Lisa Pollack, credit data analyst at Markit, takes a closer look at the Dodd-Frank reform bill and its implications for credit ratings.
Relax, take a deep breath, and imagine a world without credit ratings. Take a moment to really clear your mind of them. No more “triple A”, no more “investment grade”. In such a world, how would you calculate risk-weighted assets, the denominator of capital ratios? The Dodd-Frank Wall Street Reform and Consumer Protection Act dares to pose this question.
While Basel III has been snapping up the limelight lately, with its phase-in table and various buffers, consultation continues apace as Dodd-Frank labours through its implementation phase. The process is not unlike building a house. The legislation put the groundwork in place, there’s a blueprint, and this is the stage where we’re looking at a box of parts wondering how to start putting some of the basic plumbing together.
For example, how does one construct a “swap execution facility” (SEF)? According to ISDA, there were $464 trillion of swaps outstanding in 2009 and a SEF will be one of the places where a cleared swap is permitted to trade, so this is hardly a trivial question. In a discussion at a recent CFTC-SEC Roundtable, the debate turned to what constitutes a SEF and Jason Kastner, of the Swaps and Derivatives Markets Association, posed the question, “can you trade swaps with two paper cups and a string and carrier pigeons, or is it required that they be on a screen, an electronic screen?”
The question of credit ratings moves the entire discussion to an even more fundamental level as Section 939A of Dodd-Frank puts ratings on the prohibited materials list for the entire construction project. The Fed, OCC, FDIC, and soon-to-be-defunct OTS, are tasked with examining their use of credit ratings, removing their reliance of on them, and in so doing finding other approaches for measuring credit-worthiness. The two major potential approaches that the agencies are seeking comment on from the industry are an exposure category approach, which applies broad risk weights by the categories that an exposure falls into, and an exposure specific approach where more granular metrics, such as credit spreads, can be used.
Basel III, meanwhile, does not have ratings on the prohibited materials list. At the end of this year, revised risk weightings kick in for securitisation exposures. This particular set of edits was announced in July 2009 and for the time being it seems that the Basel Committee intends to continue relying on ratings.
Let’s go back to some of that initial blue-sky thinking though. How should creditworthiness be measured when determining the capital that financial institutions have to hold? Ratings have often been criticised for being backward-looking, based on historical scenarios which are no indication of the future, and slow to update when new information becomes available.
Frank Partnoy, a law professor at the University of San Diego and former derivatives structurer, has been arguing for over a decade that ratings-based rules should be removed. To get straight to the heart of the matter, in a reference to Constant Proportion Debt Obligations (CPDOs), those triple A-rated beasts of yore that turned out to be not-so-triple-A after all, Partnoy asked, “Does anyone believe parties paid for triple A ratings of such instruments because those ratings gave them valuable information? More likely, ratings were valuable because they permitted investors to buy something triple A-rated that paid 20 times the spread of other triple A-rated instruments.”
How investors choose to utilise credit ratings and how regulators of financial institutions integrate them into their frameworks remains, for the timing being, as two separate questions. But here and now, Section 939A marks the start of the process of disentangling ratings from the fabric of the regulatory system. Comments in response to the initial proposals by the regulators are due in by October 25, 2010.
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