Replacing Credit Ratings in Financial Regulation

The Dodd-Frank Act of 2010 required federal financial regulators to drop references to credit ratings from their regulations. An OFR brief by John Soroushian, released today, describes the alternatives to credit ratings that regulators have adopted. It also analyzes some of the challenges they face.

Credit rating agencies are private companies that rate the credit quality of debt issuers and the securities they issue. Some credit rating agencies are designated as a Nationally Recognized Statistical Rating Organization (NRSRO). For many years, financial regulations used NRSRO ratings to set investment standards and to determine how much capital a bank needed to hold.

During the 2007-09 financial crisis, many securities with high ratings lost a lot of value. The Dodd-Frank law addressed what many saw as rating agency failures. It created a new office within the Securities and Exchange Commission to monitor NRSROs. The law also required new disclosures by rating agencies, and increased their legal liability.

The OFR brief describes how financial regulators have replaced credit ratings. Most commonly, regulators now define what could make a security creditworthy. In other cases, they give companies regulatory models to use instead of credit ratings. Regulators also rely on third parties other than NRSROs to set credit standards.

All three approaches satisfy the law’s requirements. But each has potential challenges. For example, the definition approach results in less detailed distinctions among risk levels. Regulatory models can be gamed. Third parties may face incentive problems. The brief concludes that one result may be a growth in new types of services that are similar to rating agencies, but subject to less strict regulation.

Stacey Schreft is Deputy Director for Research and Analysis at the Office of Financial Research