August 13, 2010 – Congress quickly passed the massive 2,300 page Dodd-Frank Act which will profoundly reshape financial markets for years to come. Numerous federal regulators now have the immense job of writing hundreds of new regulations to enforce the bill’s sweeping mandates. Implementing and complying with the coming tidal wave of new regulations is certain to cause confusion and uncertainty by both regulators and financial institutions.
The first example of regulatory gridlock was on exhibit this week as the FDIC postponed setting capital standards for smaller banks due to the prohibition by the Dodd-Frank Act to use private credit ratings to assess the risk of various assets held by banking institutions. The risk assessment of assets is essential to determine the required amount of risk adjusted capital required to be held by a bank.
Due to the prohibition of credit reports from the three dominant credit rating agencies in the US, the FDIC stated that it must now develop “alternative standards of creditworthiness that could be used in lieu of credit ratings”. The prohibition against using the established credit rating industry has left many wondering if the Dodd-Frank Act was written too hastily and without a comprehension of the complexity and huge cost of enforcing its wide reaching mandates.
The restrictions against the credit agencies were based on their failure to properly rate the risk of mortgage securities which was a major contributing cause of the financial crisis. Nonetheless, it would have been more efficient to reform the credit rating agencies instead of prohibiting the use of their reports, especially since there is no viable alternative to their services.
The rating agency ban is equivalent to the FAA banning airlines from future purchases of Boeing or Airbus jets after a plane crash – it may sound like it makes sense until you need to buy the next plane and find out that there are no other major airline manufacturers. A ban on purchasing Boeing and Airbus jetliners would soon close down the airline industry and right now the ban on credit rating agencies is shutting down the essential task of determining proper capital levels in the banking industry. The result will be a reduction in lending by banks as they struggle to comply with confusing regulations that are subject to constant change.
FDIC Chairman Bair, in an Advance Notice of Proposed Rulemaking (ANPR) explained why the credit agencies were banned but also admitted that “finding a better substitute will not be simple” and that alternatives “are far from perfect”.
Every study of the root causes of the financial crisis highlights the role of credit ratings as a key contributing factor to the problems the led to virtual collapse of the financial sector.
Issuers created and successfully marketed complex transactions that lacked economic substance.
Investors bought these toxic assets in the hundreds of billions without performing their own analysis because they carried a AAA—the same rating assigned to debt back by the full faith and credit of the US government.
The results were devastating. Once losses exceeded expectations, the securities unraveled and investors and the issuing banks and securities firms lost billions.
So it was no surprise that as part of the regulatory reform package, Congress established provisions to address the breakdown in the credit ratings process. Section 939A of the Dodd-Frank Act requires all federal agencies to review their regulations that reference or require the use of credit ratings and remove those references.
I think that we will also find that some of the more likely replacements — credit spreads, internal models, supervisor-determined risk buckets– are far from perfect. Further, we are going to need to balance the benefits of alternative approaches with the burdens associated with implementation.
However, I also believe that the task of replacing credit ratings with a better substitute will not be simple. The agencies have used ratings beyond capital, in fact, examiners have used ratings for decades to determine whether or not to criticize corporate securities held in bank investment portfolios.
Ms. Bair also emphasized that before she can become comfortable with alternative credit rating methods they must be “sufficiently transparent and reasonably simple to implement and not add undue burden”. These comments should have been considered before passage of the Dodd-Frank Act – recreating the credit reporting industry will be neither simple nor without considerable burden upon both regulators and the financial industry.