Regulators are poised next week to start moving away from reliance on the tarnished credit rating agencies in the supervisory process, but finding other options likely will be difficult.

The Federal Deposit Insurance Corp. (FDIC) is scheduled to meet Tuesday to discuss alternatives to external ratings in setting capital requirements — the start of a yearlong process under the regulatory reform law requiring regulators to find other credit information sources.

Although lawmakers and regulators agree the steps are necessary, observers said the agencies are venturing into uncharted waters.

"If it were easy to develop other ways to measure credit quality, people would have done it a long time ago," said Claire Hill, a professor at the University of Minnesota Law School.

At issue are the ratings handed out primarily by the three largest agencies: Moody's Corp., Fitch Ratings and Standard & Poor's. The ratings serve chiefly to help investors assess the strength of a company or portfolio.

But bank regulators also use them, for, among other things, pinpointing areas to focus on in exams and determining permissible securities for a bank to hold.

The financial crisis laid bare the flaws of the credit rating agencies, which gave high scores to what proved to be toxic MBS. This raised doubts about the agencies' objectivity in evaluating debt issuers that helped to fund their operations.

As a result, the Dodd-Frank law included provisions designed to reduce the government's dependence on ratings, requiring them to come up with different methods for gauging credit strength wherever they now use external ratings. The law gives regulators a year "to remove any reference to or requirement of reliance on credit ratings."

Officials must find an alternative "as convenient and handy and low-cost as a credit rating, but also that is predictive, either with regard to risk or performance," said Wayne Abernathy, the director of financial institutions policy and regulatory affairs at the American Bankers Association.

For the bank regulators, which are already mulling changes to the Basel II regime, the first task is settling on a method to help establish capital standards.

The regulators were set as early as this summer to release a simpler version of the Basel II requirements, known as the "standardized" approach, which in other countries emphasizes credit ratings over the more complex method of using a bank's internal ratings to set capital minimums.

Now the regulators must essentially begin severing ties with the credit rating agencies before they can finish the Basel changes.

Some observers said the regulators have clear options for coming up with a simpler version of the capital accord without relying on the external ratings. The FDIC, which declined to comment, is expected at its meeting to release an advance notice of proposed rulemaking — issued jointly with the other regulators — laying out some potential alternatives while asking for industry comment.

"The idea of trying to find an approach to capital that is simpler than the internal ratings-based approach, but that doesn't over-rely on credit ratings, is a reasonable thing to explore, and I suspect that's the background of all this," said Richard Spillenkothen, formerly the Federal Reserve Board's head of bank supervision and now a director in Deloitte & Touche's regulatory and capital markets consulting practice.

Spillenkothen said that, instead of attaching a weight to risk categories determined by the credit rating of a particular investment, which is how the standardized approach has typically been implemented, the regulators could come up with risk categories based on product types and how risky they are. Instead of a triple-A rating getting a risk weight, for example, the weight could be applied to other factors.

"One option would be for the regulators to say, 'We're going to mandate that we have more risk categories,' " Spillenkothen said. "For commercial real estate … you might be able also to vary the risk weight based on the degree of loan-to-value coverage."

The approach would resemble the original Basel I accord from the 1980s in that "the regulators set more of the parameters," Spillenkothen said.

"The regulators could come up with risk weights based on their analytical assessment — their judgment — which would be the floor, and the capital charge couldn't go below that," he said. "It would be a regulatory-mandated system of risk weights, rather than basing it upon external credit rating agencies."

Still, some observers suggested the regulators may need to seek outside help for such an endeavor. "To the extent that they don't currently have the skill set to do the entire process internally, they could outsource parts of the process to different players," said Gene Phillips, a former analyst at Moody's who is now a director at PF2 Securities, a firm that evaluates structured finance products.

The University of Minnesota's Hill said the regulators face the challenge of finding an alternative system that is simple enough to understand, while still being effective.

"Whatever method you use, if it's not formulaic enough, then it's going to start looking arbitrary. If it's too formulaic, then it's too easily gamed," she said.

Before passage of the reform law, regulators were said to be considering changes to make implementation of Basel II less reliant on the rating agencies. In April the FDIC proposed eliminating debt-issuer ratings as a factor in setting the deposit insurance premiums for large banks.

"The regulatory community has been considering this challenge well before the Dodd-Frank Act," said Tom Deutsch, the executive director of the American Securitization Forum. But, he added, "The question remains: What do you use as the alternative? Do you use the bank's internal assessments of their risk? Do you use some other objective third party? Is some other third party going to be more qualified at predicting risks than the rating agencies, which have very large, sophisticated staffs? I'm not sure we'll see any alternative that will be a perfect solution for such a challenge."

Others said that, though the regulators face a difficult task, it is crucial to find an alternative to the credit rating agencies.

"The objectivity of the rating agencies is at best a matter of dispute," said Karen Shaw Petrou, the managing partner of Federal Financial Analytics. "The way to make regulatory decisions without resorting to the rating agencies is for regulators to understand risk based on credible analytics and to rely on proven forms of risk mitigation.

"This is harder, because it takes thinking and ongoing updates to ensure risk measurements reflect changing market conditions, but it's also a lot better."

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