Dodd-Frank, Risk Weighting and Capital Developments

2/2/2012

By Liz Koschik, CPA

One of the most anticipated pieces of the Dodd-Frank Act, which has yet to be fully unveiled and significantly affects the banking industry, is risk-weighted assets and the underlying capital requirements. Section 939A of the Act effectively eliminated the ability to rely on credit rating agencies such as Moody’s and Standard and Poors for investment rating. There has yet to be a better alternative provided, and therefore regulators continue to rely on rating agencies to determine asset quality for risk-based capital. Even though regulators have sought to repeal this portion of the Act through Congress, the political climate has not heeded their requests.

In December 2011, the FDIC released a set of alternatives to credit rating agency valuations. These alternatives were directed toward large banks, however, the trickle-down effect can signify potential developments for community banks. The proposed method relies mainly on evaluation of the “specific risk” of the underlying position. The alternative methods currently proposed would allow banks to either create an internal model, which must be approved by regulators, or use a standardized approach involving current market value with risk-weighted factors. This standardized approach would vary based upon the underlying investment.

• For securities of US government agencies, the US Treasury and municipalities, the proposed alternative is two-tiered and relies on both the Organization for Economic Cooperation and Development (OECD) Country Risk Classifications (CRCs) and the maturity of the instrument. Per the OECD, the current CRC for the United States is 0, and therefore the majority of securities held by a community bank would remain at a low risk weight per the proposed guidance from the FDIC. Obligations fully backed by the US government are proposed to continue within a 0% risk weighting, however municipal securities and agencies would fall within the 0.25-1.6% equity “add-on” if maturity is within two years.
• The proposed alternative to mortgage-backed securities and collateral mortgage obligations is more onerous and breaks the security into multiple tranches. The underlying security is reviewed for the proper weighted average capital requirement (had the exposure been held directly by the bank), level of subordination, size of the security, and level of historical losses.
• Remaining securities, including corporate debt positions, rely on a combination of investment grade, maturity, stock return volatility, and average spread.

In short, the risk-weighting of securities held by a bank are set to require significant analysis by the banking industry. With U.S. regulators expected to release a proposed rule implementing Basel III in the first few months of next year, these additional requirements on banks require positive communication with the regulators to understand the potential effects and underlying capital requirements. The effects of the Dodd-Frank Act continue to push regulation to community banks and, in the words of Voltaire, “Doubt is not a pleasant condition but certainty is an absurd one.”