Required by Congress to remove credit ratings from banking rules, regulators have devised a plan anchored in a Paris-based group's rankings that assign zero risk to most European government debt.

The Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency proposed rules last month to set bank capital levels using classifications made by the Organisation for Economic Co-operation and Development. The intergovernmental group, two-thirds of whose members are European Union countries, considers most EU sovereign bonds risk-free, including those of Greece and Portugal.

The proposal undermines the intent of the 2010 Dodd-Frank Act, which sought to eliminate the use of ratings by companies such as Standard & Poor's and Moody's Investors Service that are paid by the entities they rate, said Luigi De Ghenghi, a partner at law firm Davis Polk & Wardwell LLP in New York. Regulators are just replacing one set of conflicts with another, he said.

"The OECD represents the member governments, so there's an inherent conflict of interest there, too," said De Ghenghi, a member of the firm's financial-institutions group. "The regulators were dealt bad cards when they were asked to come up with alternatives to credit ratings. It's almost impossible to find something where there are no conflicts of any kind."

The Dec. 7 proposal is part of a U.S. effort to implement global capital rules revised in 2009 by the Basel Committee on Banking Supervision, which coordinates global regulation. The revisions would increase the amount of capital banks are required to have to back mortgage-linked securities and other complicated products at the heart of the 2008 financial crisis.

Market-Risk Rules

The so-called market-risk rules, which cover assets on bank trading books, were supposed to be in place by the end of 2011. An EU version went into effect Dec. 31. Dodd-Frank's credit- ratings ban slowed the process in the U.S. as regulators devised an alternative. Congress barred ratings after firms including Moody's and S&P gave their highest grades to mortgage-backed securities, which allowed lenders to treat them as risk-free.

The proposed rules could be revised after a public comment period that ends Feb. 3. A final version may be published a few months later, regulators say.

German Chancellor Angela Merkel and other European leaders earlier this year called for the creation of an independent ratings company following downgrades of EU countries by Moody's and S&P. A proposal for a nonprofit firm funded with fees from the finance industry was introduced in the European Parliament. Last month, EU Financial Services Commissioner Michel Barnier proposed forced rotation of ratings companies and said he hasn't ruled out suggesting a ban on ratings of the debt of countries receiving emergency assistance.

'OECD Straitjacket'

The U.S. proposal, which includes alternatives for rating securitizations as well as government bonds, allows regulators to increase risk weightings for nations that have defaulted on their debt within the past five years. Voluntary restructurings, such as the one Greece is negotiating with its creditors, would be considered a default, resulting in a jump in risk weighting. Until then, it would stay at zero.

"At least with this, they veer off the OECD straitjacket a bit, but it's still backward-looking," said Karen Shaw Petrou, managing partner at Washington-based research firm Federal Financial Analytics.

Market Indicators

Recognizing the weakness of OECD ratings, U.S. regulators added the debt-restructuring provision and suggested using market indicators to complement them, said Bobby Bean, the FDIC's associate director of policy, who helped draft the proposal. Among the indicators mentioned in the proposed rule are bond yields and credit-default swap spreads, which could measure investors' perceptions of default risks.

"When is the appropriate time to trigger the debt- restructuring charge?" Bean said in an interview. "Do you do it when there are discussions going on, like in the case of Greece now? These will be part of the ongoing supervisory conversation with the bank."

While the suggested use of market indicators was intended to make ratings more up-to-date, Bean said, the proposal calls for stripping out short-term volatility by using one-year averages of yields or CDS spreads.

That also would be backward-looking, Petrou said. The CDS spread of Lehman Brothers Holdings Inc. widened only a few weeks before the firm went bankrupt, so a one-year average wouldn't capture increasing risk until it was too late, she said.

The use of CDS spreads or bond yields to complement OECD classifications may not make it into the final rule, according to two regulators involved in drafting the proposal who asked not to be identified because the discussions are continuing.

'Too Narrowly'

"The regulators are interpreting Dodd-Frank too narrowly on this ratings issue," said Kenneth Bentsen, executive vice president of the Securities Industry and Financial Markets Association, a Washington-based group representing the largest U.S. banks. "The law instructs them to reduce the role of ratings in regulation, not eliminate it. But eliminating the use of ratings altogether results in running into these problems."

Other market-risk regulations proposed last year would impose higher capital charges on banks for government bonds they hold if their market values drop, Bean said. Those rules base capital levels on a bank's value-at-risk, an estimate of how much a firm could lose from trading in one day.

'Flawed Methodologies'

The Dec. 7 proposal also contains formulas for determining the riskiness of securitizations. The equations correlate risk weightings with the hierarchy of tranches: If a bond is lower in the order of receiving payments and among the first to get hit by losses when loans in the package start defaulting, it is assigned a higher risk. Moody's and S&P also would rate such a bond lower, implying a higher risk of default.

"Broadly speaking, any credit-risk system will end up somewhat emulating credit ratings done by the rating firms," said Richard Spillenkothen, a former director of banking supervision at the Fed. "Hopefully, the parts of the rating firms' flawed methodologies are fixed in these formulas."

Since the crisis, rating companies also have revised the way they evaluate securitizations in an effort to fix such defects. For example, S&P now requires that loan pools have a larger proportion of subordinated debt so the risk of the top- rated tranches defaulting is lower.

Basel III

New rules approved by the Basel committee last year and known as Basel III also rely on credit ratings for calculating how much capital banks need to protect against losses on securities and bonds on their banking books, the part of the balance sheet where they keep assets held to maturity.

The Fed, FDIC and OCC, which are trying to devise a proposal by the end of March for how to implement Basel III, will have to come up with another approach to avoid relying on credit firms. The alternatives proposed Dec. 7 probably will be repeated in the Basel III implementation plan, Spillenkothen said. Bean declined to say whether that would be the case since regulators haven't completed their work yet.

The new Basel rules, like the current ones, will allow the largest banks to use internal models to assign risk to assets, including Greek bonds, unless regulators object. The U.S. never implemented the earlier Basel framework, known as Basel II, which was adopted by the EU in 2006. Basel III rules are supposed to go into effect globally starting in 2013.

'More Nimble'

"Banks have been doing their own analysis on their sovereign exposures and don't rely on the rating firms' ratings," said Sabeth Siddique, a director at Deloitte & Touche LLP in Washington and a former assistant director of bank supervision and regulation at the Fed. "The largest banks are more nimble than the ratings firms. So their analysis could be better than what the regulators came up with, too."

Allowing banks to use internal models to determine risk enabled European lenders to reduce the amount of capital they held before the financial crisis, which led to government bailouts. The biggest U.S. banks will start using internal models when Basel III is implemented.

"If you let banks determine their own risk weighting, then you open it up to possible gaming of the results, as European banks have done for a while," said Petrou of Federal Financial Analytics. "A strong bank might choose to use higher risk in its model, but why should the weak bank do that when it can hold less capital?"

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