Reaction to Credit Agencies Means More Compliance Costs

Author: T.J. Grasmick

Congress took out its anger with the credit rating agencies for the role their flawed ratings for securitizations and other structured products played in the U.S. economic collapse by enacting Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).  Section 939A required the federal banking agencies to remove all credit rating references from their regulations and replace them with appropriate alternative standards of creditworthiness.  It is now clear that the required implementation of 939A by the regulatory agencies is another example of unintended compliance cost consequences being imposed disproportionately on community banks.

The Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) have issued Notices of Proposed Rulemakings and Proposed Guidance for Comment in order to comply with the July 21, 2012 deadline for implementing Section 939A.  Most of the references to credit ratings are in the agencies’ risked based capital rules, and press attention has focused on how only the few mega-banks with over $50 billion in assets will initially be affected by U.S. regulators’ implementation of Basel III and Dodd-Frank Section 939A.  This is evident in the FDIC’s proposal announced December 7, 2011 regarding market risk capital rules.

However, the "credit rating" term which Congress banned in Section 939A also was commonly referenced in the definition of “investment grade” for corporate debt securities investments held by all banks.  If a corporate debt security was rated in the four highest rating categories by one or more of the nationally recognized statistical rating agencies, that debt security was generally eligible for purchase by national banks, savings banks and state banks.  The FDIC’s recent pronouncement explicitly states that the federal banking agencies intend to apply these new standards for all investments, not just for debt and securitization positions. 

The OCC and FDIC’s current proposals out for comment would replace the definition of investment grade securities with a requirement that, in order to acquire a corporate debt security, banks must first determine that the issuer "has an adequate capacity to meet the financial commitments under the security for the projected life of the investment."  The OCC asserts that the elimination of references to credit ratings “does not substantively change the standards institutions should use when deciding whether securities are eligible for purchase.”  It does, however, eliminate a simple eligible-for-purchase test that was acceptable in the past.  The OCC has admitted this is a “new standard” that national banks will have to meet before purchasing investment securities.  The OCC has also acknowledged that there are no alternative measures of credit worthiness that are as transparent and relatively simple to use as credit agency ratings.

In previous testimony on Section 939A, the Federal Reserve acknowledged: “We are particularly sensitive to the difficulties of constructing effective, low-burden replacement standards for smaller banks, which have less credit-risk assessment resources than large banks.”  Similarly, the OCC recognized “...that any measure of creditworthiness likely will involve tradeoffs between more refined differentiation of creditworthiness and greater implementation burden” and requested comment as to “other alternatives permissible under Dodd-Frank Section 939A that strike a more appropriate balance.”

What does it mean for community banks to remove credit agency ratings as a sufficient test for determining whether debt securities are eligible for investment?  It means an enhanced commitment will be required of the banks and their boards of directors to ensure the bank can support its investment decisions and the capital allocated in view of its investment portfolio.  Prior decisions based predominantly on the credit agencies’ ratings for the securities will no longer be permissible.

During the FDIC public board meeting on December 7, 2011, regulators said they did not want the proposed implementation of Section 939A to impact smaller banks and would be sensitive to how credit rating alternatives would apply to such banks. But written guidance often warns banks that more is likely to be expected of them.  The OCC took the opportunity to remind banks that it has “a long-standing expectation that national banks implement a risk management process to ensure credit risk, including credit risk in the investment portfolio, is effectively identified, measured, monitored and controlled.” The FDIC made the same point.  Both the OCC and the FDIC cited interagency policy statements that have long emphasized the importance of an institution conducting a thorough credit risk analysis before and periodically after the acquisition of a security, and noted further that examiner decisions concerning investment security risk ratings and classifications will consider management’s credit risk analysis of security investments.  Just to be clear, the OCC added that the failure to maintain an adequate investment portfolio risk management process is considered an unsafe and unsound practice.

Both agencies issued guidance for comment on the due diligence steps banks should take in determining whether corporate debt securities are eligible for investment.  The OCC noted an appropriate level of due diligence “may include consideration of internal analysis, third party research and analytics including external credit ratings, internal risk ratings, default statistics, and other sources of information.”  In a schedule of Key Factors, the OCC offered examples of the due diligence steps banks should take in the future before investing in any structured products: 

• Understand the class or tranche and its relative position in the securitization structure
• Assess the position in the cash flow waterfall
• Understand loss allocation rules, the potential impact of performance triggers, and support provided by credit enhancements
• Evaluate and understand the quality of the underwriting of the underlying collateral as well as any risk concentrations
• Determine whether current underwriting is consistent with the original underwriting underlying the historical performance of the collateral and consider the affect of any changes
• Assess the structural subordination and determine if adequate given current underwriting standards
• Analyze and understand the impact of collateral deterioration on tranche performance and potential credit losses under stress scenarios 

These and other due diligence steps would replace the previously acceptable heavy reliance on favorable credit agency ratings.

So what is the bottom line?  Even if a security has strong credit agency ratings, the bank regulatory agencies believe having a “strong and robust risk management framework appropriate for the level of risk in [the] investment portfolio is particularly critical for managing portfolio credit risk.”  This means many community banks will need to allocate even more staff, management and board resources to address another Dodd-Frank change. 

Community banks should continue to speak out and request more relief from the burdens being imposed on them by the implementation of Dodd-Frank.  Contact Manatt if you have questions on this newsletter, or if you would like assistance in the submission of comments to the OCC or the FDIC.