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Analysis: Regulators, watchdogs second guess ratings reform

WASHINGTON (Reuters) - Banks and regulators are urging Congress to scale back a ban on the use of widely criticized credit raters to assess the risk of securities and investments on bank’s books, at least until a better alternative is developed.

In a rare moment of agreement over the new U.S. financial reform law some consumer advocates say banks have a point.

A broad crack down on the credit rating agencies had strong bipartisan support in Congress following widespread accusations that they gave the thumbs up to risky financial products during the financial crisis.

As part of this whip cracking the law bans the use of their work in the regulations used to oversee banks.

But now this disparate group says this provision goes too far, too quickly. The danger, they say, is that regulators will rely on otherwise untested tools when assessing the riskiness of banks.

More directly, industry officials argue banks may shy away from holding state and corporate debt because it would require too much work to prove to regulators that those investments are low risk.

“This one, I just think in the heat of the moment, they didn’t think it through,” said Barbara Roper, director of investor protection at the Consumer Federation of America and a prominent advocate for tough financial reforms.

This could be welcome reprieve for the big credit raters -- Moody’s, Fitch Ratings and Standard & Poor’s, -- who stand to lose money if regulators no longer rely on them when assessing bank riskiness.

Regulators use the work of ratings providers to assess the risk associated with a bank’s capital, the credit-worthiness of securities they hold and as an indicator of trouble spots in their books.

STRONG BIPARTISAN SUPPORT

Unlike most aspects of the Dodd-Frank reform law, the ratings ban has a bipartisan seal of approval. That means it could be tough for regulators to draw out the implementation of the ban or convince lawmakers to narrow it.

“As long as you have (credit ratings references) in, the fear would be that we would quickly fall back on primary reliance on what was obviously a failed system in the past,” said Republican Representative Scott Garrett in an interview.

Garrett was part of a rare bipartisan coalition in Congress who strongly pushed for the crackdown. Other supporters included House Financial Services Chairman Barney Frank, Republican Representative Spencer Bachus, Republican Senator George Lemieux and Democratic Senator Maria Cantwell.

The law instructs regulators to by July 2011 identify references to credit ratings agencies in their rules, come up with alternative risk assessment tools and then report to Congress on what changes they are making as a result.

Regulators, including acting Comptroller of the Currency John Walsh, have told Congress of their reservations.

Walsh said in testimony to the Senate Banking Committee in late September that the ban on using ratings in regulatory assessments “goes further than is reasonably necessary.”

And banks and industry groups are making their views known to regulators.

“We encourage the agencies to urge Congress to amend the statute to clarify that credit ratings can be used as an element of credit-worthiness,” the Securities Industry and Financial Markets Association wrote regulators in an October 25 letter.

Given the law’s deadline, regulators are moving quickly and may unveil a proposal by the end of the year. Federal Deposit Insurance Corp chairman Sheila Bair said that they will likely release a proposal by year’s end for what risk assessment tools could replace the ratings agencies.

CONCERNED ABOUT FINDING ALTERNATIVE

Proponents of scaling back the law are careful to say their concerns are not meant to be an endorsement of the ratings agencies but they worry that there is not a good alternative.

“We wish to emphasize that we agree with the goal of reducing overreliance on credit ratings,” is how Bank of America prefaced its request that regulators seek to soften the ban.

Some, however, see resistance to the ban as an example of the financial services industry fighting any costly change.

“It would help investors, but hurt the profits of both banks and the rating agencies, so I’m not surprised there’s attempt to roll back the provision,” said University of San Diego Professor Frank Partnoy, who supports the ban.

For its part Moody’s is publicly professing no problem with the government moving away from an over-reliance on ratings agencies’ work. It did warn, however, in a letter to regulators that they should rely on a “range of risk management tools” and not simply replace its work with one alternative.

On Thursday Moody’s reported a better-than-expected third-quarter profit and raised its full-year outlook.

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