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From Banking and Finance Law Daily, October 30, 2013

Agencies revise guidance on classifying, appraising securities

By Richard A. Roth, J.D.

Following up on a requirement of the Dodd-Frank Act, the federal banking prudential regulators are revising their interagency guidance on the classification and appraisal of debt securities to remove references to credit ratings. The new guidance replaces those references with new creditworthiness standards and gives examples of how those standards apply in light of the agencies’ existing classifications (OCC 2013-28, SR 13-18, and FIL-51-2013).

The interagency guidance applies to securities held by depository institutions supervised by the Federal Reserve Board, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation—national and state banks and federal and state savings associations. It replaces interagency guidance adopted in 2004.

In the aftermath of the financial crisis, there was a belief that some financial institutions, when buying securities, had relied too heavily on ratings issued by Nationally Recognized Statistical Rating Organizations (NRSROs) rather than on their own analysis and due diligence. The Dodd-Frank Act addressed this by requiring the regulatory agencies to remove references to credit ratings from their regulations and put in place alternative standards of creditworthiness. After the agencies made the required changes in their regulations, conforming changes in the 2004 interagency guidance were needed.

Creditworthiness standards. The agencies are instructing banks and thrifts that while they may continue to consider credit ratings as part of their analysis of securities, they may no longer rely on credit ratings alone. Each security being considered for purchase should be analyzed individually under a structure that could include the security’s risk characteristics, the institution’s own internal analysis, third-party research (including credit ratings), default statistics, and other relevant factors.

Asset classifications. The regulatory agencies have established three classifications for securities:

  • An asset is to be classified substandard if it is not adequately protected by the obligor’s current worth and ability to pay or by the collateral. A substandard asset has a well-defined weakness that jeopardizes full repayment, and there is a distinct possibility that the bank will suffer a loss if the weakness is not cured.
  • An asset is to be classified doubtful if it has the weakness of a substandard asset combined with additional factors that make collection in full improbable. This classification usually is an interim classification until a more appropriate treatment can be decided upon.
  • An asset is to be classified loss if it is considered to be uncollectible and of so little value that it should no longer be considered to be a “bankable” asset, even if some partial recovery is possible. An asset classified loss should be charged off.

An investment grade debt security generally will not be classified, the guidance notes, as it is characterized by a low default risk and full repayment is expected in a timely manner.

Required reappraisals. A security may not be purchased if it is not considered to be of investment grade, the guidance begins. If the pre-purchase analysis reveals that there have been previous credit losses, the security usually cannot be considered to be investment grade regardless of its current performance or projected performance, the agencies say.

Post-purchase events may require the classification of a security that has deteriorated to less than investment grade. Banks and thrifts need to engage in an ongoing analysis of the securities they hold and reclassify a security if it has deteriorated. When appropriate, a security may be returned to investment grade, the guidance adds, but this requires both a period of sustained performance and the expectation of future performance.

Examples. To help financial institutions apply the guidance, the agencies are providing six scenarios that describe facts about a hypothetical security and indicate whether the security is eligible for purchase or, if already held, should be classified.

MainStory: TopStory DoddFrankAct FinancialStability SecuritiesDerivatives

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