WASHINGTON U.S. banking regulators on Wednesday released their first proposal for replacing the work of much-maligned credit rating agencies in the rules that govern bank capital requirements.
The 2010 Dodd-Frank financial oversight law bans any reliance on credit rating agencies, such as Moody's Corp and McGraw-Hill Cos' Standard & Poor's, in banking rules but regulators have struggled to come up with an alternative.
Until a replacement is found, it will be difficult for the United States to begin implementing new international capital requirements such as Basel III.
The Federal Deposit Insurance Corp board on Wednesday voted to put out the alternatives for comment through February 3.
The credit rating alternatives proposal released on Wednesday would only directly affect a rule to update capital requirements regarding risks posed by banks' trading books. This rule applies only to the largest U.S. banks such as JPMorgan Chase, Goldman Sachs and Citigroup.
The credit rating proposal is expected, however, to lay the groundwork for a rule to be released next year on how to get rid of references to credit ratings in all bank capital rules.
That rule will affect banks of all sizes.
Among the alternatives proposed on Wednesday are using the assessments produced by the Organisation for Economic Co-operation and Development on the fiscal health of individual countries as a marker for assessing the risk of sovereign debt held by banks.
For certain assets, market indicators - such as stock price volatility - would be used to measure risk.
The amount of capital that would have to be held against securitizations would, in part, depend on the risk of the assets that make up the different parts, or tranches, of the security.
How to assess the risk of assets is key to determining how much capital banks should hold to guard against financial shocks that could sink an institution and roil the economy.
Credit rating agencies have been pilloried for not recognizing the risk of such things as mortgage backed securities leading up to the 2007-2009 financial crisis, though Dodd-Frank Congress sought to eliminate their official use by bank regulators.
Still, the directive is one of the rare parts of Dodd-Frank that regulators have openly pleaded with Congress to change.
Their argument has been that while reducing a reliance on credit ratings agencies is sensible, completely casting aside their work is troublesome because good alternatives are not readily available.
That plea has fallen on deaf congressional ears.
On Wednesday, regulators said they have made their best effort to comply with the law but noted they are entering unchartered territory.
"The approaches that are being proposed are intended to be simple and easily implemented, but they are relatively novel," Acting Comptroller of the Currency John Walsh said.
With this in mind officials said they will carefully review all the feedback they receive.
Regulators were under pressure to move forward with the alternatives now because the rule governing capital requirements for trading books is supposed to be in place early next year.
In response to the 2007-2009 financial crisis regulators from across the world agreed to update their capital guidelines to better take into account the risks posed by such things as securities made up of mortgages, which played a key role in the meltdown.
This update for trading books is known as Basel 2.5.
The agreement assumes countries can rely on credit ratings and its implementation has been delayed in the United States as regulators searched for alternatives. The United States is the only country that has such a ban.
The broader rule on how to strip credit ratings from bank regulations will be needed for the United States to move forward on implementing the new, stiffer international capital agreement know as Basel III, which begins going into affect in 2013.
U.S. regulators expect to release a proposed rule implementing Basel III in the first few months of next year.