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22 February 2012

Regulators Propose Alternatives to Credit Ratings

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In December 2011, the three federal bank regulatory agencies announced proposed amendments to their market risk capital rules to remove any references to credit ratings in order to comply with the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010.
United States Corporate/Commercial Law

Previously published in The Legal Intelligencer

In December 2011, the three federal bank regulatory agencies announced proposed amendments to their market risk capital rules to remove any references to credit ratings in order to comply with the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010. Section 939A of the act requires federal agencies to review their regulations and remove any references to or requirements of reliance on credit ratings and to replace them with alternative standards of credit-worthiness. The bank regulatory agencies were requesting comments to the December 2011 NPR until Feb. 3.

The market risk capital rules (MRCR) impose capital requirements on certain U.S. banking organizations with significant trading operations and stem from guidelines established by the Basel Committee on Banking Supervision. In order to account for revisions to the market risk framework adopted by the BCBS between July 2005 and June 2010, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation jointly proposed modifications to their MRCR in an earlier notice of proposed rulemaking published in January 2011.

However, the January 2011 NPR did not include the BCBS' methodologies for calculating standard specific risk capital requirements for certain debt and securitization positions because those methodologies generally rely on credit ratings. Capital requirements for specific risk are intended to cover the risk of adverse price movements stemming from factors related to the issuer of an individual instrument (e.g., the issuer of a debt instrument declares bankruptcy) as opposed to from general market movements (e.g., interest rates). The December 2011 NPR amends the January 2011 NPR and proposes alternative methodologies for calculating specific risk capital requirements for debt and securitization positions that do not rely on credit ratings, including the following:

Sovereign Debt Positions

Under the current MRCR, the specific risk-weighting factors for sovereign debt positions depend on whether the sovereign entity is a member of the Organization for Economic Co-operation and Development. The December 2011 NPR proposes to determine specific risk-weighting factors for a sovereign debt position (which is defined as a direct exposure to a sovereign entity) based on the Country Risk Classifications established by the OECD. The CRCs use a scale of eight risk categories ranging from 0-7, with 0 for the countries with the lowest possible risk assessment and 7 the highest. The proposed specific risk-weighting factors for sovereign debt positions would range from 0 percent for countries with a CRC of 0 or 1 to 12 percent for a sovereign position assigned a CRC of 7, and banks may assign a lower specific risk-weighting factor than the applicable CRC rating in certain situations.

In addition, exposures to U.S. sovereign debt positions and its agencies would have a 0 percent specific risk-weighting factor, sovereign entities that have no CRC generally would have an 8 percent specific risk-weighting factor and sovereign debt positions where the sovereign has defaulted on any exposure within the last five years would have a 12 percent specific risk-weighting factor. The December 2011 NPR also explained two alternative market-based approaches relying on sovereign credit default swaps and bond spreads, either as a replacement of or a supplement to the CRCs, and invited comments on these methodologies as well.

Supranational Entities and Multilateral Development Banks

Currently, exposures to certain supranational entities and multilateral development banks under the MRCR receive specific risk-weighting factors that range between 0.25 percent and 1.6 percent, depending on their remaining maturity. The BCBS did not change this classification and the December 2011 NPR proposes to apply specific risk-weighting factors that are consistent with the BCBS market risk framework. Debt positions that are exposures to the Bank for International Settlements, the European Central Bank, the European Commission and the International Monetary Fund are assigned a 0 percent specific risk-weighting factor. Exposures to MDBs (which are specifically listed in the December 2011 NPR) would also receive a 0 percent specific risk-weighting factor. Debt positions that are exposures to other regional development banks or multilateral lending institutions that do not qualify as supranational entities or MDBs would generally be subject to the proposed methodology applicable to corporate debt positions explained below.

Depository Institutions, Foreign Banks and Credit Unions

The current MRCR assign a specific risk-weighting factor ranging from 0.25 percent to 1.6 percent, based on remaining maturity, to debt positions that are exposures to banks incorporated in OECD countries. Banks incorporated in a non-OECD country receive similar specific risk-weighting factors provided certain conditions are met, such as the issuance of an investment-grade rating from a credit rating agency. Debt positions that are rated below investment grade or deemed to be of comparable credit quality are given higher specific risk-weighting factors. The agencies are proposing to provide specific risk-weighting factors based on the CRC rating of an entity's sovereign of incorporation (the country where an entity is incorporated, chartered or similarly established) instead of on OECD membership for debt positions that are exposures to depository institutions, foreign banks or credit unions.

Public Sector Entities

The December 2011 NPR defines a public sector entity as a "state, local authority, or other governmental subdivision below the level of a sovereign entity" and excludes from the definition "commercial companies owned by a government that engage in activities involving trade, commerce, or profit, which are generally conducted or performed in the private sector." Currently, specific risk-weighting factors ranging from 0.25 percent to 1.6 percent are assigned under the MRCR to general obligations and, if certain conditions are met, revenue obligations of states and other political subdivisions of OECD countries, based on maturity. Under the proposed rules, a debt position that is an exposure to a PSE would receive a specific risk-weighting factor based on the CRC assigned to the PSE's country of incorporation and on whether the position is a general obligation or a revenue obligation. The agencies also propose to permit a bank to use specific risk-weighting factors assigned by a banking supervisor of a foreign country to debt positions that are exposures to PSEs in that foreign country because the agencies have allowed it under certain circumstances in the past. A bank may not, however, assign a specific risk-weighting factor lower than the lowest specific risk-weighting factor assigned to that PSE's sovereign of incorporation.

Corporate Debt Positions

Under the current MRCR, specific risk-weighting factors for covered corporate debt positions range from 0.25 to 8 percent depending on the investment grade and remaining maturity of the instrument. Capital requirements are a function of the type of obligor, the credit rating of the obligor and the remaining maturity of the exposure. In the December 2011 NPR, a "corporate debt position" is defined as a debt position that has an exposure to a company that is not a sovereign entity, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, an MDB, a depository institution, a foreign bank, a credit union, a PSE, a government-sponsored entity or a securitization.

The proposed rules would allow a bank to rely on market-based information and historical accounting information (referred to as "indicator-based methodology") to assign specific risk-weighting factors to corporate debt positions that are exposures to publicly-traded, nonfinancial institutions. Banks may also choose to not use the indicator-based methodology and simply assign an 8 percent specific risk-weighting factor to all of their corporate debt positions. The agencies categorize financial institutions separately from other entities in the December 2011 NPR and are proposing that all corporate debt positions issued by financial institutions (other than those that are exposures to a depository institution, foreign bank or credit union) also be assigned a specific risk-weighting factor of 8 percent.

Securitization Positions

Currently, under the MRCR, a bank is not required to model specific risk if it calculates a specific risk capital add-on for each securitization position subject to the MRCR using a standardized method. Under the standardized method, the absolute value of the current market value of each net long and net short position in a securitization position is multiplied by the specific risk-weighting factor specified in the MRCR, which ranges from 0 to 8 percent depending on the credit rating and remaining contractual maturity of the position. Also, banks must apply the highest specific risk-weighting factor (8 percent) to unrated securitization positions.

The December 2011 NPR proposes a simplified version of the Basel II advanced approaches supervisory formula approach issued by the BCBS to assign specific risk-weighting factors to securitization positions. If a bank does not use the simplified supervisory formula approach (SSFA), a securitization position would bear a specific risk-weighting factor of 100 percent, which is roughly equivalent to a 1,250 percent risk weight. The SSFA specific risk-weighting factor for a position depends on several inputs, which the agencies believe are readily available from prospectuses and from servicer reports for existing securitizations. A bank may use the SSFA to determine its specific risk-weighting factor for a securitization position only if it has information to assign each of the inputs. Otherwise, the bank must apply a specific risk-weighting factor of 100 percent.

As with other measures proposed to comply with the act, the December 2011 NPR is complex and requires a diligent review to understand its provisions. However, the full impact of its methodologies cannot be fully comprehended until they are implemented. These methodologies are relatively novel and the U.S. is currently the only country with a ban on credit ratings. Although the agencies believe that the capital requirements under the proposed methodologies generally would be comparable to those produced by the BCBS' standardized measurement method, the accuracy of that remains to be seen.

Furthermore, Section 939A of the act addressed the criticism that the U.S. government "sanctioned" credit ratings by having them incorporated into federal regulation. The agencies believe that Section 939A was not intended to apply to assessments of creditworthiness of organizations such as the OECD but by replacing credit ratings with another third-party assessment of risk, the reliance on credit ratings could simply shift to this third party.

Lastly, the proposed rules do not apply to small banking organizations because they apply only to banking organizations with aggregated trading assets and trading liabilities equal to 10 percent or more of quarter-end total assets or aggregate trading assets and liabilities equal to at least $1 billion. However, the proposed rules will affect banks of all sizes. The agencies have indicated that the alternative approaches to credit ratings that emerge will also be applied in subsequent rules because consistency is crucial to reduce opportunities for regulatory arbitrage.

The agencies expect to finalize the December 2011 NPR and the July 2011 NPR after receipt and consideration of comments.

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