Alert August 17, 2010

Agencies Issue ANPR on Alternatives to the Use of Credit Ratings in Capital Rules

The FDIC, the OCC and the FRB (the “Agencies”) issued a joint advance notice of proposed rulemaking (the “ANPR”) regarding alternatives to the use of credit ratings in the Agencies’ risk-based capital rules for banking organizations.  The ANPR was issued in response to Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires the Agencies to review, by July 21, 2011, (1) their regulations requiring the use of an assessment of the credit-worthiness of a security or money market instrument and (2) any references to or requirements in such regulations regarding credit ratings.  The Agencies must “modify any such regulations identified by the review to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as [the Agencies] shall determine as appropriate for such regulations.”  In making such determination, the Agencies must “seek to establish, to the extent feasible, uniform standards of credit-worthiness” for use by the Agencies, taking into account the entities they regulate and the purposes for which such entities would rely on such standards of credit-worthiness.

The ANPR describes the areas in the Agencies’ risk-based capital standards where the Agencies rely on credit ratings, as well as the Basel Committee on Banking Supervision’s (the “Basel Committee”) recent amendments to the Basel Accord.  Specifically, the Agencies’ capital rules reference credit ratings issued by nationally recognized statistical rating organizations in four general areas: (1) the assignment of risk weights to securitization exposures under the general risk-based capital rules and advanced approaches rules; (2) the assignment of risk weights to claims on, or guaranteed by, qualifying securities firms under the general risk-based capital rules; (3) the assignment of certain standardized specific risk add-ons under the Agencies’ market risk rule; and (4) the determination of eligibility of certain guarantors and collateral for purposes of the credit risk mitigation framework under the advanced approaches rules.  In addition, the Basel “standardized” approach for credit risk relies extensively on credit ratings to assign risk weights to various exposures.

Through the ANPR, the Agencies are seeking comments on alternative standards of credit-worthiness that could be used for purposes of their risk-based capital standards.  The ANPR notes that the Agencies are considering a wide range of approaches, including (a) developing risk weights for exposure categories based on objective criteria (such as the type of obligor and certain characteristics of the exposure) similar to the risk bucketing approach of the general risk-based capital rules, and (b) developing broad qualitative and quantitative credit-worthiness standards (such as credit spreads or debt-to-equity ratios) that banking organizations could use to measure the credit risk associated with exposures within a particular exposure category.

In evaluating these approaches, the Agencies noted that they will, to the extent practicable, consider whether any such approach would: (i) appropriately distinguish the credit risk associated with a particular exposure within an asset class; (ii) be sufficiently transparent, replicable, and defined to allow banking organizations of varying size and complexity to arrive at the same assessment of credit-worthiness for similar exposures and to allow for appropriate supervisory review; (iii) provide for the timely and accurate measurement of negative and positive changes in credit-worthiness; (iv) minimize opportunities for regulatory capital arbitrage; (v) be reasonably simple to implement and not add undue burden on banking organizations; and (vi) foster prudent risk management.  The ANPR requests comments on the advantages and disadvantages of the proposed approaches, as well as any suggestions for other approaches that would meet the stated credit-worthiness standard.

The ANPR provides a detailed discussion of how the approaches might be implemented with respect to certain specific exposure categories, including: (1) sovereign exposures; (2) public sector entity (“PSE”) exposures; (3) bank exposures; and (iv) corporate exposures.  For example, the ANPR discusses the possibility of expanding the general risk-based capital treatment of these exposures to the other risk-based capital regimes.  The ANPR also discusses the possibility of using certain key financial, economic and market indicators and measures to determine the correct risk weighting for such exposures, or assigning exposures to one of a limited number of risk weight categories based on an assessment of the exposure’s probability of default or expected loss.

With respect to securitization exposures, the Agencies are seeking comment on a number of proposals, including: (a) using the risk-based capital rules in effect prior to the implementation of the “recourse rule,” which would eliminate all references to credit ratings and result in all securitization exposures receiving the same risk weight regardless of the amount of subordination in the securitization structure; (b) requiring banks to “gross-up” any such exposure by maintaining capital against its securitization exposure as well as all more senior exposures; (c) adopting the Basel Committee’s approach to calculating capital requirements for securitization exposures that is based on the level of subordination and the type of underlying exposures and which uses a “concentration ratio” (equal to the sum of the notional amounts of all the tranches divided by the sum of the notional amounts of the tranches junior to or pari passu with the tranche in which the position is held including that tranche itself); and (d) designing a risk-weighting approach based on a supervisory formula.  In addition, with respect to guarantees and collateral, the ANPR notes the possibility of the Agencies incorporating into the recognition of collateral and guarantees some of the credit-worthiness standards discussed above for sovereign, PSE, bank and corporate exposures.

The ANPR requests comments on all of the potential approaches, and commenters are asked to provide quantitative and qualitative support and/or analysis for proposed alternative methods.  The ANPR notes that the Agencies recognize that a “more refined differentiation of credit-worthiness may be achievable only at the expense of greater implementation burden,” and therefore are also seeking comment on the feasibility of and burden associated with each of the various alternative standards for banking organizations of varying size and complexity. 

Before approving the issuance of the ANPR, several members of the FDIC’s Board of Directors expressed concern about completely eliminating the use of credit ratings.  In this regard, the ANPR notes that the Agencies are “interested in whether development of alternatives to the use of credit ratings would involve, in most circumstances, cost considerations greater than those under the current regulations.”

Eliminating the use of credit ratings will also further delay implementation in the U.S. of the so-called Basel II “Standardized Approach” and revisions to the market risk rules.  Both the Standardized Approach, a simpler version of Basel II that is expected to be optional for all U.S. banks that are not required to adopt the Basel II advanced approaches, and the proposed revisions to the market risk rules, use external ratings.  Efforts to finalize these initiatives have now been delayed indefinitely until the Agencies determine appropriate alternatives to the use of such external ratings.

Comments on the ANPR are due within 60 days after its publication in the Federal Register, which is expected shortly.  The OTS is expected to join the Agencies in issuing the ANPR upon clearance by the Office of Management and Budget.

The Alert will continue to monitor this area and provide updates on material developments as they occur.