FDIC Seeks Comment on Alternatives to Ratings for Grading Debt

The Federal Deposit Insurance Corp. is seeking comment on proposals for meeting a Dodd-Frank Act requirement that banks use an alternative to credit ratings for valuing debt in their trading books.

FDIC board members voted 3-0 at a meeting in Washington today to propose three methods for replacing ratings in a proposal devised with the Federal Reserve and the Office of the Comptroller of the Currency. The proposals, which would affect how much capital a bank has to reserve against potential losses, would change valuation methods while maintaining ratios required under existing international rules, the FDIC said.

“The agencies have developed credit ratings replacement alternatives that use readily available and objective data,” acting FDIC chairman Martin Gruenberg said in a statement.

Dodd-Frank, the regulatory overhaul enacted last year, called for federal agencies to find alternative measures of creditworthiness after lawmakers faulted ratings firms such as Moody’s Corp. (MCO) and McGraw-Hill Cos. (MHP)Standard & Poor’s unit over grades on securitized debt before the subprime mortgage market collapsed. The proposal approved today by the FDIC would affect only assets in bank trading books.

For securitized products, the FDIC proposed that banks assess how much capital they need to set aside based on the capital required for the assets that underpin the security. They must also take into account the order in which losses are absorbed under the product’s structure, the FDIC said.

For sovereign and bank debt, the FDIC proposed use of a classification system run by the Paris-based Organization for Economic Cooperation and Development. And for non-financial corporate debt that is publicly traded, the agency proposed using a mixture of leverage ratios, cash flow and stock volatility to determine how much capital to set aside.

‘Select Few’

The rule would affect fewer than 20 banks, “a select few of the largest institutions,” according to Bobby Bean, the FDIC’s associate director in the division of risk management and supervision. Those lenders have more than $10 billion in total trading assets and liabilities or more than 10 percent of their total assets in trading liabilities, Bean said.

Hugh Carney, senior counsel at the American Bankers Association said the rule may affect smaller banks as well.

A stated goal of the FDIC is to eliminate the potential for arbitrage between bank trading portfolios and lending books by valuing assets using the same formula, something the agency plans to address in future rulemakings. If the FDIC extends the methods proposed today to lending assets, the rule would then affect much smaller banks as well, Carney said in an interview.

“This proposal has implications far beyond its official scope,” he said.

To contact the reporter on this story: Carter Dougherty in Washington at cdougherty6@bloomberg.net.

To contact the editor responsible for this story: Lawrence Roberts at lroberts13@bloomberg.net.

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