OFR Report: Credit Rating Alternatives Pose Regulatory Challenges

Alternative approaches to the use of credit ratings, as mandated by Dodd-Frank, pose challenges for regulators and could give rise to new types of services that are similar to rating agencies but subject to less stringent regulation, the Office of Financial Research reported on Thursday.

The Dodd-Frank Act called for the elimination of credit ratings after it became clear that the system had created “perverse incentives” for rating agencies to inflate ratings to expand their business, which contributed to the financial crisis. Since then, regulators have turned to alternative approaches including definitions, regulatory models and third party classifications to set credit standards.

As the OFR brief pointed out, however, each of these approaches comes with its own set of challenges. The definition-based approach, for example, gives a high level of discretion to companies and their regulators to make determinations about what makes a security creditworthy, and relies on the accurate identification of risk in different securities. Regulatory models can be inaccurate or gamed, and third parties can be susceptible to competitive pressures, OFR said.