A research analyst at the Treasury Department's Office of Financial Research examined the challenges posed by the alternative standards of creditworthiness used to replace credit ratings following their elimination from federal financial regulation by the Dodd-Frank Act. The author identified these alternatives under the categories: definitions, regulatory models, and third party classifications.
The author summarizes the challenges for these alternative approaches:
- Definitions: Defining creditworthiness for certain securities: (i) gives too much discretion to companies and disregards their incentive to overstate the quality of their assets; and (ii) results in a loss of granularity for analyzing different levels of credit risk, which can incentivize a financial institution to take more risk because it receives no regulatory benefits from holding safer securities.
- Regulatory Models: Regulatory models to set capital requirements can result in: (i) an incorrect categorization of the riskiness of securities, if the model is inaccurate; and (ii) a strong incentive for market participants to game these models.
- Third-Party Classification: Third parties that assist in setting credit standards may face incentive issues. Regulators may need to consider: (i) a third party's funding, incentive structure and competitive pressures; e.g., by regularly reviewing the firewalls in place to ensure a third party is not using information it gains from its role as a service provider to support its other businesses, such as asset management; and (ii) ensuring that a third party is properly measuring credit risk.
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