Recently, the primary federal bank regulators took the latest step in the long and winding road toward the replacement of credit ratings in the analysis of investment securities by insured financial institutions. You will recall this process began with the passage of the Dodd-Frank Act in July 2010 that, in the wake of the financial crisis in 2008, required government regulators of all types to deemphasize the role of credit ratings from the traditional credit rating firms.

The three primary federal bank regulators — the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation — in November issued regulatory guidance in the form of an agreement among themselves regarding the appropriate approach to the asset classification of investment securities for regulatory purposes. The guidance applies to national banks, state-chartered banks, and state- and federally-chartered savings associations, and supersedes previous guidance from 2004.

Essentially, the issuance provides guidance about the application of the common adverse supervisory asset classification terms of “substandard,” “doubtful” and “loss” to investment securities after credit deterioration occurs. The supervisory asset definitions have not changed, but the approach to the topic certainly has.

Previously, credit ratings from nationally recognized statistical rating organizations were critical to this process. The 2004 guidance observed:

In an effort to streamline the examination process and achieve as much consistency as possible, examiners will use the published ratings provided by nationally recognized statistical ratings organizations (NRSROs) as a proxy for the supervisory classification definitions. (Emphasis supplied.)

That is no longer the case, as the current announcement makes clear:

Depository institutions are expected to perform an assessment of creditworthiness that is not solely reliant on external credit ratings provided by Nationally Recognized Statistical Ration Organizations (NRSRO). Such an assessment may include internal risk analyses and a risk rating framework, third-party research and analytics (which could include NRSRO credit ratings), default statistics and other sources of data as appropriate for the particular security. (Emphasis supplied.)

To circumvent adverse classification, a security must have a credit assessment supporting its treatment as an “investment grade” security. A security is investment grade, generally speaking, when the issuer has adequate capacity to meet its financial commitments for the life of the asset. (The guidance notes that state-chartered institutions should consult state law because the definition of “investment grade” may be defined differently by state law.)

The heart of the announcement is a table of examples that describes six common situations when credit deterioration has occurred in a bond, moving from best case to worst case, and impact of the credit deterioration on bonds currently held and being considered for purchase. (See pages 6-8 of the agreement.)

For example, assume an other-than-temporary impairment was recognized, then, subsequent to that determination, the credit condition that led to the impairment no longer exists and current analysis provides that all contractual payments will be received as provided for in the bond indenture. Then the bond is upgraded to a pass classification from the adverse classification, and such a bond is eligible for purchase because it is considered investment grade.

The table demonstrates, however, that the incurrence of actual credit losses makes an upgrade to investment grade impossible even if current analysis suggests all future payments would be received. This is so even if the credit developments are such that the bond might be upgraded from an adverse classification to a pass.

There is one exception to this treatment: the occurrence of a court supervised, legally binding restructure of the agreement, provided the issuer has performed for a suitable period of time under the court-approved restructure plan. In this case, the bond qualifies for treatment as investment grade.

The issuance is available on the websites of the regulatory agencies.