Dodd-Frank Ban on Ratings Delays U.S. Implementing Basel Rule

A 24-line section of the 848-page Dodd-Frank Act is delaying U.S. implementation of international rules for how much capital banks need to hold against securitized assets.

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.

“Implementation in the U.S. is going to be more complicated than other places,” said Scott Anenberg, a former attorney for the Federal Deposit Insurance Corp. and now co-head of the financial-services practice at law firm Mayer Brown LLP in Washington. “One reason will be complications raised by capital provisions in the Dodd-Frank bill. It can make things difficult when politicians attempt to legislate on matters that for good reasons have traditionally been left to regulators.”

Market-Risk Rules

The Federal Reserve, the FDIC, the Office of the Comptroller of the Currency and the Office of Thrift Supervision were on the verge of completing a draft rule on market risk when the Dodd-Frank bill was passed in July, said three people with knowledge of the work. The ban on ratings forced them to go back to the drawing board, the people said. The search for an alternative will be a significant undertaking for the regulators, two of the people said.

Section 939A of the Dodd-Frank Act reflects criticism of Moody’s and S&P for giving mortgage-related securities investment-grade ratings they didn’t deserve. The ratings helped inflate a U.S. housing bubble, as trillions of dollars of risky home loans were packaged into bonds and sold to investors as safe, lawmakers and economists have said.

Current Basel trading-book rules treat all top-rated bonds the same, allowing banks to hold as little capital against AAA rated mortgage-backed securities as they do against Treasuries. The trading book is a subset of the balance sheet where banks park assets they intend to trade in markets, as opposed to the banking book where assets are meant to be held until maturity or at least for a longer period.

‘Nonsense’

At a meeting with reporters in Washington today, Massachusetts Representative Barney Frank said concern about the conflicting rules was “nonsense.” Frank, a Democrat who chairs the House Committee on Financial Services, co-authored the bill with Senate banking committee Chairman Christopher Dodd, a Connecticut Democrat.

“I haven’t heard that from any of the regulators,” Frank said. “Nobody with an official responsibility has ever said that was a problem.”

The new rules require higher capital charges for securitized bonds than for corporate or sovereign debt, bringing the trading-book standards in line with the banking book. Ratings scales of outside firms are used to calculate how much capital is required for different securities. The change will increase banks’ capital charges by as much as 4 percentage points, according to a Basel study.

Implementation Delayed

The Basel committee decided in June, a month before passage of the Dodd-Frank bill, to push back implementation of the new trading-book rules by a year, to the end of 2011, after U.S. regulators pleaded for more time to complete their domestic proposals, according to people familiar with the discussions. The European Parliament, the lawmaking body of the European Union, approved the changes in July. They will go into effect at the end of next year.

The Basel committee, made up of regulators and central bankers from 27 countries, sets capital and liquidity requirements for banks worldwide. Each country then translates those standards into domestic rules. While the EU writes them into law, the U.S. typically does it through rulemaking by the Fed and other regulators. The Dodd-Frank Act gives the agencies authority to strengthen capital and liquidity requirements.

Alternatives to Ratings

One solution under consideration by U.S. regulators is to let banks devise their own ratings for securities they own, loosely based on external ratings, one of the people involved in the discussions said. Another is to ask Congress to revise the law to remove or soften the ban, according to another person briefed on the talks.

Last month, the Fed and the other U.S. agencies issued a rulemaking proposal to comply with the Dodd-Frank requirement on the elimination of external ratings from their regulations. The document lists possible ways of replacing ratings in banking rules, including capital charges on holdings of securitized products, and asks the industry for alternatives.

The open solicitation of ideas means regulators are far from agreeing on a solution, said an official from one of the agencies, who asked not to be identified because the discussions are private. Many of the options being considered give banks more leeway in how they calculate the riskiness of their securitized assets, which conflicts with the Basel committee’s recent attempts to decrease banks’ autonomy in assessing risk, the official said.

European Suspicion

European suspicion that the U.S. would delay or fail to adopt new capital rules colored debate in Basel, Switzerland, this year. The wariness surfaced again this month, when the committee was divided between those seeking higher capital ratios and those arguing for lower figures. Germany, which wanted lower ratios and more time to implement them, accused the U.S. of pushing for tougher rules that it probably wouldn’t adopt, according to people with knowledge of the discussions.

European Central Bank Governing Council member Axel Weber, who’s also president of Germany’s Bundesbank, said on Sept. 8 that the U.S. needs to follow through.

“It can’t be that we’ll implement Basel in Europe and not in the U.S.,” Weber said before a weekend meeting where the committee reached agreement on higher ratios while giving the banks more than eight years to comply.

Peter Sands, chief executive officer of London-based Standard Chartered Plc, also expressed concern whether new Basel rules “will be implemented in a consistent manner globally.”

Basel II

“We shouldn’t expect everybody to move in sync, but the degree of difference and contradictions should be kept to a minimum as much as possible,” Sands said in an interview yesterday at Bloomberg headquarters in New York.

The U.S. has still not fully implemented the current capital regime, known as Basel II, which was promulgated in 2004 and implemented by most European countries three years later.

After U.S. regulators agreed to the rules, community banks lobbied lawmakers, saying the new standards would give large banks an unfair advantage because they were the only ones able to invest in the complicated risk-management systems on which Basel II was based. Those rules allowed banks to use their own mathematical models to measure the riskiness of their assets, resulting in some firms reducing the amount of capital they had to hold by as much as 29 percent, according to data compiled by the Basel committee.

Basel III

Under pressure from Congress, which held hearings in 2005 and 2006, regulators set up hurdles that needed to be cleared before banks would be allowed to reduce their capital. While the largest U.S. banks are on schedule to complete the process by the first quarter of 2011, regulators have told them not to lower their capital now that new rules, known as Basel III, are on the way. There isn’t a schedule for smaller banks to comply with the older regime.

After the Basel committee completes its work on the new rules at the end of the year, their implementation in the U.S. will face obstacles too, said Mayer Brown’s Anenberg. The procedure the Fed and other U.S. regulators follow with Basel compliance is to propose rules along the lines of the framework and ask for comments from the industry. U.S. banks will oppose parts of Basel III they’re not happy with, such as the restrictions on the use of mortgage-servicing rights in capital calculations, Anenberg said.

‘Battle by Banks’

“There will be a battle by banks to change some of it,” he said. “And U.S. regulators already face a huge task in implementing Dodd-Frank in the next couple of years. So implementation of Basel changes may not be an immediate priority.”

The Dodd-Frank Act requires 67 studies and 243 new rules to be created by regulators, according to a paper by New York-based law firm Davis Polk & Wardwell LLP. Basel member countries will have until the end of 2012 to draw up national regulations to comply with Basel III, which is scheduled to go into effect between 2013 and 2023.

Other elements of Dodd-Frank contradict Basel III rules. A clause in the act that bans counting hybrid bonds as capital has different time frames than Basel III. It gives larger banks less time to phase out the bonds and smaller banks more time. The Dodd-Frank rule against external ratings also runs counter to sections of Basel III, which rely on such ratings to determine capital charges for certain assets. U.S. regulators will have to reconcile the two, bankers and lobbyists say.

Unlike Basel II, which was pushed by banks when politicians weren’t paying attention to capital rules, the post-crisis environment will help regulators overcome hurdles and implement Basel III, says Brett Barragate, a partner at law firm Jones Day in New York.

“They might struggle with finding solutions to such conflicts, but regulators can’t drag their feet too much on implementing Basel,” said Barragate, who represents JPMorgan Chase & Co. and Bank of America Corp. among other lenders. “If the political environment changes in the next few years, this resolve could dissipate, but at this stage the pressure seems to be on for implementation.”

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net.

To contact the editors responsible for this story: Alec McCabe at amccabe@bloomberg.net.

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