The big three credit rating agencies have long made the disclaimer that investors should not use ratings as a substitute for independent judgment. Now regulators want banks to prove they aren't doing that.
Regulators told American Banker they are drafting rules that would require banks to demonstrate they had done their own research to receive the regulatory capital benefits of holding highly rated bonds from securitizations. A regulated institution that relied solely on ratings for evaluating an investment's safety would have to hold loss reserves against the full value of its position, regardless of whether its holdings were rated triple-A or junk.
"If you can't use a rating because you don't want to get all the information, then presumably you won't buy the instrument," said a person familiar with the position of the Federal Deposit Insurance Corp., one of multiple agencies drafting the proposed rules.
The move is a potentially significant step toward reducing bank and examiner dependence on the opinions of officially recognized rating agencies. But the agencies are still haggling with one another over the specific language. And a case can be made that years of credit losses on investment-grade securities have already instilled a healthy respect for the principle of "caveat emptor" among banks.
In no way would the rules preclude more formulaic approaches to regulatory capital; a blanket doubling of the amount of capital banks must hold against resecuritized products is part of pending Basel II enhancements. Still, some regulators and observers see the proposal as putting more of an onus on all parties to reach an independent judgment.
"It's going to take more effort on the part of the regulator" as well as the banks, said Larry White, a professor of finance at New York University's Stern School of Business. "They're going to have to do more in the way of what they do when they're looking at other types of loans in the portfolio."
Representatives of the rating agencies either declined to comment or did not respond to questions about prospective changes in regulators' approach to the use of ratings.
That regulators would support such a process struck some rating agency critics as a healthy development. Some factions in Washington support an even more radical approach that would strip "nationally recognized statistical rating organizations" such as Moody's Corp., Fitch Inc. and Standard & Poor's of any official recognition in regulatory capital requirements. Congress has extensively debated ratings reform but not taken concrete action.
Gene Phillips, a former Moody's analyst and current director at PF2 Securities, a structured finance evaluation firm, said requiring and verifying buyer diligence would be preferable to a general regulatory approach he characterizes as "let's make it impossible for things to be complex." Rating users "ought to be able to prove they are familiar with what's behind the rating," Phillips said.
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