August 31, 2010

Risk-Based Bank Capital Guidelines

Federal Banking Agencies Seek Comment on Alternatives to Credit Ratings in Risk-Based Capital Guidelines
SUMMARY
On August 10, 2010, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision published a joint Advance Notice of Proposed Rulemaking seeking comment on the feasibility of certain proposed alternatives, as well as any other methodologies that commenters may wish to present, to the use of credit agency ratings in the respective agencies risk-based capital guidelines as mandated by Section 939A of the Dodd-Frank legislation. While recognizing that the agencies are considering a wide range of approaches to these issues, the advanced notice broadly discusses two possible alternatives: (i) assigning risk-weightings to an exposure based on its type and (ii) developing methodologies that would allow banking organizations to assign individual weightings more specific to each of their exposures based on market-based measures such as credit spreads, obligor-specific factors like debt-toequity ratios, and other criteria. The advance notice then suggests how these approaches might influence rule-making across various exposure types.

BACKGROUND
This advanced notice follows the enactment into law on July 21 of Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act which requires Federal agencies to review their regulations that require an assessment of credit-worthiness of a security or money market instrument and any references or requirements in such regulations regarding credit ratings. Agencies must then replace any references to credit ratings with an appropriate alternate standard of credit-worthiness. Currently, many of the Federal banking agencies general risk-based capital, market risk and related rules and regulations, such as the Basel II-based internal ratings and advanced approach regulations currently applicable to large internationally active banking organizations, rely on the use of credit ratings issued by nationally

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recognized statistical rating agencies in order to, among other things, assign appropriate risk-weightings to specific assets such as debt securities for purposes of calculating a banking organizations risk-based capital requirements. In addition, two documents recently issued by the Basel Committee on Banking Supervision entitled Enhancements to the Basel II Framework and Strengthening the Resilience of the Banking Sector also make extensive use of credit ratings, and thus raise issues under DoddFrank.1

PRINCIPLES GUIDING UNIFORM STANDARDS OF CREDIT-WORTHINESS

The advance notice states that the evaluation of methodologies to replace credit ratings will be guided by the following principles: Distinguishing risks associated with a particular exposure within an asset class; Creating a transparent, replicable, and clearly defined system that allows different types of banking organizations and regulators to arrive at the same assessments; Providing for timely and accurate measurements of changes in credit-worthiness; Minimizing opportunities for regulatory capital arbitrage; Being reasonably simple to implement and not being unnecessarily burdensome on banking organizations; and Fostering prudential risk management.

Nevertheless, the Federal banking agencies recognize that adopting such alternative methods will necessarily involve trade-offs among such principles.

PROPOSED ALTERNATIVE APPROACHES TO CREDIT RATINGS

The advanced notice states that the Federal banking agencies are considering a wide range of approaches of varying complexities and risk-sensitivity and describes two general possible approaches an exposure category approach and an exposure specific approach in greater detail. Risk-Weighting Based on Exposure Category Under the exposure category approach, all references to credit ratings in applicable capital regulations would be deleted and the general approach of current risk-based rules would be retained. Under this approach, an individual credit exposure would be risk weighted based on the general characteristics of the category to which such exposure belongs. For example, all non-securitization exposures would
1

The advanced notice makes the observation that Section 939A is limited to requiring a review of agency regulations to those pertaining to a credit-worthiness assessment of an instrument. Using a consistent approach, the Advanced Notice of Proposed Rulemaking also issued on August 10, 2010 by the Office of the Comptroller of the Currency with respect to impact of Section 939A of Dodd-Frank on the OCCs other regulations which depend on ratings, such as 12 C.F.R. Part 1 governing permissible investments by national banks, requests comment on whether Section 939A prohibits the use of credit ratings as a proxy for measuring other characteristics of a security such as liquidity or marketability. -2-

Risk-Based Bank Capital Guidelines August 31, 2010

receive a 100 percent weighting, unless otherwise specified. Greater risk sensitivity could be achieved by creating more discrete exposure categories based on defined criteria, such as for sovereign, bank and public sector entities. Risk-Weighting by Specific Exposure Under the exposure specific approach, banking organizations would be required to perform a qualitative and quantitative analysis of individual exposures in accordance with standards set forth by the applicable Federal banking agencies. Those standards would be based on broad metrics, such as credit spreads, obligor financial data such as debt-to-equity ratios, and/or relevant other information.2 Default probability of the exposure may also be considered, including the use of third-party information providers to assess that particular risk. The advanced notice states, however, that this refined differentiation of creditworthiness may result in higher implementation costs, and, in particular, that consultation of third parties raises issues of reliance and consistency of application.

APPROACH BY EXPOSURE TYPE

For illustrative purposes, the advanced notice also provides more detail on how the exposure category approach and exposure specific approach could be applied to different classes of credit exposures. Sovereigns Exposure Category Approach Assign risk weightings based on membership in certain international organizations such as the G-20, the Basel Committee or the International Monetary Funds New Arrangements to Borrow program. Additional criteria could include credit spreads or recent debt restructuring. Specific Exposure Approach Incorporate country risk classifications used by specified international organizations, or use key financial and economic indicators using prescribed ratios and sources such as the IMF or the Organization for Economic Cooperation and Development.

Public Sector Entity Exposure Category Approach Continue to use general risk-based capital rules that draw upon the public sector entitys, or PSE, ultimate sovereigns membership in the OECD and PSEs exposures source of repayment (general obligation, industrial revenue, etc.). Specific Exposure Approach Require the use of a variety of financial and economic data to assess risk, such as credit spreads, or debt-to-revenue or debt-to-asset value ratios; alternatively, permit banking organizations to apply data from third parties based on certain criteria, or apply data relating to the PSEs sovereign.

The advanced notice also suggests that banking agencies could consider approaching debt securities similarly to the National Association of Insurance Commissioners where a third-party assessor would inform the agencies understanding of risks and their ultimate determination of the risk-based capital requirement for individual securities. -3-

Risk-Based Bank Capital Guidelines August 31, 2010

Banks Exposure Category Approach Continue to use general risk-based capital rules that assign risk-weightings based on the exposures membership in the OECD (currently 20 percent weight given to U.S. depository institutions and foreign banks, 100 percent for nonOECD incorporated banks). Specific Exposure Approach Federal banking agencies could: Use a variety of financial and market indicators to assess risk. Such factors could include the ratio of core deposits to total liabilities, or the banks credit quality as assessed by the relationship between non-performing items and total assets. Weigh publicly-traded banks using market information such as spreads between bond yields and Treasury securities.

Corporate Exposure Category Approach Continue to use general risk-based capital rules that weigh corporate exposures at 100 percent. Specific Exposure Approach Allow banking organizations to: Use a variety of financial and market indicators, including balance sheet or cash flow ratios (current assets-to-current liabilities, debt-to-equity, or a form of debt service-tocash flow ratio). Weigh publicly-traded corporations using credit spreads, equity-price implied default probability, or measures of capital adequacy and liquidity. Assign risk weights according to objective criteria and external data that would include credit analyses (but not credit ratings) provided by third parties.

Securitization Exposures Exposure Category Approach Revert to rules in effect prior to the 2001 recourse rule, which would result in equal risk-weighting for all securitizations irrespective of subordination. Specific Exposure Approach Require banks to maintain capital against their securitization exposure, as well as all exposure senior to the banks exposure in the securitization structure. This grossed-up exposure would then be weighted according to the underlying securitized exposure. Assess credit risk of grossed-up securitization exposure based on underlying pool and the exposure itself; risk-weightings could then be based on, for example, the securitization transactions overcollateralization ratio, interest coverage ratio or waterfall priority. Assign all senior securitization exposure a weighting based on underlying exposure type and the amount of subordination that provides credit enhancement.3

The advanced notice states that this approach would only apply to senior tranches, however, and would not differentiate between exposures with significant credit support and those where lower tranches had been reduced or eliminated by losses. -4-

Risk-Based Bank Capital Guidelines August 31, 2010

Adopt the Basel Committee approach that would use a concentration ratio to set minimum capital requirements.4 Have banking agencies develop a simplified supervisory formula approach that would use exposure-specific inputs to recognize multiple sources of risk linked to securitizations.

Guarantees and collateral Exposure Category Approach Expand the recognition of collateral and guarantees currently provided in general risk-based capital rules by substituting weighting of the collateral or guarantor for that of the exposure. Specific Exposure Approach Have banking agencies incorporate into the recognition of collateral and guarantees certain credit-worthiness standards discussed above for sovereign, PSE, bank and corporate exposures.

IMPLICATIONS
Implicit in the advance notice is a recognition by the Federal banking agencies that implementing the requirements of Section 939A of Dodd-Frank will be quite challenging in practice. The two approaches outlined represent two distinct ways of eliminating the reliance on credit ratings for purposes of the riskbased capital guidelines, each with its own advantages and disadvantages. On the one hand, the Moreover, it exposure category approach is simpler to administer and implement, but, by necessity, can only provide a rough justice approach for purposes of risk-weighing a particular credit exposure. represents, in effect, a step backwards in the evolution of international risk-based capital standards as exemplified by the Basel II advanced approach. One the other hand, the specific exposure approach provided finer risk-based distinctions for specific credit exposures, but would be more difficult for banking regulators and banking organizations to implement because (whether internally or through the use of a third party), the kinds of analytical exercises that rating agencies undergo to assign a rating to a particular debt instrument would need to be replicated in some form or another, in many cases without the benefit of information that was heretofore provided by issuers to the rating agencies.

COMMENTS
Given the magnitude of the task mandated by Section 939A, the Federal banking agencies are asking for a wide range of views in advance of more formal rulemaking in this area. As such, the advanced notice poses nine questions, each with multiple subparts, including:
4

The advanced notice notes that this proposal would effectively make the capital requirement no less than that resulting from a direct exposure to the underlying assets. The concentration ratio would be equal to the sum of the notional amounts of all tranches divided by the sum of the notional amounts of the tranches junior to or pari passu with the tranche held, including the exposure itself (if the concentration ratio equals 12.5 percent or more, the exposure would be deducted from the banking organizations capital). The capital requirement would be 8 percent of the weighted-average risk weight that would be applied to the underlying securitized exposures multiplied by the concentration ratio. -5-

Risk-Based Bank Capital Guidelines August 31, 2010

What other principles should guide the evaluation of methodologies for replacing credit ratings for purposes of risk-based capital guidelines? What are the advantages and disadvantages of the two general approaches? What approaches would appropriately reflect various exposure categories of banking institutions? What financial and economic indicators should be considered in the context of risk-weighting sovereign credit and PSE exposures? What are the advantages and disadvantages to the proposed approaches to bank and corporate credit exposures? What is the potential for unintended consequences arising from the proposed approaches?

Comments on the advanced notice are due no later than October 25, 2010 and should include both qualitative and quantitative support and/or analyses. * * *

Copyright Sullivan & Cromwell LLP 2010 -6Risk-Based Bank Capital Guidelines August 31, 2010

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