Credit Ratings in Capital Regulation—Are They Really Going Away?

Published May 15, 2012

Almost two years ago, on the heels of—if not still amidst—the worst financial crisis since the early 1930s, President Barack Obama signed the “Wall Street Reform and Consumer Protection Act of 2010” (Dodd-Frank) into law. Given the long-repeated chain of failed legislative and regulatory responses to previous crises, one might well wonder whether this massive 848-page piece of legislation helps us or not.

In one material area, the Dodd-Frank law included provisions dealing with credit rating “agencies.” These firms were at the center of our latest disaster. Dodd-Frank added new oversight and constraints for these firms. But Dodd-Frank also took a valuable step in prescribing their roles, calling for alternatives. Only time will tell, however, whether the reforms will actually be implemented and not stymied by special interest groups.

Capital has been regulated in the financial services industry for many years. The basic motive asserted for doing this is simple. Other things equal, more capital means more credit stability. And our regulators have long told us they work to promote stability, with capital regulation as a means to that end.

Poorly Capitalized

But the financial sector proved to be sorely undercapitalized in our latest financial crisis. This despite the government having provided various forms of insurance, along with the capital regulation advertised to promote stability.

What went wrong?

Capital regulation didn’t do what we were told it does. There are varying takes on this complex topic, to be sure. But some commonsense interpretations hold up:

  • Once the regulators developed a basic floor for capital levels, they drew a line in the sand giving the industry a valuable put option. If the value of banking assets deteriorates significantly, and the system is threatened despite the floor established by regulators to promote stability, public capital can effectively replace private capital. “Private” risk-takers can take more risk and maximize the return on their own capital, and if things go sour, they can “put” the bad results to the public. (A put option allows a person the right to sell a specified amount of an underlying security at a specified price within a specified time. Puts become more valuable as the underlying asset declines relative to the stated selling price.)
  • In turn, the regulators have had a history of making their regulations more complex, and in theory, risk-sensitive, in part because of the way government backstops can substitute for private capital in bank capital decisions. Regulators worked cooperatively, across financial sectors as well as internationally, asserting they were making capital regulations more sensitive to asset risk. One way they did this was to incorporate the opinions of credit rating agencies into their capital regulations. Banks and other financial institutions were required to hold more capital for lower-rated assets, and vice versa.

Floor Too Low

Putting these two planks together leads to some basic conclusions. Bank capital requirements simply had a floor that was too low—setting aside the question whether bank capital regulations should exist to begin with. In turn, the sophisticated fine-tuning advertised to make capital requirements more sensitive to asset risk effectively outsourced capital regulations to rating “agencies” being paid by issuers of the assets they were rating. Disastrous results—and predictable ones, not only in hindsight—followed.

Consider the aftermath of the deposit insurance crisis in the 1980s. In 1991 Congress passed the FDIC Improvement Act, or FDICIA. Among other things, FDICIA was advertised as addressing the problem of regulatory forbearance in dealing with failing and insolvent institutions. These “zombie” institutions had incentives to gamble for resurrection, and ended up digging even bigger holes for taxpayers. FDICIA developed a scheme of “tripwires” mandating regulatory action and intervention for financial firms with deteriorating capital levels.

But these tripwires, like capital regulation generally, relied in important part on credit ratings from a sanctioned few credit rating enterprises. Over time, credit rating firms enjoyed the fruits of an oligopoly protected by regulations advertised to protect the markets and the public.

In turn, the use of flawed, overly optimistic, inflated, and corrupt ratings in capital regulation played a significant role in the recent damaging financial crisis.

Resistance to Change

Passed into law in mid-2010, section 939A of Dodd-Frank directed regulators to review references to credit ratings in their regulations, delete them, and replace them with alternatives. This directive, described by Holman Jenkins of The Wall Street Journal as “a rare useful provision of Dodd-Frank,” is still facing an uphill battle.

More than a year after Dodd-Frank passed, banking regulators proposed new rules in December 2011 to implement the changes. But these are only proposals, and many in the financial industry, including regulators, have been stubbornly resisting change.

Regulators requested public comments in their December 2011 proposals. Designed to allow public input into the rulemaking process, the comment process can be a useful learning device, but it can also help cement the influence of special interest groups dedicating the most resources to the effort.

Our next article on this topic will review the public comments provided on this issue, as well as the evolving regulatory responses to the input they have been receiving.

William Bergman ([email protected]) is an economist who writes from Chicago.