Bank regulators expressed frustration July 27 over a little-noticed and initially uncontroversial provision of Dodd-Frank that forces them to eliminate references to credit ratings in most bank regulations.
Although the measure had strong bipartisan support in Congress last year, the regulators said it is proving nearly impossible to implement. Under the law, regulators are required to substitute references to credit ratings with other standards of creditworthiness.
But regulators said their options are limited, and not necessarily superior to the existing credit ratings.
"Developing such appropriate alternative standards of creditworthiness is proving an exceptionally challenging task," David Wilson, chief national bank examiner at the Office of the Comptroller of the Currency, told the House subcommittee on financial oversight.
Credit ratings are used in several places throughout banking regulations, including determining a bank's capital requirements. But lawmakers lost faith in the credit rating agencies as a result of the housing crisis, citing multiple instances where the agencies gave triple-A ratings to securities that were far riskier in nature.
In an effort to reduce the importance of the agencies, lawmakers added a provision to the regulatory reform law that would remove the agencies' judgments from the government's own assessments of creditworthiness.
Mark Van Der Weide, senior associate director of the Federal Reserve Board's division of banking supervision, said the central bank is considering several alternatives. Among them are market-based indicators such as bond spreads, approaches that rely on balance-sheet financial ratios, and internal risk assessments by banks. But none of them are perfect, he said.
"Each of these approaches, like the use of credit ratings, has strengths and weaknesses," said Van Der Weide.
For example, allowing banks to make their own estimates of the risk associated with their investments could result in inconsistent requirements across institutions, as the Federal Deposit Insurance Corp. (FDIC) noted in written testimony.
"Over time, this could result in a significant decline in capital requirements and opportunities for banks to engage in capital arbitrage," the FDIC said.
Conversely, using a complex mathematical formula to determine creditworthiness might provide greater precision, but it could also prove unwieldy for small banks.
Wilson said a solution "must not be so complex and burdensome that they are impractical and unduly burdensome for community and regional banks to use."
Regulators also fear that the move away from a reliance on credit ratings will conflict with Basel III international capital requirements.
"So we also need to synchronize our efforts with the international accord," Van Der Weide said.
Although members of the subcommittee pushed Wednesday for the regulators to implement the law, there were also signs that they will be sensitive to the regulators' concerns.
House Financial Services Committee Chairman Spencer Bachus suggested that Dodd-Frank allows the regulators to consider credit ratings as one of a number of factors when evaluating creditworthiness.
Bachus, R-AL, told the regulators that the law "asks you to replace the reliance on credit rating agency as the sole basis with alternative systems of credit worthiness, which could include credit rating. It could include credit rating."
"This is not a holy grail," Bachus continued, referring to the provision in last year's Dodd-Frank Act. "I know it is a complicated job, and it's easy to criticize. But you are the professionals, and we did intend to give you discretion, but we also intended to give you direction."