Bank Regulators Abandon Credit Ratings To Measure Risk

Do these new regulations from the Office of the Controller of Currency which regulates certain aspects of our banks mean that banks can ignore credit ratings on U.S. debt they invest in as part of their Tier 1 capital ratios? Is this a preparation for an eventual and likely downgrade of the U.S. Treasury’s credit rating?

The Dodd-Frank legislation required the OCC, FDIC, and the Fed to examine alternatives to credit ratings in determining thing such as bank capital requirements. They have spelled out approaches to measuring risk other than credit ratings. The idea was that the credit rating agencies failed us during the Crash of ’08.

But perhaps this raises an underlying issue regarding banks’ capital ratios. That issue is that banks can use debt of their sovereigns as capital in calculating their Tier 1 capital requirements. If the sovereign is downgraded, in many countries that doesn’t affect the banks’ capital requirements. Not being an expert in this field, I ask my readers to chime in here and see if they have an answer to this question: Does it matter if the U.S. credit rating is downgraded? Would that impact their capital ratios and require them to raise additional capital?

Establishing higher standards of creditworthiness of a bank’s capital base is a worthy and necessary goal, but does jettisoning the entire credit rating system actually help sovereigns if they are downgraded? That is, if they are downgraded would banks then dump their Treasurys and create market havoc? Or, if they are downgraded and they can ignore credit ratings, can banks continue to count Treasurys at par in meeting capital requirements?

Inquiring minds wish to know.

Here is the OCC release from today:

November 29, 2011

OCC Proposes Rule to Remove References to Credit Ratings and Guidance on Due Diligence Requirements in Determining Whether Investment Securities Are Eligible for Investment

WASHINGTON — The Office of the Comptroller of the Currency (OCC) proposed a rule to remove references to credit ratings from various OCC regulations and related guidance today to assist national banks and federal savings associations in meeting due diligence requirements in assessing credit risk for portfolio investments.

The proposed rule and guidance was published in the Federal Register. Comments may be submitted through December 29, 2011.

Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires federal agencies to review regulations that require the use of an assessment of creditworthiness of a security or money market instrument and any references to, or requirements in, those regulations regarding credit ratings. Section 939A then requires the federal agencies to modify the regulations identified during the review to substitute any references to, or requirements of, reliance on credit ratings with such standards of creditworthiness that each agency determines to be appropriate.

The proposed OCC rule would remove references to credit ratings in the OCC’s non-capital regulations. In particular, the OCC proposes to amend the definition of “investment grade” in 12 CFR Part 1 to no longer reference credit ratings. In addition to following the standard under the proposed rule, national banks and federal savings associations would be expected to continue to maintain appropriate ongoing reviews of their investment portfolios to verify that they meet safety and soundness requirements appropriate for the institution’s risk profile and for the size and complexity of the portfolios.

The proposed guidance clarifies steps national banks should take to demonstrate they have properly verified their investments meet the newly established credit quality standards under 12 CFR Part 1 and steps national banks and federal savings associations should take to demonstrate they met due diligence requirements when purchasing investment securities and conducting ongoing reviews of their investment portfolios. Additionally, when purchasing corporate debt securities, federal savings associations will need to follow requirements to be established by the Federal Deposit Insurance Corporation pursuant to 12 U.S.C. 1831e(d) (as amended by section 939(a)(2) of the Dodd-Frank Act).


3 comments to Bank Regulators Abandon Credit Ratings To Measure Risk

  • Buck

    Paragraph 4 of the release: “The proposed OCC rule would remove references to credit ratings in the OCC’s non-capital regulations.”

  • Yes but the section of the Dodd-Frank Act deals with all securities. But thanks, you are probably correct.

  • Lionheart

    This feels like one more step down on the ladder toward a formal currency devaluation (14-15% is the current rumor by Q3 2012), and yet another move toward currency controls as part of that process?