Basel Committee’s Proposed Revisions to the Securitization Framework

by Dechert LLP
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The Basel Committee on Banking Supervision (the “Basel Committee”) published a consultative document, “Revisions to the Basel Securitisation Framework” (the “Proposed Revisions”) on December 18, 2012, which proposes substantial changes in how banks calculate their risk-based capital requirements related to securitization exposures. The Proposed Revisions are intended to, among other things, make capital requirements for securitizations more prudent and risk-sensitive and to mitigate mechanistic reliance on external credit ratings. This OnPoint provides an overview of the two proposed alternatives for calculating the capital for securitization exposures, specifically discussing the major components of each alternative and how both alternatives work, and concludes with a brief summary of the American Securitization Forum’s response to the Proposed Revisions. 

Background

The Basel Committee is a committee based in Basel, Switzerland, consisting of senior central bankers from 27 leading industrial countries. The Basel Committee provides a forum for regular cooperation on banking supervisory matters with the goal of enhancing the understanding of key supervisory issues and improving the quality of banking supervision worldwide. It fulfills this objective by, among other things, issuing supervisory standards in areas that the Basel Committee considers most in need. The Basel Committee issued the first international risk-based capital standards for banking organizations in 1988, known as Basel I. In 2004, the Basel Committee revisited the standards and issued a second Basel accord, known as Basel II. In 2009, the Basel Committee introduced several enhancements to the Basel II framework to address deficiencies identified during the financial crisis. These interim measures primarily addressed immediate concerns over resecuritizations. In 2010, the Basel Committee issued the third installment of the Basel accords, known as Basel III, which aimed at strengthening bank capital requirements and increasing bank liquidity and bank leverage. The Basel Committee noted at the time that it was “conducting a more fundamental review of the securitisation framework, including its reliance on external ratings.”1 Following up on its commitment to conduct a more “fundamental review,”2  the Basel Committee concluded that both external ratings for, and bank assessments of, securitization exposures often did not accurately reflect the risks of securitization. As a result, the Basel Committee issued a comprehensive set of proposals that are discussed below.  

The Proposed Revisions set out the Basel Committee’s observations on the role that securitizations played during the financial crisis and its conclusions on the shortcomings of the existing securitization framework. According to the Proposed Revisions, the weaknesses of securitizations include (i) an overly mechanistic reliance on external credit ratings, (ii) risk weights for highly rated senior securitization exposures that are too low, and (iii) risk weights for low-rated senior exposures that are too high. To address these concerns, the Basel Committee has proposed two alternative approaches (“Alternative A” and “Alternative B”) for determining risk weights of securitization exposures. Both alternatives include a Revised Ratings-Based Approach (the “RRBA”), a Simplified Supervisory Formula Approach (the “SSFA”), and a Modified Supervisory Formula Approach (the “MSFA”). The SSFA is similar to the simplified supervisory formula that the U.S. federal banking agencies adopted in their final market risk capital rules, which took effect January 1, 2013,3 and included as part of the proposed risk-based capital rules they issued for comment in June 2012.4 The RRBA, SSFA, and MSFA and the proposed alternative approaches are discussed below.   

The Building Blocks of the Proposed Ratings – RRBA, SSFA and MSFA

The current securitization framework consists of two approaches to quantify required capital for credit risk, a Standardized Approach (the “SA”) and an Internal Ratings-Based Approach (the “IRB”). Under the SA, the more basic of the two approaches, banks use ratings from external credit rating agencies to quantify required capital for credit risk. Under the IRB, the more complex approach, banks can use their own internal estimated risk parameters for calculating credit risk when there is no external rating. Only banks meeting certain conditions and disclosure requirements may use the IRB.

Under both the SA and the IRB, a bank incorporates a Ratings-Based Approach (the “RBA”) into its analysis. The existing RBA consists of risk-weight tables, which are different for each approach. The Basel Committee has proposed to revise the RBA by, among other things, replacing the dual tables with one revised table to be used for both approaches. According to the Proposed Revisions, by using a single RBA, the Basel Committee “seeks to reduce arbitrage opportunities across banks that use different regulatory capital regimes for securitisation exposures and to make the overall capital framework more consistent.”5 Other revisions in the RRBA include a proposal to give national regulators the discretion to increase risk weights for high-risk pool assets. The RRBA also includes revised parameters for senior and non-senior tranches, where both tranches would be adjusted by tranche maturity and non-senior tranches would also be adjusted based on their thickness within the structure of a securitization. 

In order to apply the RRBA, there must be at least two eligible credit ratings for a securitization exposure, and a bank must use the lower of the two ratings (or the second best in the case of more than two available ratings). According to the Basel Committee, requiring at least two ratings and using the lower of the two “mitigates the risk of relying on a potentially flawed methodology or isolated errors embedded in the ratings of a single rating agency.”6 Under Alternative A for determining risk weights, a bank may use the RRBA to risk-weight all of its securitization exposures. Under Alternative B, a bank may use the RRBA only for the most senior exposures. 

Another common feature of Alternative A and Alternative B is the SSFA. The Basel Committee introduced the SSFA based on its recognition that certain jurisdictions prohibit the use of, or reference to, credit ratings and that the availability of credit ratings is limited for structured products that are originated in certain jurisdictions. The SSFA is a simplified version of the Supervisory Formula Approach (the “SFA”) used in the Basel II IRB approach, and closely follows the United States’ SSFA framework. According to the Proposed Revisions, “[t]he SSFA is a formula that starts with the SA capital requirements for all exposures underlying a securitisation and then assigns risk weights to specific tranches based on the subordination level of the tranche . . . .”7 The SSFA uses five parameters to determine the risk weight of a securitization exposure: (i) the weighted average capital requirement of the underlying assets under the SA; (ii) the attachment point of the securitization exposure (i.e., the percentage threshold at which asset losses would first be allocated to the exposure); (iii) the detachment point of the securitization exposure (i.e., the percentage threshold at which losses would no longer be allocated to the exposure); (iv) the supervisory adjustment factor, which determines the overall level of capital required for all tranches of a securitization; and (v) the delinquencies of the underlying assets.

The third major building block of Alternative A and Alternative B is the MSFA. The MSFA is a modified version of the existing SFA. Among other changes, the proposed MSFA adjusts for defaults occurring over extended periods. By contrast, the current SFA only looks at defaults over a one-year horizon, which the Basel Committee views as resulting in understated capital requirements for securitizations with longer maturities. Also, the proposed MSFA would be used only where banks can develop IRB parameter estimates for all of the underlying exposures. Under the existing SFA, a bank may use the IRB approach for some exposures and the SA for other exposures in the underlying pool.

How the Proposed Alternatives Work

As indicated, the Proposed Revisions create two alternatives for calculating the capital for securitization exposures. Under Alternative A, a bank must use the MSFA to determine the risk weight for a securitization exposure unless (i) the appropriate supervisor has restricted the use of the MSFA for that type of exposure or transaction, (ii) the appropriate supervisor has not approved a bank to use an IRB for the underlying exposures in the securitization pool, or (iii) the bank does not have sufficient information to estimate the IRB capital requirements for each underlying exposure. If a bank is not restricted by (i) or (ii) but nevertheless fails to use the MSFA, it would need to explain to its supervisor all instances in which it did not calculate the MSFA for a securitization exposure. Once a bank used the MSFA for a securitization exposure, it would be expected to use the MSFA for as long as it held the exposure. The Proposed Revisions are unclear as to whether a bank could use the MSFA for one tranche of a securitization but not for another tranche of the same securitization.  

If a bank could not use the MSFA for a securitization exposure, it would then use the RRBA or the SSFA for that exposure, depending on its jurisdiction’s choice. In jurisdictions that adopt the RRBA, a bank could use the Internal Assessment Approach (the “IAA”) instead of the RRBA for asset-backed commercial paper (the “ABCP”) conduits. The IAA, a concept from the Basel II accord, permits a bank to set the risk-based capital for its exposure to ABCP conduits based on its internal assessment of the credit quality of the exposure. If a bank was unable to use any these approaches, then it would use a fall-back approach, referred to as the Backstop Concentration Ratio Approach (the “BCRA”), which uses the SA weighted-average risk weights for the underlying pool, increased for non-senior tranches by a factor of two to ensure that the approach is sufficiently conservative. 

Ultimately, if a bank could not compute the BCRA for a securitization exposure, it would be required to assign a risk weight of 1250% to the exposure. Applying a 1250% risk weight to an investment in a securitization may cause a bank to write off the investment as a total loss. For example, if a bank held 8% of Tier 1 capital, then for each $100 of loans on its books, it would hold $8 of paid-in capital and surplus from its common stock or other permissible Tier 1 assets. Weighting an asset at 1250% of its actual book value would cause the bank in effect to hold capital for the asset on a dollar-for-dollar basis, since it would be required to hold $100 of capital for each $100 of loans (i.e., $8 x 12.5 = $100).  

Under Alternative B, a bank would determine the risk weight of a securitization exposure by first determining whether the exposure was a “senior high-quality securitisation exposure,”8 that is, an exposure that demonstrated strong credit quality, had a very low default risk, and was “invulnerable to foreseeable events.”9 For a senior high-quality securitization exposure, a bank could choose to apply either the RRBA (or the IAA for ABCP conduits) or the MSFA. In addition, if a bank was unable to use the MSFA, the SSFA could be used if permitted by its supervisors. If a bank was unable to apply any of these approaches, it would use the BCRA, or ultimately, assign a 1250% risk weight to the exposure, as in Alternative A. According to the Basel Committee, in order to “limit the possibility of regulatory gaming,”10  banks would be expected to apply the same approach consistently over time. 

For all other exposures, including non-senior tranches and senior tranches that are not high-quality, a bank would be required to use a new concentration ratio, the CRKIRB, which is a ratio based on an internal risk-based calculation for all of the underlying exposures. If a bank did not have the information to calculate the CRKIRB, it would be required to apply the BCRA formula or assign a 1250% risk weight. The use of these formulas for tranches that do not qualify as senior high-quality securitisation exposures is in line with the Basel Committee’s goal of decreasing reliance on external ratings. 

The American Securitization Forum’s Comment to the Proposed Revisions

On March 14, 2013, the American Securitization Forum (the “ASF”) released a comment letter in response to the Proposed Revisions. According to the comment letter, the ASF supports the adoption of Alternative A and believes it is the better of the two proposed alternatives. While not perfect, Alternative A would permit the use of the MSFA, RRBA or SSFA for all exposures (other than re-securitizations), which, among other things, would avoid “significant differences in risk weights between senior and subordinate tranches in securitization tranches. . . . .”11 By contrast, the ASF states that Alternative B is too restricted and that its “resulting contrasts in risk weights between senior and subordinated securitization exposures and between securitizations of high quality senior exposures and relatively lower quality exposures is not warranted in many transactions.”12 The ASF also states that a key factor in its support of the adoption of Alternative A is its assumption that the Basel Committee is open to permitting the use of the MSFA as a capital calculation method for securitization exposures of all banks, specifically to banks that use the SA approach, which, according to the ASF, would promote consistency in risk weights for securitization exposures across banks and across jurisdictions. Even so, the ASF has “significant concerns”13 with many aspects of the Proposed Revisions and is of the firm belief that, where possible, banks should use the same approach, preferably the MSFA, for determining capital charges for securitization exposures. The ASF believes that the MSFA is the most risk-sensitive of all of the approaches.  

Conclusion

The comment period on the Proposed Revisions closed on March 15, and the Basel Committee is currently undertaking a qualitative impact study. The Basel Committee plans on considering the submitted comments as well as the qualitative impact study results in formulating a revised securitization framework.

Footnotes

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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