FDIC Signals Flexibility in Exams That Look Past Credit Ratings

WASHINGTON — The development of tools to replace credit ratings to assess banks' investment portfolios will likely require a "learning curve" as examiners and institutions hone new methods to gauge the quality of securities, a Federal Deposit Insurance Corp. report said Thursday.

"Methods for measuring and monitoring credit risk in the investment portfolio will evolve, and best practices will emerge, as bankers, regulators, and investment advisors identify more effective credit review techniques," the agency said in "Supervisory Insights", a semiannual journal that communicates FDIC approaches to supervision.

Following criticism of how rating agencies had given high marks to mortgage bonds that went bust in the crisis, the Dodd-Frank Act instructed the federal agencies to find new assessment tools wherever regulations had previously called for using external credit ratings.

Last year, the Office of the Comptroller of the Currency issued a rule outlining a process for banks and regulators to replace credit ratings with new steps to assess creditworthiness of securities. The rule applies not just to nationally-chartered institutions, since OCC regulations statutorily govern permissible investments for both state-chartered and national banks. As required by Dodd-Frank, the FDIC issued a similar rule dealing with thrifts' investments in corporate bonds.

Under the rules, investment securities must meet a new "investment grade" standard with banks verifying that a security has a low risk of default and produces full and timely payments of interest and principal.

The FDIC article, authored by Eric W. Reither, a senior capital markets specialist in the agency's risk management supervision division, said institutions have sought clarification on how examiners will interpret the OCC rules.

The report said in lieu of using credit ratings, "examiners will focus … more on the adequacy of pre-purchase analysis, integration of various credit factors other than credit ratings and monitoring procedures."

Reither included templates for how banks could conduct due diligence on two examples of securities: a municipal bond and a corporate bond.

The template for assessing municipal bonds featured a scorecard for evaluating a series of individual characteristics about the bond, including the health of the municipality's local economy and the municipality's budget performance. The corporate bond template noted that the credit analysis is similar to assessing commercial term loans.

"Such credit analysis attempts to determine the repayment capacity of the borrower; in other words, the potential for default risk," the report said. "This approach is convenient given the new rule defines investment grade, in part, as a security where default risk is low."

Reither wrote that the new rules are not intended to greatly change the scope of allowed investments, and the reform law did not prohibit banks from using external credit ratings as part of their overall reviews.

"The depth of due diligence that examiners expect will depend in part on the size, complexity, and risk characteristics of the securities portfolio," the report said. "Thus, for example, institutions with high concentrations of particular types of securities relative to capital would be expected to perform more comprehensive due diligence and ongoing monitoring."

The report indicated there will be flexibility in how examiners interpret the rules at the outset.

"The supervisory agencies expect the transition away from reliance on credit ratings to entail a learning curve for both bankers and examiners," it said. "As long as management demonstrates that it has made good-faith progress to comply with the OCC rule, FDIC examiners, at their initial examination reviews, will work with banks as they transition away from a ratings-centric bond selection and monitoring process. Examiners may offer constructive recommendations or suggestions on due diligence efforts, as appropriate."

Despite the removal of credit ratings, many of the standards regulators use to assess investment portfolios have not changed since Dodd-Frank, the report added.

"From a bond analysis and investment due diligence perspective, the need to look beyond the credit rating is not a new supervisory expectation," the report said.