WASHINGTON — Even as they begin dropping credit ratings as a supervisory source, regulators signaled Tuesday they are worried about abandoning their use altogether, suggesting that potential alternatives are not much of an improvement.

The agencies issued a joint proposal laying out potential substitutes for credit ratings in setting capital minimums, but top officials warned that Congress' decision to eliminate them from the supervisory process may be a mistake.

"I'll stick my neck out, too, and say I do hope we don't send the pendulum too far in the other direction," said FDIC Chairman Sheila Bair at the agency's board meeting Tuesday, echoing concerns raised by Comptroller of the Currency John Dugan.

The regulatory reform law gives regulators just one year to find alternatives wherever they now use external ratings. The proposal is the first step toward doing so, as well as the start of making hundreds of rules the reform law requires regulators to write.

Still, board members suggested that the credit rating provision was too extreme.

Dugan, attending his last FDIC board meeting before stepping down as comptroller, said the provision was "well-intentioned" but warned: "I do worry there is a little bit of throwing the baby out with the bathwater."

"Since it is my last day, … let me take this opportunity to say I worry about this particular provision of the Dodd-Frank Act," he said. There are "credit ratings for several issuers that have worked well over the years and have been particularly useful for smaller institutions to rely on, and they have done so in a quite safe and sound way."

In addition to approving the proposal issued Tuesday, the OCC is working on a separate plan that would scrap the use of rating agencies in determining national banks' investment limits.

Bair said mitigating the role of the ratings agencies is necessary. In a written statement given to reporters at the meeting, she criticized the agencies for assigning "absurdly high ratings" to certain toxic assets that "relied on untested econometric models and overly optimistic assumptions."

But she repeatedly highlighted how difficult finding a replacement will be.

"We will move quickly to get comment out," she said during the meeting. "If we can find alternatives, I think we should vigorously pursue those. Hopefully the comment process will enlighten us that, as problematic as ratings were in this crisis, … finding alternatives is going to be very, very difficult. We want to make sure that what we're replacing them with is better."

In the written statement, Bair noted that potential alternatives to external ratings have their drawbacks, and she said a final path for the regulators will "need to pass some tests before I can get fully comfortable" with it.

"The [regulatory] agencies have used ratings beyond capital; in fact, examiners have used ratings for decades to determine whether or not to criticize corporate securities held in bank investment portfolios," she said. "I think that we will also find that some of the more likely replacements — credit spreads, internal models, supervisor-determined risk buckets — are far from perfect. Further, we are going to need to balance the benefits of alternative approaches with the burdens associated with implementation."

Observers said the reservations expressed by the regulators may give momentum to an effort to repeal the provision in future legislation.

"It's certainly significant that the heads of the FDIC, OTS and OCC all questioned the wisdom of eliminating the use of credit ratings in bank capital rules," said Jaret Seiberg, an analyst at Concept Capital. "To us, that means that there is an opportunity for industry to have Congress repeal this provision as part of a regulatory relief bill."

For now, however, Bair said the regulators intend to move forward. "The statute is quite explicit about what Congress wants us to do, so we're going to try to do that," she said at the board meeting. "We look forward to public commenters helping us when trying to formulate alternatives."

The proposal, which will be out for comment for 60 days, is meant to address concerns about the simpler version of Basel II capital requirements that U.S. banks would use under the so-called "standardized" approach, which relies heavily on external ratings. Regulators must find alternatives to the ratings agencies before any next moves on enforcing the international capital accords.

The proposal floats three options to help guide capital guidelines, including returning to a simpler capital regime, as under Basel I, which never used ratings agencies. Alternatively, regulators could develop a diverse set of risk categories, such as the creditworthiness of corporate borrowers, that would each be given a specific risk weighting.

Under the third option in the advanced notice of proposed rulemaking, regulators would establish basic parameters for banks to apply risk weightings themselves. The FDIC has in the past expressed concern about using such internal modeling, which is more in line with the "advanced" approach of Basel II, but the staff memo to the FDIC board said, "Discussion of these issues is included in the ANPR to solicit a full range of views."

Bair and Dugan were not alone in raising concerns about the plan. Though not focusing specifically on finding replacements for credit ratings, John Bowman, the acting director of the Office of Thrift Supervision, said regulators should be mindful overall of the repercussions that could result from carrying out the law's provisions.

"I also would caution, going forward, this is the first of some undefined number of regulations that our industry is going to be subjected to," he said. "I really commend staff for their hard work and ask that they be sensitive to the cumulative impact of this journey all the regulators are embarking on."

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