The US federal banking regulators (Fed, OCC, and FDIC) yesterday proposed rules that apparently would remove ratings from capital regulation for large banks. This comes a few months after the deadline set by Dodd-Frank.
What jumps out at me on a quick read is the rules’ treatment of market-based alternatives to credit ratings. The idea of using market prices instead of credit ratings enjoys widespread academic support, although it has problems because market prices reflect factors other than credit risk. The rules incorporate stock-market volatility into the capital requirements for corporate bond holdings, but otherwise do not call for use of market prices.
The accompanying explanation goes into some depth about what market-based alternatives to ratings would look like, suggesting that the regulators are kepeing this option open.
1. Will the bank regulators really go all the way with this? The agencies acknowledge that “most commenters shared a general concern regarding the removal of credit ratings from the risk-based capital rules and asserted that credit ratings can be a valuable tool for assessing creditworthiness.” The regulators don’t address this. Comments on the revised rule are open until Feb. 3, 2012, so we’ll see how this evolves.
2. Will state insurance regulators follow suit? So far, the state insurance regulators, through their national organization (the NAIC), have taken limited steps to reduce rating reliance, but nothing like the complete elimination Dodd-Frank seems to require. The question is important because insurers actually own more foreign and corporate bonds, and more municipal bonds, than banks do.
3. The big question: If this really marks the beginning of the end of rating-dependent regulation, will rating agencies still wield power? Ratings are currently used in settings where it is not clear that they are required by regulation, but will this fade away if they are written out of regulations? If not, is that because the agencies provide valuable financial analysis or for some other reason?
The Wall Street Journal (subscription required) reports that regulators are getting ready to start evaluating alternatives to credit ratings for bank capital regulation. The FDIC will present and solicit comment on proposals for alternatives to credit ratings tomorrow, including (1) greater use of credit spreads, (2) having supervisors devise their own risk metrics, and (3) use of existing bank internal models.
It’s good that they’re getting this under way quickly, as federal regulators are required to eliminate ratings from federal regulation in a year. As many commenters, including me, have noted, these alternatives all have serious challenges. Credit spreads incorporate credit risk, market liquidity, and market psychology in a mix that is difficult to disentangle. Supervisors presumably are not eager to take on the responsibility for assessing the credit risk of their regulated entities’ portfolios, or they wouldn’t have outsourced the job in the first place. Budgetary issues apparently starved the insurance industry’s in-house credit risk assessor. And using bank internal models has widely been criticized for allowing the fox to guard the henhouse.
As federal regulators move to end rating-dependent regulation – a move favored by the market leaders, Moody’s and Standard & Poor’s, though not by the second-tier agencies Fitch and DBRS – keep in mind that the federal root-and-branch approach will not in itself end regulatory use of ratings. The state regulators who oversee the insurance industry and its vast demand for fixed-income products have not shown any appetite to eliminate rating-dependent regulation. So unless state insurance regulators follow suit on their own or state regulation of insurance is preempted in this area, at least part of the problem of rating-dependent regulation for rating quality will persist.
So Blanche Lincoln’s eleventh-hour introduction of a provision that would have required the banks to spin off their swaps desks into separate affiliates may just have been what allowed her to beat back that primary challenge from the left. I hadn’t been following its surprising survival or inevitable dilution that closely, and I was surprised recently to read that banks will be allowed to continue to trade “investment-grade” swaps. Given that “investment grade” is usually defined in terms of ratings, that seemed a little weird in light of Congress’ s very aggressive move to get rid of rating-dependent regulation at the federal level altogether in Sec. 939A of the bill, as discussed in my previous post.
Turning to the text of the conference report and working through a layer of definitions I won’t go into here, it seems that what people call the swap spinoff requirement of Sec. 716 has an exception for banks’ dealing and trading in swaps (other than CDS) that involve “rates or reference assets that are permissible for investment by a national bank under the paragraph designated as ‘Seventh’ of section 5136 of the Revised Statutes of the United States ( 12 U.S.C. 24).”
12 U.S.C. 24, in turn, doesn’t tell us exactly all the assets that are permissible for a national bank. It specifies some securities in which such a bank can invest and goes on to provide that national banks may purchase “investment securities” as that term is defined by the Comptroller of the Currency. And credit ratings lie at the heart of the Comptroller’s rules about what national banks can purchase. See 12 C.F.R. §§ 1.2-1.3. Indeed, the Comptroller’s use of ratings for this purpose – introduced in the 1930’s – is often cited as the canonical example of rating-dependent regulation.
So it seems that Congress is actually adopting a rating-dependent regulation to define its new swap-spinoff rule while at the same time instructing regulators to get rid of all rating-dependent regulation in Sec. 939A. I suppose the provisions aren’t exactly inconsistent, because Sec. 939A gives the regulators one year to eliminate rating-dependent regulation and there is a two-year period before the swaps desks have to be separated (Sec. 716(f)). And I’d be hard-pressed to identify a significant market in swaps other than CDS on investment-grade assets. But it still strikes me as a bit weird.
The struggle over rating-dependent regulation — often discussed in the academic literature — has been largely eclipsed in the discussion of the financial-regulation bill. But it’s been quite a tussle. The House GOP wanted to eliminate all federal regulatory dependence on ratings in three months. The Frank bill that actually passed the House would have eliminated rating-dependent regulation at certain agencies in a year and ordered the rest of the agencies to study the issue. Then we had the Dodd bill that had only a study, and the Cantwell/LeMieux amendment, which added repeal of certain statutory (but not regulatory) references.
Now we have the conference report, which seems to follow the House model and requires elimination of rating-dependent regulation within one year of enactment – see Sec. 939A of the conference report.
Most people these days seem to favor getting credit ratings out of the regulatory system. Your humble blogger has been a bit of a dissenter here, although a diffident one. It certainly makes sense to think about reducing reliance n ratings, but regulators who’ve done so since the beginning of the crisis, such as the SEC and the NAIC, seem to be backing away from the idea.
Maybe the idea is that there has been a failure of bureaucratic will here, so that what we need is to order namby-pamby regulators to do their own regulating. But completely eliminating the use of ratings throughout the federal system seems precipitous, especially given that (a) federal reliance on ratings has never to my knowledge been surveyed and critically assessed; and (b) as far as I know, no viable alternative to credit ratings exists. The legislation instructs regulatory agencies to “substitute such standard of credit-worthiness as each agency shall deem appropriate for such regulations.” Unless a lot of thinking about this has been going on behind the scenes, the order to completely replace credit ratings within a year seem a bit rash.
An interesting wrinkle: The requirement to abandon rating-dependent regulation apparently applies only to regulations that “require the use of an assessment of credit-worthiness of a security or money market instrument.” Although one would think that that’s where credit ratings find their way into regulations, I’m not sure that that’s true. For example, in the SEC’s net capital rule, credit ratings seem to be used as a proxy for liquidity rather than credit quality. And the “underwriter’s exemptions” under ERISA, which are an important use of ratings in the context of structured products, the high credit rating is used to satisfy conflict-of-interest standards.
Would such uses come under the requirement to eliminate rating-dependent regulation? It would be odd if these rating-dependent regulations escaped the statute precisely because they do not use ratings for their intended purpose.
The conference report on the financial-reform bill, now called the Dodd-Frank Wall Street Reform and Consumer Protection Act is up (click “Dodd-Frank Conference Report”).
The rating-agency portion is Title IX, Subtitle C (pages 1349-1399). I’ve excerpted it in a Word document here. The document isn’t the prettiest – lots of line numbers are at the end of the preceding line – but you get what you pay for.
Substantive comment will be forthcoming.
Joseph Grundfest today put at “almost zero” the chance that the Commission ultimately would adopt a Franken-Amendment-style third-party board to assign the agencies to give initial ratings. Grundfest is a former SEC Commissioner, current professor of law and business at Stanford, and one of the country’s most respected authorities on the SEC. The comment came in an appearance on Bay Area public radio in response to a question from your humble blogger.
Grundfest explained that the SEC’s institutional incentives cause it not to want the extensive supervisory authority that the Franken Amendment would confer on it.
The answer confirms what I suspected: After all, Congress directed the SEC to adopt rules to ”prohibit , or require the management and disclosure of” conflicts of interest in the 2006 Credit Rating Agency Reform Act, and the SEC has shown no appetite for anything nearly as radical as the Franken Amendment.
Judge Lewis Kaplan of the Southern District of New York rejected another securities action against the rating agencies in an opinion dated yesterday, In re IndyMac Mortgage-Backed Securities Litig., 09 Civ. 4583 (LAK). Following the reasoning of his decision earlier this year in In re Lehman Bros. Secs. & ERISA Litig., 684 F. Supp. 2d 485, Kaplan holds that “ratings are opinions and therefore actionable under the Securities Act only if not truly held by the ratings agencies when issued.”
The plaintiffs alleged that the ratings were on mortgage pass-through certificates issued by IndyMac were based on outdated models, that the agencies had a conflict of interest because they were paid by the issuer, and that the ratings were not based on an independent investigation. Kaplan finds that there was no duty to disclose the issuer-pays conflict of interest because it was widely known in the market, and that the agencies’ role in structuring the securities was immaterial.
In rejecting the outdated-models and failure-to-investigate arguments, Kaplan found that they were “at most a challenge to the accuracy of the ratings themselves.” This highlights the poor fit between fraud-based theories and rating quality. We can debate the proper roles of markets, courts, and regulators in getting the “right” level of rating quality, but Kaplan’s statement highlights that fraud liability doesn’t get at the issue directly – even if rating agencies can be liable for fraud in the case where they issue a rating without believing in it.
Apparently (WSJ – subscription required) Congress’ conference language on rating agencies follows the Senate draft and would create securities-fraud liability for agencies that “knowingly or recklessly” fail to conduct a “reasonable investigation” of the rated securities, and would have helped the plaintiffs out here. Even here, the link between the liability standard and what we actually care about could be a lot tighter. If the agency had verified the borrowers’ credit quality but had used a model that resulted in poor-quality ratings, I’m not sure that’s fairly characterized as a failure to “investigate.”