OFR Analyst Highlights Challenges Posed By Alternative Credit Rating Standards

A research analyst at the Treasury Department's Office of Financial Research examined the challenges posed by the alternative standards of creditworthiness used to replace credit ratings following their elimination from federal financial regulation by the Dodd-Frank Act. The author identified these alternatives under the categories: definitions, regulatory models, and third party classifications.

The author summarizes the challenges for these alternative approaches:

• Definitions: Defining creditworthiness for certain securities: (i) gives too much discretion to companies and disregards their incentive to overstate the quality of their assets; and (ii) results in a loss of granularity for analyzing different levels of credit risk, which can incentivize a financial institution to take more risk because it receives no regulatory benefits from holding safer securities.