An investment banking firm is warning federal regulators that a congressional mandate to stop relying on the credit ratings of Standard & Poor's and other agencies could be disruptive to the MBS market and increase capital requirements for depository institutions.

It could have "severe unintended consequences to bank and thrift capital and lending capacity from disruptions in pricing and liquidity" in the MBS market, said Sandler O'Neill Partners in a comment letter to the banking agencies.

The comment letter also points out that the congressional mandate in the Dodd-Frank bill places regulators in conflict with the Basel III capital accord, which relies heavily on credit ratings.

"We believe the best the agencies can do is to report this unavoidable conflict to Congress," writes Sandler principals Joseph Longino and Thomas Killian. They suggested a "middle path" that should be recommended to lawmakers.

The principals favor a regulation forcing credit rating agencies to register with the Securities and Exchange Commission, and allowing the Securities and Exchange Commission to conduct periodic reviews of their ratings. In addition, banks would have to obtain at least two ratings on MBS and other securities (accepting the lowest rating) to achieve a capital risk weighting of less than 100%.

"Such an approach would substantially fulfill congressional intent by increasing competition and supervisory discipline for [the credit rating agencies] — assuring multiple points of view on the credit of bank-eligible investments," the principals said.

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