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Federal bank regulators moved ahead with an effort required under Dodd-Frank to reduce reliance on credit ratings in assessing risk on bank's trading books.
December 7
WASHINGTON — A plan by regulators to reduce banks' reliance on credit ratings may ultimately overstate capital requirements, improperly account for risk sensitivity and put U.S. firms at a competitive disadvantage, according to the largest banks and their representatives.
In nearly two dozen comment letters to federal regulators, the financial services industry also cited potential conflicts with Basel II rules, a possible negative impact on small banks and further unintended consequences.
"Unfortunately, the proposed rules … tend to favor simplicity and ease of application over the need for sophisticated measurement techniques that are sensitive to the characteristics and risks of the assets being weighted," wrote Glenn Hubbard, co-chair of the Committee on Capital Markets Regulation.
The Dodd-Frank Act calls on regulators to remove any reliance on credit ratings for the purposes of capital and other regulatory requirements.
The proposal is one piece of fulfilling that mandate, and would apply only to market risk capital rules as part of an effort by the U.S. to comply with international standards under Basel II.
It took regulators a year to develop the proposal given its complexity and impact, but even with all that time, many criticized the agencies' plan.
Regulators have said the plan would 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.
But the concern shared by many observers is that the plan would capture far more banks and could dictate the way ahead for regulators as they comply with other requirements of the financial reform law.
Regulators have said they would be sensitive to how credit rating alternatives would apply to smaller banks, but that has done little to quell the issue.
"While the market risk capital rules, and therefore this proposed rule, do not apply to community banks … decisions agencies make as they develop a final rule on alternatives to credit ratings for the purposes of market risk capital rules ultimately could have an impact on rules that do apply to community banks," wrote Ann Grochala, vice president of lending and housing policy for the Independent Community Bankers of America.
The American Bankers Association made a similar point but went further, asking regulators to withdraw and re-propose the plan with changes to account for general capital rules. "ABA believes any requirements of general applicability should be first proposed in a rule of general applicability, otherwise, as in this case, the great majority of affected banks will not be adequately on notice to consider the proposal, evaluate its affects, and share their comments," wrote Hugh Carney, senior counsel for the ABA.
David Stevens, former head of the Federal Housing Administration and now president of the Mortgage Bankers Association, also stressed the importance of a risk-based capital regime that could be "implemented by banks of all sizes in a cost efficient and timely manner that does not place a strain on their resources."
Several banks suggested the plan did not accurately capture a firm's riskiness and would unduly burden domestic banks.
"We believe that capital charges inconsistent with the actual risk of a given exposure could inappropriately motivate banking organizations to make investment decisions based solely on capital which doesn't reflect the risk involved," wrote Candice Koederitz, managing director for Morgan Stanley. "Furthermore, it is critical that the alternative creditworthiness standard not put U.S. banking organizations at a competitive disadvantage relative to non-U.S. institutions that operate under the Basel II regime."
Stevens also raised the potential for regulatory arbitrage by non-U.S. institutions, which must adhere to risk based capital guidelines under Basel but which do not have to comply with the proposal. "This could result in reduced allocations for U.S. operations of foreign banks or the movement of U.S. bank securitization assets for regulatory risk based capital purposes," he wrote.
The proposal would establish three methods for calculating specific risk requirements for debt and securitization positions.
The first approach would use data from the Organization for Economic Cooperation and Development, which classifies the risk of each country's sovereign debt by assigning them a score of zero to 7, from lowest to highest.
The Capital Markets Committee called this approach "problematic," citing the OECD's classification system's limited history, the intergovernmental organization's own political and economic agenda and the risk of not accurately reflecting default.
The second approach would use financial and market indicators to assess risk on debt positions exposed to public, nonfinancial 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 final method, which drew the most attention, applies to securitization exposures. In that case a bank would use a 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.
This approach, dubbed SSFA, is meant to provide relatively higher capital requirements to more junior tranches of a securitization exposure which have proven to be the most risky positions.
Wells Fargo, which asked regulators to provide a quantitative impact study on securitizations in both the trading book and banking books before implementing the proposal, called SSFA "an inadequate method for assigning required regulatory capital for securitizations," wrote Paul Ackerman, a Wells executive vice president and its treasurer.
He said the formula creates an inappropriate risk management incentive and competitive inequalities. So, for example, the minimum risk-weight floor of 20% would place U.S. banks at a competitive disadvantage to foreign banks which have a floor of 7%, he wrote.
The formula also overlooks established forms of credit enhancements like overcollateralization, excess spread and funded reserve accounts. It also lacks a forward looking view, he argued.
"We do not believe the proposal achieves the fundamental goal of a rule to reasonably assign capital to securitization exposure commensurate with the inherent risk of exposure," Ackerman wrote.
Adding to that, the formula itself is an intricate equation that could prove difficult for banks to use, the ABA's Carney warned.
The MBA shared that concern, arguing it could be a large drag for banks.
"If a bank cannot, or chooses not to use the SSFA, a securitization position would be subject to a 100% of asset value risk-based capital charge, which roughly corresponds to a 1,250 percent risk weight," Stevens wrote. "MBA is concerned that banks that are not able to implement the SSFA would be put into a market risk RBC category that is currently associated with the highest risk securities."
The comment deadline closed Feb. 3. Many trade groups said they needed more time to weigh the full impact of the proposal.
"We are of the view that the February 3, 2012 comment deadline for this proposal which calls for a fundamental shift in capital regulation does not provide sufficient time to understand the full scope of the rule, and comment in a meaningful manner," the Clearing House Association, Securities Industry and Financial Markets Association, the ABA and the Financial Services Roundtable wrote in a joint letter.
