Removing Regulators Reliance on Ratings

One of the little-discussed parts of the summer's big financial regulation bill was a provision which would eliminate private credit ratings from all laws and regulations. This sounds like a sensible idea, given the rather poor performance of the rating agencies since the housing bubble. But weaning regulators' off ratings is easier said than done. What's the alternative?

The Wall Street Journal reports that the Federal Deposit Insurance Corporation is on the verge of proposing other options, in cooperation with other regulators. Here's what's being considered:

Among the options being discussed is a greater use of credit spreads, having supervisors develop their own risk metrics and a reliance on existing internal models, according to people familiar with the situation.

Agency officials aren't expected to endorse a particular approach and instead plan to encourage input from banks, academics and other regulators. "It's very difficult to come up with a perfect substitute," a person familiar with the situation said, noting that regulators have been using credit ratings for decades. "We have to be very explicit if we're going to take external ratings out, we're going to have to put something extremely specific in." This person added that some combination of measures could be used.

Let's consider the three proposals suggested:

Credit Spreads

For any debt (held as an asset by a bank), the market can provide a risk premium. This is often computed by comparing the risk premium of the debt with that of a Treasury bond with a similar maturity, which is interpreted as being about as risk-free as you can get. The higher the spread is between the yields of these two bonds, the riskier the asset. An associated capital requirement could then be calculated accordingly. Credit default swaps could also help here.

While this is arguably the best method, it isn't perfect. Often the market is just as wrong as everyone else -- like we saw with the housing bubble. In late 2006, subprime mortgage-backed securities were still seen as being quite safe by virtually everyone in the market, so the credit spread didn't accurately dictate the real risk much better than the bonds' AAA-ratings. You could also argue that the market can sometimes overreact when it panics, and that could cause a credit crisis to deepen even more quickly, if capital is tied to worried investors.

Regulator Risk Metrics

Why don't regulators just create their own risk metrics for various types of assets? Well, that's exactly what the private rating agencies attempted to do during the housing bubble. We all know how that turned out. Are we really expected to believe that regulators would do better than the private risk evaluators did? After all, regulators didn't call the housing bust either.

Moreover, there's some possibility that regulators could err on the side of being too conservative. More prudent regulatory rules applied to capital levels are a legitimate response to the financial crisis. But regulators could take things too far, since they have no incentive to strike the appropriate balance.

Reliance on Internal Models

Presumably, this means banks' internal models of risk. For every asset a bank owns, it calculates how much it's worth. As the risk of the asset changes, so will its price.

This option has the opposite problem of the regulators controlling the models. Just as they could develop rules that are too conservative, banks could be too liberal. Financial institutions would want their assets to count for as much capital as possible. Even if they learn that asset quality is deteriorating, they won't want to ante up more capital to cover them. So they'll be slow -- at best -- to revise their models to be more conservative as the market evolves.

So none of these ideas is a silver bullet, But maybe if you combine all these, you come up with a winner? Perhaps, but it's hard to see how. Do you create a weighting for each of the three? Do you have different market triggers where the capital metric changes as economic shocks hit? Reconciling three very different methods of assessing risk might not be easy. Unfortunately, there's no perfect solution. Because the market, regulators, and banks won't ever be certain of the future, very accurate risk assessments will never be possible. The question, then, is whether some of these proposals can do better than the rating agencies.