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Basel's ratings reliance complicates task for US regulators
January 11, 2013 / 9:21 PM / in 5 years

Basel's ratings reliance complicates task for US regulators

Jan 11 (IFR) - Proposed new international banking standards conflict with US legislation, and analysts say that could further slow efforts to bring US banks in line with their global counterparts.

The discrepancy concerns the use of credit agency ratings, which many blamed for fuelling the financial crisis that initially prompted the wave of new regulations.

The so-called Basel Committee, which is drafting new standards intended to prevent another crisis, requires the use of credit ratings to evaluate the assets that banks hold as reserve capital.

But under Dodd-Frank, the 2010 US legislation also aimed at staving off another global market meltdown, US regulators are prohibited from using agency ratings.

The issue came to light this week when the committee announced that RMBS or residential mortgage-backed securities - the same kinds of investment products, consisting of bundles of home loans, that played such a key role in the crisis - can be counted towards a bank’s liquidity coverage ratio (LCR).

But the committee said the only RMBS that could be used were those with a credit rating of double-A or higher - a distinction that US regulators would not be allowed to impose on US banks. It also allowed corporate bonds rated BBB- to A+.

“While US regulators have generally agreed to implement the standards published by the Basel Committee, the Basel Committee’s publications are not international treaties and therefore are not legally binding,” said Stephanie Collins, a spokeswoman for the Office of the Comptroller of the Currency.

“In fact, where the Basel Committee standards conflict with US law, we cannot implement them,” she said.

GOOD INTENTIONS

One key component of the financial crisis was the collapse of mortgage-related bonds that had been given top ratings for creditworthiness but turned out to be riddled with bad loans.

US lawmakers who were crafting Dodd-Frank after the crisis then banned the use of agency ratings.

As a result, US regulators have had to improvise complicated formulas that replicate - and in some cases essentially duplicate - the calculations performed by the credit agencies.

That task was massively complex, and the Federal Reserve Board did not finalize the first set of formulas, regarding how to assess the creditworthiness of risk-based capital, until June.

This week, however, the Basel Committee issued new guidelines allowing RMBS and other securities to be counted toward LCR - a specified amount of high-quality liquid assets (HQLA) that banks must hold to guard against periods of sustained crisis and stress in the market.

Now US regulators may have to go back and painstakingly revise those formulas to apply to liquidity provisions as well as the risk-capital requirements - a necessity likely to delay the process of implementing the eventual standards, known as Basel III, even longer.

“Because Dodd-Frank prohibits the use of credit ratings, it remains to be seen how this week’s particular provisions will be modified for purposes of the eventual US implementation of the LCR,” law firm Sullivan & Cromwell said in a client note this week.

Analysts say regulators have their work cut out for them.

“The regulators are generally under pressure to get the implementation of Basel III wrapped up, and the rating piece is one important part of that,” said Dwight Smith, a specialist on bank regulation and a partner at the law firm of Morrison Foerster.

“The way that the regulators go about determining alternatives for ratings for the LCR does not necessarily have to be the same approach they used for determining rating alternatives for purposes of risk weighting,” Smith told IFR.

“Liquidity measures banks’ ability to sell the securities, and risk weightings measure the value of continuing to hold them. They may want to approach it differently this time.”

Barbara Hagenbaugh, a spokeswoman for the Federal Reserve, said: “We fully intend to use other tools besides credit ratings for the liquidity coverage ratio, similar to how we did it for the Basel (risk) capital provisions.”

TROUBLE AHEAD

Some experts say that the need to use an alternative to credit ratings will seriously complicate the implementation of new capital standards for banks in the United States.

One result, according to Kevin Barnard, a partner at law firm Arnold & Porter, is that US standards could end up significantly different than those implemented in other countries because of differences in risk weighting frameworks.

Others say that banks will continue to use ratings as an input in their internal liquidity models anyway.

“One can make the argument that Congress went overboard on external credit ratings by mandating that they be removed from all regulations,” said Luigi De Ghenghi, a partner at law firm Davis Polk & Wardwell.

“Many bank executives say external credit ratings are still a useful metric. While you might be foolhardy to rely on it as the sole creditworthiness metric, especially for more complex structured paper, there’s no point in throwing out the baby with the bathwater,” he said.

“It’s a useful piece of information to have.”

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