Proposed Federal Rules Regarding Alternatives to Credit Ratings

H. Rodgin Cohen is a partner and senior chairman of Sullivan & Cromwell LLP focusing on acquisition, corporate governance, regulatory and securities law matters. This post is based on the executive summary of a Sullivan & Cromwell publication by Andrew Gladin and Joel Alfonso; the complete publication is available here.

The Federal banking agencies have recently issued three notices of proposed rulemaking (and applicable related guidance) in connection with the implementation of Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Section 939A generally requires that all Federal agencies remove from their regulations references to and requirements of reliance on credit ratings and replace them with appropriate alternatives for evaluating creditworthiness.

Market Risk Capital NPR:

The Office of the Comptroller of the Currency (the “OCC”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Federal Deposit Insurance Corporation (the “FDIC” and, together with the Federal Reserve and the OCC, the “agencies”) issued a joint notice of proposed rulemaking (the “Market Risk Capital NPR”) concerning their market risk capital rules applicable to certain U.S. banking organizations with significant trading operations by proposing standards of creditworthiness to be used in place of credit ratings when calculating the specific risk capital requirements for covered debt and securitization positions, including the following:

  • Sovereigns. Specific risk-weighting factors for debt issued by sovereigns would generally be based on the Country Risk Classification (“CRC”) established for the relevant sovereign by the Organization for Economic Co-operation and Development (the “OECD”). Exposures to the U.S. government and its agencies would receive a specific risk-weighting factor of zero percent.
  • Certain Supranational Entities and Multilateral Development Banks. Debt exposures to the Bank for International Settlements, the European Central Bank, the European Commission and the International Monetary Fund would receive a zero percent specific risk-weighting factor. Debt exposures to certain specified multilateral development banks (“MDBs”) also would receive a zero percent specific risk-weighting factor as would exposures to any other multilateral lending institution or regional development bank in which the U.S. government is a shareholder or contributing member.
  • Government Sponsored Entities (“GSEs”). Specific risk-weighting factors for debt positions in GSEs, including the Federal National Mortgage Association (”Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), would vary from 0.25 to 1.6 percent, based on maturity. Equity exposures (including GSE preferred stock) would be assigned a specific risk-weighting factor of 8.0 percent.
  • Depository Institutions, Foreign Banks and Credit Unions. Specific risk-weighting factors for debt exposures to depository institutions, foreign banks and credit unions would range from 0.25 to 12.0 percent depending on the CRC of the country of incorporation of the relevant issuer. Depository institutions, foreign banks and credit unions incorporated in countries with no CRC would be assigned a specific risk-weighting factor of 8.0 percent.
  • Public Sector Entities (“PSEs”). Specific risk-weighting factors for PSE exposures would range from 0.25 to 12.0 percent depending on the CRC of the PSE’s home country, as well as whether the exposure is a general obligation or revenue obligation. PSE’s in countries with no CRC would receive a specific risk-weighting factor of 8.0 percent.
  • Corporate Debt. Positions in publicly traded nonfinancial companies would be assigned a specific risk-weighting factor based on an indicator-based methodology that requires banks to determine the leverage, cash flow and stock price volatility of the applicable company (based on publicly available financial data) and, in certain cases where the stock price volatility and leverage of the public company is sufficiently low, the remaining maturity of the position. Positions in non-publicly traded companies and financial companies would receive a specific risk-weighting factor of 8.0 percent.
  • Securitizations. Specific risk-weighting factors would be calculated using a simplified version of the Basel II advanced-approaches supervisory formula approach. The simplified formula has several inputs, including (i) a weighted-average capital requirement based on the underlying exposures of the securitization, (ii) the position’s level of subordination and relative size within the securitization and (iii) the level of losses actually experienced on the underlying exposures. This approach would apply a 100 percent specific risk-weighting factor to securitization positions that absorb losses up to the amount of capital that is required for the underlying exposures under the agencies’ general risk-based capital rules if they were held directly by the relevant bank.

The agencies have indicated that similar methodologies to those proposed in the Market Risk Capital NPR may be incorporated into their risk-based capital rules more generally.

The Market Risk Capital NPR also considers, and requests comments on, several alternatives to the methodologies described above, including the methodologies proposed for determining the specific risk-weighting factors for corporate debt and securitizations.

Comments are due by February 3, 2012.

Investment Securities NPRs:

The OCC issued a notice of proposed rulemaking that would remove references to credit ratings from various OCC regulations, including the definition of “investment grade” in 12 C.F.R., part 1 (which is used, in part, to determine whether a national bank is permitted to hold particular securities). The proposed rule would provide that a security would be “investment grade” (and therefore generally eligible for purchase by a national bank if other provisions are satisfied) if the issuer of the security has an “adequate capacity” to meet financial commitments under the instrument for the projected life of the assets or exposures, thereby removing references to credit ratings from these regulations. In determining whether an issuer satisfies this standard, banks would be permitted to consult external credit ratings, although a bank must supplement external ratings with due diligence processes and analyses appropriate for the bank’s risk profile and for the size and complexity of the instrument.

The OCC also issued related guidance to clarify steps national banks should ordinarily take to demonstrate that they have verified their investments meet the credit quality standards set forth in the OCC’s proposed rule, steps to be taken in connection with the purchase of investment securities and ongoing reviews of investment portfolios. The FDIC issued a similar notice of proposed rulemaking (such notice of proposed rulemaking, together with the OCC’s notice of proposed rulemaking described above, the “Investment Securities NPRs”) and related guidance with respect to savings associations.

Comments on the OCC’s Investment Securities NPR and the FDIC’s Investment Securities NPR are due by December 29, 2011 and February 13, 2012, respectively.

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One Comment

  1. Douglas Levene
    Posted Wednesday, January 11, 2012 at 1:24 pm | Permalink

    It’s hard to take seriously any attempt to propose alternatives to agency credit ratings that does not mention CDS spreads. It is apparent that CDS spreads provide a far more accurate and timely measure of credit risk than credit ratings or, for that matter, the various alternatives proposed by the federal banking agencies. That seems to be true for sovereigns as well as corporate and GSE credits.

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