Basel III vs Dodd-Frank on ratings agencies and risk weights

The disastrous twins, ratings agency credit ratings and RWAs (risk weighted assets), are still embedded in Basel III. Dodd-Frank does not like this much.

The ratings agencies are still a big part of Basel III, though the December draft does allow for the alternative possibility of using bank-internal models for assessing credit risk. Alas, the very obvious risk that banks would game their own internal models, and the perceived need for a public standard to regulate to, was the very reason that Basel II relied so heavily on external ratings agency ratings in the first place, rather than bank-internal ones. Banks promptly gamed the ratings agency ratings instead. It seems that under Basel III, banks are to have a choice of which models to game.

If you get the feeling that Basel isn’t really on the right track with this whole credit rating thing, you might have a point.

Over on the other side of the pond, there is much greater dissatisfaction with the role of the agencies. Dodd-Frank is professedly keen to turf them out of a regulatory role altogether, though it was rather vague on specifics. Now the post-Dodd-Frank rulemaking phase has produced  this request for comment (see FT Alphaville for the link and surrounding interesting commentary from Markit). Overview of the Section, from the request for comments :

Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act), enacted on July 21, 2010, requires the [regulatory] agencies to review their regulations that require the use of an assessment of creditworthiness of a security or money market instrument and make reference to, or have requirements regarding, credit ratings. The agencies must then modify their regulations to remove any reference to, or requirements of reliance on, credit ratings in such regulations and substitute in their place other standards of creditworthiness that the agencies determine to be appropriate for such regulations.

This advanced notice of proposed rulemaking (ANPR) describes the areas in the agencies’ risk-based capital standards and Basel changes that could affect those standards that make reference to credit ratings and requests comment on potential alternatives to the use of credit ratings.

Which sounds rather swingeing. Implementing this part of the Act really is a most daunting problem though; credit ratings are everywhere:

The agencies’ risk-based capital standards reference credit ratings issued by NRSROs (credit ratings) in four general areas: (1) The assignment of risk weights to securitization exposures under the general risk-based capital rules and advanced approaches rules; (2) the assignment of risk weights to claims on, or guaranteed by, qualifying securities firms under the general riskbased capital rules; (3) the assignment of certain standardized specific risk add-ons under the agencies’ market risk rule;  and (4) the determination of eligibility of certain guarantors and collateral for purposes of the credit risk mitigation framework under the advanced approaches rules. In 2008, the agencies issued a notice of proposed rulemaking that sought comment on implementation in the United States of certain aspects of the standardized approach in the Basel Accord. The Basel standardized approach for credit risk (Basel standardized approach) relies extensively on credit ratings to assign risk weights to various exposures.

This divergence on ratings agencies is a striking disagreement between Dodd-Frank and Basel III. Perhaps it doesn’t bode well for the level international playing field, that favourite rhetorical tool of bank lobbyists seeking to water down regulation; but at least someone’s started to have a crack at the problem.

On creditworthiness assessments, the first subject of the RFC, this is not a request for comments “on potential alternatives to the use of credit ratings”. All we have so far is this set of principles:

Section 939A of the Act requires the agencies to establish, to the extent feasible, uniform standards of creditworthiness to replace references to, or requirements of reliance on, credit ratings for purposes of the agencies’ regulations. The agencies are therefore considering alternative creditworthiness standards, including those currently in use in the agencies’ regulations, supervisory guidance, and market practices. The agencies recognize that any measure of creditworthiness will involve a tradeoff among the principles listed below. For example, a more refined differentiation of risk might be achievable only at the expense of greater implementation burden. In evaluating any standard of creditworthiness for purposes of determining risk-based capital requirements, the agencies will, to the extent practicable and consistent with the other objectives, consider whether the standard would:

• Appropriately distinguish the credit risk associated with a particular exposure within an asset class;
• Be sufficiently transparent, unbiased, replicable, and defined to allow banking organizations of varying size and complexity to arrive at the same assessment of creditworthiness for similar exposures and to allow for appropriate supervisory review;
• Provide for the timely and accurate measurement of negative and positive changes in creditworthiness;
• Minimize opportunities for regulatory capital arbitrage;
• Be reasonably simple to implement and not add undue burden on banking organizations; and
• Foster prudent risk management.

This is a reasonable list of what didn’t happen last time out. If it wasn’t for all those prudent qualifications (“to the extent feasible”, “tradeoff”, “to the extent practicable”) you could get the feeling that Something Was Going To Be Done.  Over to you, commenters, say the Fed, OCC, OTS, FDIC and Treasury: comment on our principles, and note how hard they will be to put into practice. One hopes this part of the request for comments isn’t a straw in the wind. It makes it look as if parts of the Dodd-Frank consultative process could turn into an exercise in crowdsourcing excuses for poor implementation of Dodd-Frank. That would be unsatisfactory.

Happily there is more meat in Possible Alternatives to Credit Ratings in the Risk-Based Capital Standards.

The role of RWAs is another big divergence between Dodd-Frank and Basel III. In Basel II and III there are rules that (roughly speaking) map from the riskiness of an asset (deduced from credit ratings and creditor type) to an amount of capital to be held to cover possible underperformance of the asset; this is the concept of risk-weighted assets, RWAs.

Certainly Basel III toughens bank capital standards, probably in idiosyncratic ways depending on the nationality of the bank (some of those old capital loopholes crept back in). But the RWA system also has a big role in defining the capital requirement. So boosting the capital requirement without fixing the weaknesses of the RWA approach, or finding a way to chuck it out altogether, leaves a big unsolved problem flapping in the breeze. In particular, the mythmaking around  the chimerical riskless asset, “AAA”, is still intact, with the promise of a zero capital weight for a suitably rated  asset. That is a good game, of course, with dumb reg-arbitrage-aware banks accumulating vast holdings in the ‘riskless’ stuff: see CDOs 2004-2007 (step forward ML, UBS, AIG, Landesbanken etc etc) or sovereign bonds right now (step forward SocGen, BNP, and, one suspects, Landesbanken again). Sport, too, for the smart black-hearted fiends who spot the illusion; last time that was Magnetar, GS, Lippmann at DB , Michael Lewis’s Big Short crew. I’m not sure who is going to profit from sovereign bond defaults or restructurings but I imagine the positions are already “on”.

So, one can at least comment on this bit of the RFC:

One way to eliminate references to credit ratings in the riskbased capital standards would be for the agencies to delete all of the sections in their risk-based capital regulations that refer to credit ratings and retain the remainder of the general risk-based capital rules. Under this approach, all non-securitization exposures generally would receive a 100 percent risk-weight unless otherwise specified. For example, certain sovereign and bank exposures would be assigned a zero percent or a 20 percent risk weight, respectively.

This has the look of a straw man, too swingeing to be acceptable. Except it doesn’t go far enough: zero percent risk weights – no no no and no. Absolutely nothing should attract a zero percent risk weight. That must change – and changing it is tantamount to requiring still more capital, so it wouldn’t be popular.

Also I quite like the demure way that bank exposures are compared with sovereign exposures. In the era of the big bondholder bailout, you might (with some snark) think them to be equivalent. But consider a putative sovereign debt crisis (say in Ireland or Portugal just now), when a sort of gearing effect ought to be expected to kick in: if, via some crisis, your sovereign risk weight is suddenly 20%, not zero, then the debts of banks guaranteed by that sovereign might be best weighted at 100%. No table of static risk weights can capture that kind of eventuality.

One can make any number of other straw-man risk-weighting proposals. A dollar-only example, for simplicity: weight US Treasuries at some non-zero percentage, and then weight everything else according to the spread over Treasuries. Sure, yield spreads tell you about more than credit risk, but there is your market based system; it will be no worse than what we have now, and is more flexible and responsive and granular. The document actually proposes something like this for corporates:

Alternatively, some corporate exposures for publicly traded firms could be risk weighted on the basis of market-based measures, such as credit spreads and equity-price implied default probability, and measures of capital adequacy and liquidity.

But: these types of market-based approaches are procyclical as hell; manipulable, too, no doubt; and come with some spectacular feedback effects when it all goes wrong. The basic problem remains – with this kind of market-based rule in place, every bank rushes off the same cliff at the same time (VaR doesn’t help either), and a few beady-eyed scallywags clean up. Probably something to add to the principles list, to make it even tougher to live up to: “The regulatory framework should not promote crowded trades”.

There are many many more ideas in the RFC – too much to do justice to in a single post. But remember, the framing is such that one might doubt whether the officialdom’s collective heart is really in it:

This ANPR seeks comment on standards of creditworthiness other than credit ratings that may be used for purposes of the risk-based capital standards. The various alternative approaches in this ANPR may present challenges of feasibility in varying degrees. The agencies would appreciate commenters’ views on the feasibility of implementing the suggestions for alternative approaches in this ANPR and any methodologies that commenters may provide.

This is of course an opportunity for lobbyists to work the international reg arbitrage ratchet, once again, towards whichever approach (Basel or US) is most permissive. Let us hope that is not where the comment process takes us, and that the whole business of getting ratings agencies and RWAs out of the regulatory framework doesn’t just end up on the ‘too difficult’ pile.