Standard & Poor's downgrade of U.S. debt last week is likely to hasten the replacement of credit ratings within bank regulatory requirements.
The Dodd-Frank Act enacted last year required the banking agencies to remove all references to credit ratings within existing rules, but the regulators have dragged their feet on carrying out that mandate.
Instead, regulators have testified to Congress that replacing the credit ratings is easier said than done, and subtly suggested lawmakers revisit the issue.
With the S&P downgrade enraging Senate Democrats and the Treasury Department, it is highly unlikely that Congress will seek to overturn the requirement, however, and some lawmakers are expected to put more pressure on the agencies to move quickly.
"It will reinforce the view of those in Congress who believe that Dodd-Frank made the right decision," said Wayne Abernathy, executive vice president of financial institutions policy at the American Bankers Association (ABA) and a former Treasury official in the Bush administration. "What they will say is, 'We put this provision in Dodd-Frank because these are largely as educated opinions as you want to grant them, but they're educated opinions, and they shouldn't be carrying with them the force of law.'"
Already, a backlash against the rating agencies appears to be developing in Congress.
The Senate Banking Committee has said it will look into last week's downgrade, and Chairman Tim Johnson said he disagreed with the rating agency's move.
"I am deeply disappointed in S&P's decision to enter into the game of political punditry," he said in a press release.
Karen Shaw Petrou, a managing partner at Federal Financial Analytics, said the S&P decision was wholly subjective, based on their political judgment rather than a long-term view of U.S. credit worthiness. But it also spotlighted the fact that regulators have not yet removed credit ratings from the bank regulatory process.
"Regulators knew that created risk in the market," Petrou said. "Dodd-Frank in fact told the regulators to fix that and a year later we haven't because it isn't an easy fix to make. So we put it aside and now we're exactly back in the same soup."
The Dodd-Frank provision that sought to reduce the reliance on credit ratings is one of the few parts of the law that has strong bipartisan support on Capitol Hill.
"Congress is not now going to go back and say, "Oops, we were wrong. We love ratings,'" Petrou said. "It's not going to happen. What you will see is the banking agencies finally putting their shoulder to it and implementing Dodd-Frank to end reliance on ratings."
For the past year, the Federal Reserve Board, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. (FDIC) have taken a few initial steps in developing a new set of alternative standards to replace the existing credit ratings agencies, but have lagged in implementing the statute.
To date, the regulators have put together an early draft proposal for comment and held a roundtable discussion with experts to come up with ideas for a possible replacement.
In their plan, the regulators offered a wide range of approaches with "varying complexity and risk-sensitivity" as alternatives, according to the Fed's July report to Congress.
That report said that "the need for alternative standards should be risk sensitive, should be easy to implement, be defined to allow banking organizations of varying size and complexity to arrive at the same assessment of creditworthiness for similar exposures, and take account of the costs and burdens imposed on small firms."
But the regulators have had difficulty settling on an alternative to credit ratings.
At a Congressional hearing with the regulators last month, the FDIC warned that if the standards are too detailed, they could create a compliance burden for banks, but if they are not detailed enough, they may not accurately distinguish the credit risk of a particular investment.
"Balancing the goals of risk sensitivity on the one hand, and not placing undue burdens on banks on the other, will be important," the FDIC said in a written statement.
The alternatives that the bank regulators are considering as potential replacements for credit ratings include bond spreads and other market-based indicators, a reliance on balance-sheet financial ratios, and self-assessments of credit risk by the banks themselves.
The regulators also noted that taking steps to reduce the reliance on credit ratings will complicate the task of harmonizing bank capital requirements internationally.
"Although the international financial regulatory community is working to reduce reliance on credit ratings, the Basel capital framework continues to incorporate credit ratings in material ways," Mark Van Der Weide, senior associate director of banking supervision at the Federal Reserve Board, testified.
Industry experts, banking organizations, trade associations, and others are not without concern over the statute with some suggesting it could lead to competitive distortions across the international banking industry.
Small banks, for example, "are not in a position to do their own thorough analysis of any security and debt issuance that they might seek to invest in," said Karen Thomas, senior executive vice president of government relations and public policy for the Independent Community Bankers of America (ICBA).
ICBA is supporting legislation, introduced in May, that would amend Dodd-Frank to allow regulators to require that credit ratings are confirmed by additional analysis where warranted.
Thomas said the S&P downgrade shines a spotlight on the issue, but it won't make it any easier for regulators to find a solution without a change in the law.
"It certainly adds another wrinkle," she said.
Abernathy said removing references to the agencies may allow them to express their views more freely.
"I think our view is let the ratings agencies be sources of information that we can use in interacting with regulators, while we recognize that it shouldn't be mandatory," he said. "Having just three major rating agencies is probably several too few," he added.
James Gellert, the chief executive officer of Rapid Ratings, a smaller rating agency that does not have official government recognition for regulatory purposes, is among those who favor reducing the reliance on incumbent firms such as S&P.
Gellert said S&P's downgrade of U.S. debt will spur regulators to implement the Dodd-Frank mandate.
"This will help," Gellert said.
Although markets tumbled Monday, industry observers said investors were taking S&P's opinion in stride.
"Really, the reason the market is thrown off is that it's a reflection of a weakening economy, rather than the downgrade itself," said Fred Cannon, an analyst with KBW's Keefe, Bruyette & Woods. "Because per Dodd-Frank, and per the history, the agencies clearly lost credibility during the financial crisis. They're still important, but …they don't have the same authority they did prior to the crisis."
But other analysts see it differently. Good or bad, the agencies are still an important third-party review, said John Douglas, a partner with Davis Polk & Wardell and former general counsel at the FDIC.
"People criticize the rating agencies and say, "They missed the subprime mortgage crisis. They're bad, evil,' and write them out of the regulations," he said. "But at the end of the day it's a third party view of our creditworthiness. … You kind of have to listen and put it in to the mix of all the things you consider. It's just one factor of many that you evaluate."
Others said the agencies will continue to have an important influence, even if a downgrade doesn't have any technical implications for banks.
"The ratings agencies and the ratings themselves are so entrenched and ingrained in the way [banks] treat assets," said Jeffrey Hare, a partner with DLA Piper in Washington. "At least for the foreseeable future, there's not an alternative, and they're going to have an impact."
Amy Friend, managing director at Promontory Financial Group, agreed.
"People are still looking to the rating agencies as arbiters because there is no alternative," she said. "The banking regulators have said they are not going to change risk weightings but because there is nothing else in place, the market still looks at the ratings as somewhat of a reliable indicator."