spreads or the probability of default implied by equity prices, as well as capital adequacy and liquidity.
The regulators also suggest that banking organizations might be permitted external data, including credit analyses provided by certain third parties, but it is hard to see how that would be consistent with Section 939A’s prohibition against the use of credit ratings.
Since 2001, the general risk-based capital rules have permitted banks to use credit ratings to risk-weight securitization exposures. The standardized approach proposed in 2008 would require use of credit ratings. Section 939A, of course, again, prohibits that.
One option the regulators mention is a return to the pre-2001 rules, in which case all securitization exposures would receive the same risk weighting irrespective of subordination, which does not seem very logical. However, the regulators mention a number of other options.
One is that banks “gross up” their exposure number to reflect the risk of higher tranches that are, in essence, supported by the tranche held by the bank. Risk weighting, however, would be that of the securitized assets.
An even more complex option the regulators suggest would be take the grossed up exposure and then risk weight it based on features of the pool of assets securitized, such as the ratio by which the securitization transaction was over collateralized, the interest coverage ratio, or priority in the cash flow waterfall.
Yet another option they mention is to risk weight the most senior securitization exposure in a manner that reflects the nature of the underlying assets and also considers the aggregate amount of subordination that supports the senior exposure.
Another option mentioned by the regulators is one adopted by the Basel Committee which takes into account the level of subordination and type of assets underlying the securitization. This approach uses a “concentration ratio” based on dividing the sum of the notional amounts of all tranches by the sum of the tranches junior or pari passu to the tranche held by the bank (including that tranche itself). The concentration ratio is then multiplied by weighted average risk weight applicable to the type of assets underlying the securitization.
A final securitization option the regulators mention is designing a risk-weighting approach based on a supervisory formula built on the capital requirements of the underlying exposures. However, the information necessary to calculate capital requirements for underlying exposures are not always available to banks purchasing a securitization instrument.
Guarantees and Collateral
The general risk-based capital rules currently grant limited recognition to guarantees and collateral.5 The proposed standardized approach recognizes guarantees based on the credit rating of the guarantor and collateral with certain credit ratings. Again, Section 939A would preclude the use of such credit ratings. The regulators suggest that an option here might be simply to substitute the risk weighting appropriate to the guarantor or the collateral for that of the guaranteed or secured exposure. It is also suggested that this approach could be augmented by creditworthiness standards discussed above.
The agencies recognize that there may well be a direct correlation between refinement and burden, and they solicit input on costs and burdens associated with each alternative.
Community banks do not have the resources to undertake comprehensive credit analyses of every individual security in which they wish to invest. Having been able to rely upon the work of expert rating agencies has spared community banks the need for such resources. That appears to be about to change. Even if the regulators spare community banks this burden and expense, providing larger banks these alternatives potentially gives larger banks competitive advantages over community banks by letting the larger banks carry lower amounts of capital against the same assets against which smaller banks are required to hold higher amounts. The regulators were sensitive to this concern when they proposed the standardized approach in 2008 in order to reduce somewhat the advantage that larger banks were expected to have under the Basel II advanced approach.
At least one bank capital expert has suggested that “any replacement system will be more expensive and more cumbersome.”6 Staffs of credit rating agencies have considerable expertise in rating credit, arguably even more than the expertise of many community banks. Credit ratings will still be available as investors in the market undoubtedly will continue to depend on them. Thus, the product of that expertise will be readily available to banks and regulators, but ironically, Section 939A precludes their availing themselves of that tempting resource. The Comptroller of the Currency (who sits on the FDIC’s board of directors) and the Chairman of the FDIC have both acknowledged that credit ratings have been helpful in some areas, particularly ratings for single issuers of corporate debt. The Comptroller particularly noted how useful credit ratings have been to smaller institutions.
While credit ratings may not have always been perfect guides to credit risk, they have, in many cases, proven to be helpful to banks and regulators. On the other hand, some of the options mentioned by the regulators, such as credit spreads, internal models, and supervisor-determined risk buckets, are also imperfect tools, but would be much more costly and burdensome to use than readily available credit ratings. Indeed, it is difficult to see how a community bank, using any of the options mentioned by the bank regulators in the ANPR, might have been able to undertake a more accurate analysis of a structured finance exposure than the professional NRSROs did. Nonetheless, it is hard to argue with any proposal that a bank should more fully understand the risks of any investment.
The regulators appear to be sensitive to the fact that, the more refined a system they impose, the greater the burden. We need to hope that the attractiveness of building a more refined framework will not be so enticing that the regulators decide that burden should be secondary.
The ANPR provides a 60-day period for public comment. That expires Monday, October 25, 2010. Under Section 939A, the regulators have until July 21, 2011 to remove the references to credit ratings from their capital rules.