OFR Analyst Highlights Challenges Posed by Alternative Credit Rating Standards
Commentary by Steven Lofchie
A research analyst at the Treasury Department's Office of Financial Research examined the challenges posed by the alternative standards of creditworthiness used to replace credit ratings following their elimination from federal financial regulation by the Dodd-Frank Act. The author identified these alternatives under the categories: definitions, regulatory models, and third party classifications.
The author summarizes the challenges for these alternative approaches:
- Definitions: Defining creditworthiness for certain securities: (i) gives too much discretion to companies and disregards their incentive to overstate the quality of their assets; and (ii) results in a loss of granularity for analyzing different levels of credit risk, which can incentivize a financial institution to take more risk because it receives no regulatory benefits from holding safer securities.
- Regulatory Models: Regulatory models to set capital requirements can result in: (i) an incorrect categorization of the riskiness of securities, if the model is inaccurate; and (ii) a strong incentive for market participants to game these models.
- Third-Party Classification: Third parties that assist in setting credit standards may face incentive issues. Regulators may need to consider: (i) a third party's funding, incentive structure and competitive pressures; e.g., by regularly reviewing the firewalls in place to ensure a third party is not using information it gains from its role as a service provider to support its other businesses, such as asset management; and (ii) ensuring that a third party is properly measuring credit risk.
Commentary
Ready, fire, aim. This study is an unintentional critique of how Dodd-Frank and its related rulemaking has played out. First, mandate a change. Then, conduct a study to determine that, even if the prior system was somewhat flawed, the mandated alternatives are arguably worse.
There are any number of provisions of Dodd-Frank as to which one could arguably make the same point. Mandated central clearing remains the poster child of the bunch. First, mandate central clearing on the theory (or misguided hope) that it makes risks disappear, then conduct studies that conclude: whoops, it didn't work.
As to the argument that the loss of granularity incentivizes holding risk securities over safe ones, that is the very criticism that is constantly made of the liquidity capital ratio mandated by the bank regulators, particularly the FDIC. Yet, somehow the FDIC entirely misses the point. See, e.g., FDIC Vice Chair Defends Higher Leverage Ratio. Perhaps the FDIC will read this brief and make the connection.