Basel III capital requirements, Dodd-Frank ban on using credit ratings in regulations and disclosure by banks

A Reuter's article highlighted how the Dodd-Frank Act impacts the adoption of Basel III capital requirements in the US.

The Act bans the use of credit ratings in US bank regulations.  However, these same banned credit ratings are used to in determining the risk-weighting of an asset for compliance with the Basel III capital requirements.

The question is what can be used as a substitute for relying on the credit ratings for three or four firms?

Under the FDR Framework, the substitute is to replace the opinion of three or four firms with the opinion of the market.  This is easily achieved by requiring disclosure of each bank's current asset and liability-level data.  Market participants including competitors, credit and equity market analysts, and valuation experts will use this data to perform their own risk assessments of the assets on the individual bank's balance sheet.

Rather than having to rely on three or four firms, regulators can now rely on the assessment of risk by the market participants.

The United States' ability to implement global capital rules is being made more difficult by a provision in the Dodd-Frank financial reform law, JPMorgan Securities said in a research note released on Friday. 

The 2010 law bans the use of credit agency ratings, such as those provided by Moody's Corp and McGraw-Hill Cos' Standard & Poor's, in U.S. banking regulations. 

That is a problem for bank regulators, who currently have no good alternative to the credit ratings they use to help judge the risk on banks' books when determining capital requirements. 

... The ban on credit ratings in U.S. regulations will also likely make it more difficult to implement the latest sweeping global capital accord reached as part of the Basel III agreement, the note said. 

That agreement does not have to be fully in place until 2019, but U.S. regulators hope to begin issuing draft rules by the end of this year. 

... Last summer U.S. regulators sought comment on what could be done to replace credit ratings in their rules. They say good alternatives have yet to materialize. 

The Dodd-Frank change has been a burr in their saddle. 

"The Dodd-Frank Act's prohibition against the use of credit ratings also will impede our efforts to achieve international consistency in the implementation of Basel III," acting Comptroller of the Currency John Walsh told the House Financial Services Committee on June 16. 

The Basel III agreement is a response to the financial crisis and aims to force banks to meet tougher capital standards so they can better withstand a financial shock. 

Regulators have asked the U.S. Congress to amend the law to deal with the credit rating problem, but that seems unlikely for the foreseeable future. 

One possible outcome is that regulators will require banks to perform their own risk assessments to replace the work of credit rating agencies, and the banks' assessments would be reviewed by a third party, said Karen Petrou, managing partner at Federal Financial Analytics, a regulatory policy consulting firm. 

That third party could wind up being the credit raters, she said. 

"This is a sort of halfway house," she said.