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Dodd-Frank & Basel III: A Round Peg and Square Hole?

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To put it simply and bluntly, Dodd-Frank & Basel III have components that are logically contradictory.

Principal among the contradictions is the handling of credit ratings. Dodd-Frank Wall Street Reform and Consumer Protection Act seeks to limit their impact—while Basel IIIseems to default to them, as a lesser of evils, in the framework for determining capital requirements for risk weighted assets.

Felix Salmon takes up the issue of mutual exclusivity in a blog post Thursday.

Salmon dryly observes: "Squaring this circle, it turns out, is very hard indeed."

Salmon also quotes a detailed article by Melvyn Westlake in Global Risk Regulator:

"'Nobody has put forward any really satisfactory ideas,' admits a Federal Reserve regulator. Already, the absence of a practical alternative to credit ratings has begun to impair new rulemaking in Washington…"

"The inability to find a solution and the looming deadline is 'a source of a great deal of concern,' says Karen Petrou, executive director of Federal Financial Analytics, a Washington consultancy on regulation. 'The agencies are informally admitting that they are stumped. But the deadline is only six months away, so something has got to happen. The law is very clear. It says there may be no reference to ratings,' she adds. 'We are going to have a hell of a time with the Basel III rules because of the way ratings are still embedded in them,' Petrou reckons…"

Salmon continues to quote Westlake on the so-called "alternatives":

"Finding an alternative to ratings 'is not proving an easy task,' confirms Nancy Hunt, associate director for capital markets in the FDIC's supervision and consumer protection division. 'We are looking at several approaches, some more mathematical than others, and trying to backtest them to see if they perform better than rating agencies,' she says. 'It's a very complex and involved process. But we have a law, and we have to figure out how to do this.'"

But Felix Salmon isn't entirely comfortable with the backtest substitution as a panacea—and for some very good reasons.

Salmon explains:

"Backtesting is important, of course, but it's also dangerous: it assumes that the future will be like the past, when the whole point of crises is that they happen when something unprecedented happens. Given the wobbliness of a lot of OECD sovereign debt, for instance, it would surely not be a good idea to put in place a rule which assumes that no OECD debt will ever default or be restructured."

If we are stuck with credit rating agencies—relying on them to some greater or lesser degree to provide a subjective opinion on the creditworthiness of securities—perhaps it's time to get serious about reforming the way the agencies do business, as well as the overall market context in which they exist.

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