A provision of the Dodd-Frank Act that takes effect Jan. 1 may prove costly for many community banks.
Critics claim a rule to bar banks from relying on ratings agencies to assess the value of their investments will increase compliance costs, spur concentration and even shrink investment income. With so many potential downsides, is this yet another unintended consequence of the massive 2010 reform law?
North Carolina's acting banking commissioner, Ray Grace, called the rule "simplistic and reactionary."
"To just dismiss the ratings system across the board because they dropped the ball during the run-up to the crisis I think is mistaken," he said in an interview.
Section 939A of Dodd-Frank tells the regulators to remove references to credit ratings from existing rules. Lawmakers were angry that the ratings agencies blithely awarded high ratings to sketchy mortgage securities and ordered the regulators to find an alternative.
Easier said than done.
Regulators have thrashed about for two years, searching for a solution. Risk-based capital rules have received the most attention because banks use credit ratings to slot assets into various risk-weight categories for capital calculations.
But while regulators have yet to finish that regulation, there is one area where this part of Dodd-Frank has been adopted. The Office of the Comptroller of the Currency finalized a rule last June that will bar banks from relying on credit ratings to assess the value of their investments.
This rule, which takes effect in seven weeks, applies to a bank's existing investment portfolio and any new securities it buys. It applies to both state and national banks because the Federal Reserve Board and the Federal Deposit Insurance Corp. follow the OCC's lead on rules governing investment portfolios. (The FDIC put out a similar rule for federal savings associations because Dodd-Frank required it.) So consider this the "credit ratings lite" rule. Not the main event, but still a big change for a lot of banks.
The OCC rule tells banks they can no longer rely solely on credit ratings to assess whether an asset is "investment grade."
"An institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution's risk profile and for the size and complexity of the instrument," the OCC said. "Banks may rely on other sources of information, including their own internal systems or analytics provided by third parties, when conducting due diligence and determining whether a particular security is a permissible and appropriate investment."
In plain English the OCC is telling banks they need to find an alternative to credit ratings to judge the quality of their investment securities. That means they have to do the analysis themselves or hire an expert.
Many community banks don't have the expertise in house to do that kind of analysis, so they will either have to hire outsiders or shift more of their investment portfolios into supersafe Treasuries, which don't require such a rigorous assessment.
If banks crowd into government securities, that could lead to concentrations and erode investment income.
Banks also may buy larger securities in a bid to lower analysis costs. That, too, could lead to unhealthy concentrations in the investment portfolio. (The larger the security, the fewer you have and the less analysis you have to do.) Cris Naser, senior counsel at the American Bankers Association, says all these repercussions are possible.
"It's going to be cost-prohibitive for community banks to use third-party servicers," she says, which may force them to load up on the safest securities. "Then, concentration is a concern."
The coming rule could make it harder for weaker municipalities and corporates to sell debt as banks pile into Treasury bonds.
"All of our clients are already making the move" into safer investments, says Don Musso, president and chief executive of FinPro, a consulting firm in Liberty Corner, N.J.
Musso says the OCC should extend the Jan. 1 deadline. "It's better to miss a deadline than to put in place a law that makes zero sense," he says. "There is just no way banks are going to meet this deadline."
"There is a lot of confusion around this. State banks don't believe the OCC directive applies to them. And it does. It's a huge cost, maybe 10 to 25 basis points" of an investment portfolio's total return. "That's a lot of money."
FDIC and Fed spokespeople confirmed that the OCC directive does apply to state banks.
Peter Inverso, the president and CEO of the $1.8 billion-asset Roma Bank in Robbinsville, N.J., has hired FinPro to assess all of its nongovernment securities and a sampling of its governments.
"It's going to be very, very expensive," he said, noting that those resources will be diverted from other efforts like lending.
Inverso wondered why Congress didn't just fix the primary problem of weak rating agencies.
"Instead of strengthening the credit ratings agencies' standards, they are putting the burden on banks," Inverso said.
Enforcement is yet another concern.
"People don't know how regulators are going to react when the examiners come in," she said. "You're going to get a whole lot of interpretations in the field."
Inverso agreed: "We're not quite sure what examiners will be looking for."
The OCC doesn't see this rule as significant. Officials point to the fact that since 1998 banks have been required to do due diligence on their investments. They see this rule as merely an extension of that one.
"For many banks this does not constitute a significant change," said spokesman Bryan Hubbard.
Still, the agency concedes it's been getting a lot of questions about how to comply, so it will be issuing a "clarification" by yearend. [The agency did put out "guidance" to go with its final rule, and any banker looking for more details should see the matrix chart.]
Exactly what's left to clarify is unclear but don't expect big changes. The OCC sees this as something banks, of all sizes, should be doing as a matter of course.
And it's a hard point to argue. Banks should know what sorts of risk they are taking on in their investment portfolios. But I can't help thinking this rule will do little more than make bankers' — and examiners' — jobs harder without making the system much safer.