Federal regulators took another step Wednesday toward lessening banks' reliance on credit ratings by proposing three methods for assessing risk on firms' trading books.
The joint proposal, issued by the Federal Deposit Insurance Corp. (FDIC), the Federal Reserve Board, and the Office of the Comptroller of the Currency (OCC), was approved by the FDIC board by a 3-0 vote. It would establish new capital requirements by using alternative means for evaluating how much capital banks will need to hold to offset risks with investments in securitizations and debt.
The new methodology will "cause a significant increase in capital charges for certain positions, particularly for those positions that were downgraded throughout the crisis," according to an FDIC official who spoke on condition of anonymity.
The plan would only apply to the largest, most complex financial institutions — less than 20 banks in total — which have more than $10 billion in total trading assets and liabilities or would have more than 10% of their assets in trading liability.
During the FDIC board meeting, regulators sought assurance on that point, saying they did not want the proposal to impact smaller banks. Going forward, regulators said they would be sensitive to how credit rating alternatives would apply to such banks.
FDIC staff said they tried to use an approach that relies on readily available public information, in order to make the process as uncomplicated as possible.
"We've tried to create a methodology that even for the large institutions, would rather be simple, considering other alternatives that we could come up with to implement," said Bobby Bean, an associate director of capital markets in the FDIC's division of risk management and supervision.
The proposal is required by Dodd-Frank, which said regulators had to remove any reliance on credit ratings for the purposes of capital and other regulatory requirements. Regulators have struggled with how to do so, a point they made again on Wednesday.
"This has been a real challenge to come up with an alternative," said Acting FDIC Director Martin Gruenberg, during the meeting.
He was backed by FDIC board member Tom Curry, the Obama administration's nominee to head the OCC, who described implementation as a "very difficult … difficult process."
Acting Comptroller John Walsh went one step further, noting the effort the OCC has made in trying to persuade Congress to show some flexibility in this area to include some limited reliance on credit ratings, especially for small community banks and for simpler products.
"Certainly no one would argue that sole reliance on external ratings in risk management makes sense because some ratings, especially for structured products, failed badly during the financial crisis," Walsh said. "But in many areas, there are no alternative measures of credit worthiness that are as transparent and relatively simple to use that allow for consistent implementation across banks and that effectively differentiate risk as traditional ratings and as mentioned the Basel framework is substantially reliant on ratings."
The proposal would establish three methods for calculating specific risk requirements for debt and securitization positions (the plan is open for comment until Feb. 3, 2012).
"These methodologies will yield results that are transparent and consistent from banking organization to banking organization," Bean said.
The first approach would use data from the Organization of Economic Cooperation and Development, which classifies the risk of each country's sovereign debt by assigning them a score of zero to seven, from lowest to highest.
For example, for a country with a zero rating, sovereign debt positions would receive a capital charge of 0%, while sovereign debt positions for a country rated 7 would face a 12% capital charge. The capital charges are equivalent to a risk weight between 0% and 150%, according to Bean.
Because there's a chance a country may misclassify its risk, particularly in cases were sovereign debt restructuring has occurred, a capital charge of 12% would be applied to any sovereign debt position where a country has defaulted on any exposure during the past five years.
The rule also calls for a capital charge on all debt positions that are exposed to depository institutions, foreign banks, credit unions, or other public sector entities, like municipalities. In the case of municipalities and other similar entities, a distinction would be made whether the exposure was a general obligation or revenue obligation.
The second method would use financial and market indicators to assess risk on debt positions exposed to public, non-financial corporations. In those cases, a bank would be able to assign a capital charge based on indicators, including leverage, cash flow and stock price volatility.
The capital charge would range from 0.25% for a low risk position with maturities that expire in less than six months to 12% for higher risk positions — an equivalent to risk weights between 3% and 150%.
Bean said, however, that this type of approach wouldn't work for "non-public, non-financial corporate exposures, or for financial corporate exposures." Instead, the proposal would assign a capital charge of 8%, equivalent to a risk weight of 100%, in those cases.
The third method applies to securitization exposures. In that case, a bank would use supervisory formula, called a simplified supervisory formula. While very technical, it is broken down into four pieces of information that can be used to obtain the appropriate capital requirement.
SSFA, as it is called, is meant to provide "relatively higher capital requirements to more junior tranches of a securitization exposure," which have been proven to be the most risky positions, according to Bean.
These positions are the first to absorb losses, and more senior positions would face relatively lower requirements. It would apply a 100% capital charge, the equivalent to a 1,200% risk weight, to the highest risk, and gradually decrease based upon level of seniority.
Despite the significant work already completed by the regulators, they still have a lot of ground to cover to comply with Dodd-Frank, including capital requirements pertaining to the banking book, the trading book's counterpart.
Walsh urged consistency when regulators begin work on applying such alternatives to the banking book.
"I think consistency between rules in these two areas is important to reduce opportunities for regulatory capital arbitrage, but it will also mean that a new approach will affect banks large and small, so we hope to receive feedback from the broader banking industry, not just the large banks, on whether this proposal represents a practical and effective alternative to ratings," said Walsh.
But not everyone was convinced the latest proposal would be safe for small community banks.
"This proposal has implications far beyond its official scope," said Hugh Carney, senior counsel for the American Bankers Association. "The Basel trading book treatment of securitizations is supposed to mirror the banking book treatment. So, whatever is adopted in this proposal will likely be adopted in banking book at a later date. It's a little bit disingenuous for the regulators to raise an issue that is important to all banks in a proposal that is directly applicable to just a few. To me, it seems like the regulators' effort to increase capital at the large banks is coming at the expense of small banks being involved in the rulemaking process."
Separately, the FDIC discussed and approved a second proposal at its meeting, which is aimed at providing federal and state savings associations with alternative standards for determining the permissibility of investments in corporate debt securities.