3 Reasons Cutting Out Ratings Shouldn't Delay New Global Banking Rules

New financial regulation has been boiling over since July. That's when the U.S. passed the massive Dodd-Frank regulation bill. Then, earlier this month the Basel Committee announced its new capital standards that global banks must follow with its Basel III accord. But a new report from Yalman Onaran at Bloomberg suggests that these two efforts might not mesh particularly well. A provision in Dodd-Frank strips rating agencies influence from regulations, and that could make it more difficult to implement the new capital rules.

Here's an excerpt from the Bloomberg article explaining the problem that this creates:

The financial-overhaul legislation, signed by President Barack Obama in July, requires regulators to remove all references to credit ratings of securities from their rules. Revised standards on how much capital banks need to hold against such assets in their trading books, approved by the Basel Committee on Banking Supervision in 2009, rely on such ratings.

That means the U.S. will have to develop another mechanism that doesn't depend on firms such as Moody's Investors Service and Standard & Poor's, a process that threatens to slow adoption of the Basel rules on market risk as well as a separate package of regulations on bank capital and liquidity agreed to this month, known as Basel III, bankers and lawyers say. The delay also gives ammunition to European regulators and politicians who have criticized the U.S. for dragging its feet on compliance with previous standards while pushing for their approval.

It's a little difficult to see why this would be such a huge problem, however, considering the legislation and the Basel III timeline.

What Conflict?

First, as the timeline for Basel III shows, the new rules don't even begin to be implemented until January 2013. Meanwhile, the section of Dodd-Frank requiring ratings to be stripped from U.S. regulations appears to go into effect no later than July 2013 -- three years after the bill was signed. Would it really be that serious a problem if the U.S. required banks to satisfy the first stage of Basel III six months late?

Would It Even Take That Long?

Moreover, the "no later than" language of Dodd-Frank implies that regulators could forbid reliance on rating agencies even sooner. And what would prevent them from doing so? Determining how to evaluate risk is a pretty difficult problem to solve. But if regulators are required by the bill to devise some alternative to the rating agencies, then they have no choice but to do so. Why should it take more than three years to decide how to do it?

What Does This Have To Do With Basel III?

Finally, what does the rating agency problem even have to do with implementing Basel III. As I understand it, Basel III does not specifically require the use of rating agencies. It allows each individual nation determine how to evaluate risk. Even if a new risk weighting system isn't in place by 2013, regulators could just demand that U.S. banks use the old one or some other transitional system temporarily until they finalize their new risk evaluation plan. U.S. banks would then still be in compliance on time.

To be sure, creating a new framework for determining how much capital should be set aside based on the risk of various assets and securities will be a very difficult task. But it shouldn't technically hamper the U.S.'s ability to comply with Basel III.