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.
