U.S. Basel III Final Rule and its Impact on the Securitization Framework

The three U.S. federal banking agencies (the “Agencies”) have adopted a final rule (the “Rule”) that implements the Basel III regulatory capital framework and comprehensively revises the regulatory capital requirements for all U.S. banking organizations.1 The Rule represents the most extensive overhaul of U.S. banking capital standards since the adoption of Basel I in 1989, and applies to all banking organizations currently subject to minimum capital requirements. Among other things, the Rule broadens the definition of a securitization exposure to encompass a wider range of investments, replaces the ratings-based approach in Basel II with a simplified supervisory formula approach (the “SSFA”), permits the continued use of the existing gross-up approach as an alternative to the SSFA, and imposes new due diligence requirements for banking organizations that invest in securitization exposures. This OnPoint discusses some key aspects of the Rule as they apply to the capital support required for securitization exposures.

Background

As discussed in a previous OnPoint,2 the Basel Committee on Banking Supervision (the “Basel Committee”), which is composed of central banks and banking regulators from 27 leading industrial countries, has issued three sets of international regulatory capital accords. The most recent accord, known as Basel III, was prompted by the recent global financial crisis and is intended to improve both the quality and quantity of a banking organization’s capital. The Basel accords are not legally binding, but they are backed by the commitments of the members of the Basel Committee to implement these standards and guidelines in their home jurisdictions.

On June 12, 2012, the Agencies approved a joint notice of proposed rulemaking (the “NPR”) which proposed revisions to the capital adequacy guidelines and prompt corrective action rules then in effect to incorporate the standards of the Basel III accord, as modified consistent with the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Rule is largely consistent with the NPR and substantially completes this process. With regard to the treatment of securitization exposures, it includes both a standardized approach that generally applies to all banking organizations, which this OnPoint discusses, and an advanced approach for the largest and most internationally active institutions.

Commenters raised three issues that they felt may have adverse economic or competitive effects, but that the Rule left unchanged. According to some commenters, U.S. banking organizations would be placed at a competitive disadvantage against international investors, which may continue to rely on credit ratings to risk-weight their securitization exposures. Commenters also expressed concern that some banking organizations would be unable to obtain relevant market data or to conduct due diligence for certain exposures, and that supervisors may apply due diligence requirements unevenly, which may dampen investor interest. The Agencies noted that they were prohibited by the Dodd-Frank Act from accommodating continued reliance on credit ratings, and stated that the due diligence requirements were generally appropriate. It remains to be seen what, if any, market-based effects these aspects of the Rule may have. 

Expanded Definition of Securitization Exposure

Consistent with the NPR, the Rule defines a securitization exposure as “an on- or off- balance sheet credit exposure (including credit-enhancing representations and warranties) that arises from a traditional or synthetic securitization (including a resecuritization), or an exposure that directly or indirectly references a securitization exposure.”3 According to the Agencies, both the designation of an investment as a securitization exposure and the calculation of the risk-based capital requirements for a securitization exposure are to be guided by the economic substance of a transaction rather than its legal form. As stated in the preamble to the Rule, provided there is a tranching of the underlying credit risk, a securitization exposure could include, among other things, loans, asset-backed securities, mortgage-backed securities, resecuritizations, lines of credit and other liquidity facilities, guarantees and other types of credit derivatives, loan servicing assets and servicer cash advance facilities, and credit-enhancing representations and warranties. Interest-only strips and retained tranches may also cause an investment to be a securitization exposure. If there is no tranching of the underlying credit risk, the preamble to the Rule indicates that the obligation would not be treated as a securitization exposure. 

Overall, coverage has been broadened from the prior U.S. capital requirements under Basel II. In addition, a 20% floor has been established as the minimum risk weight for any securitization exposure, regardless of the underlying credit risk.

The Agencies have stated that all or substantially all of the underlying exposures of a securitization must be financial exposures, i.e., loans, commitments, credit derivatives, guarantees, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities. According to the Agencies, the securitization framework is designed to address the tranching of the credit risk of financial exposures and is not designed to apply, for example, to credit exposures to commercial or industrial companies or nonfinancial assets. Therefore, as stated in the preamble to the Rule, a specialized loan to finance the construction or acquisition of large-scale projects (e.g., airports or power plants), objects (e.g., ships or satellites), or commodities (e.g., reserves, precious metals or oil) would not be a securitization exposure because the assets backing the loan (e.g., the facility, object or commodity) are nonfinancial assets. As a staff member at one of the Agencies has explained, an issuance, whether tranched or untranched, backed by a lien on assets generally is not a securitization exposure, but an issuance backed by a financial instrument that is in turn backed by a lien on assets may be. Further, a loan to finance the construction or acquisition of commercial real estate that is not “specialized” should be treated the same as a project finance loan or other “specialized” loan. 

The Rule provides some exemptions from the definition of a securitization exposure. For instance, an operating company does not fall within the scope of a securitization exposure, even if substantially all of its assets are financial exposures, since operating companies are generally established to conduct business with clients with the goal of earning a profit in their own right and generally produce goods or provide services beyond the business of investing, reinvesting, holding or trading in financial assets. As a result, an equity investment in an operating company would generally not be treated as a securitization exposure.4

In addition, the Rule exempts exposures to investment funds and pension funds. Investment funds registered with the SEC under the Investment Company Act of 1940 and pension funds regulated under ERISA are exempt because such entities are intensively regulated and are subject to strict leverage requirements.5 For investment funds that are not specifically excluded from the securitization framework, the Rule provides discretion to the primary federal supervisor of a banking organization “to exclude from the definition . . . those transactions in which the underlying exposures are owned by an investment firm that exercises substantially unfettered control over the size and composition of its assets, liabilities, and off-balance sheet exposures.”6

The Rule acknowledges that “[t]he line between securitization exposures and non-securitization exposures may be difficult to identify in some circumstances.”7 The Rule states that the Agencies may expand the scope of the securitization framework to include other transactions if doing so is justified by the economics of the transaction, and that the Agencies will consider the economic substance, leverage, and risk profile of a transaction to ensure that an appropriate risk-based capital treatment is applied.8 A number of factors will be considered when assessing the economic substance of a transaction (e.g., the amount of equity in the structure, overall leverage, redemption rights, and the ability of the junior tranches to absorb losses without interrupting the flow of contractual payments to more senior tranches). Even so, the distinction between a financial asset and a nonfinancial asset may be blurry at times, and the factors that the Agencies are required to consider when making this determination may present significant implementation burdens. 

The Agencies rejected commenter concerns that the scope of the securitization framework was overly broad and the suggestion that the definition of “securitization exposure” be narrowed to exposures to the tranched credit risk associated with an identifiable pool of assets. According to the Agencies, narrowing the definition in this manner would exclude certain credit risk exposures that are appropriately captured, such as certain first-loss or other tranched guarantees provided to a single underlying exposure.9

Definition of Synthetic Securitizations

As in the NPR, the Rule defines a synthetic securitization as a transaction in which the following occurs:

(1) all or a portion of the credit risk of one or more underlying exposures is transferred to one or more third parties through the use of one or more credit derivatives or guarantees (other than a guarantee that transfers only the credit risk of an individual retail exposure); (2) the credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority; (3) performance of the securitization exposures depends upon the performance of the underlying exposures; and (4) all or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities).10

This definition has been adopted largely as proposed, except that the Rule clarifies that, in addition to transactions in which a portion of the credit risk is transferred, transactions in which such risk is retained through the use of credit derivatives are subject to the securitization framework.11

Definition of Resecuritization

The Agencies rejected requests that resecuritizations that include a minimal amount (e.g., less than 5%) of securitization exposures among the underlying assets be exempted from the definition of resecuritization, or that a pro rata treatment be applied so that only that portion of a securitization backed by underlying securitization exposures be subject to a higher capital surcharge. Instead, the Rule retains the proposed definition of a resecuritization exposure as “an on- or off-balance sheet exposure to a resecuritization; or an exposure that directly or indirectly references a resecuritization exposure.”12 However, pass-through securities that are pooled together to back newly issued tranched securities are not treated as resecuritizations because the underlying pass-through securities do not provide tranched credit protection and for that reason are not considered to be securitizations.13

Elimination of the Ratings-Based Approach

The Rule eliminates the use of a ratings-based approach for assigning risk-based capital requirements to securitization exposures, as required by Section 939A of the Dodd-Frank Act, and replaces it with the SSFA. With the elimination of the ratings-based approach, banking organizations are required to calculate risk weights internally. The SSFA, which is a simplified version of the supervisory formula approach used in Basel II, may be applied for this purpose. Adopted in the Rule largely as proposed, the SSFA starts with a baseline capital requirement derived from the risk weights that apply to the exposures underlying a securitization, and then adjusts those risk weights based on the level of subordination of a banking organization’s investment within the structure of a securitization. Thus, the SSFA applies relatively higher capital requirements to more risky junior tranches of a securitization, which are the first to absorb losses, and relatively lower requirements to more senior tranches.

The SSFA raised several concerns among commenters on the NPR. In particular, commenters stated that implementation of the SSFA would generally restrict credit growth and create competitive inequities with other jurisdictions implementing ratings-based approaches.14 Although the Agencies acknowledged that there may be differences in capital requirements under the SSFA and a ratings-based approach, they noted that the Dodd-Frank Act prohibited them from referring to or relying on credit ratings in their regulations. However, the Agencies indicated that they would monitor the SSFA and consider modifications, if any, based on its performance. Commenters also raised concerns about the 20% floor level for all securitization exposures and requested that it be lowered for certain low-risk exposures. In response, the Agencies justified the floor level by stating that a 20% floor “is prudent given the performance of many securitization exposures during the recent crisis.”15

As an alternative to the SSFA, a banking organization may choose to apply a 1,250% risk weight to any securitization exposure (e.g., apply a 100% capital charge). Commenters criticized this provision on the grounds that it would penalize banks in certain circumstances and could require them to hold more capital against a securitization exposure than the actual exposure amount at risk. They requested that the amount of risk-based capital required to be held against an institution’s exposure be capped at the exposure amount.16 However, the Agencies retained this provision as proposed in the NPR, based on their stated desire to provide simplicity and comparability in risk-weighted asset amounts for the same securitization exposure across banking institutions. 

The Gross-Up Approach

As an alternative to the SSFA, banking organizations may continue to apply the gross-up approach, which was available under the Agencies’ capital requirements under Basel II. In this approach, an asset’s percentage risk weight is based on the amount of credit-enhanced assets (i.e., the tranches of a securitization that are senior to an organization’s exposure) for which the bank directly or indirectly assumes the credit risk. To calculate the risk weight of a securitization exposure under the gross-up approach, a banking organization must provide four inputs: (i) the dollar amount of the exposure; (ii) the pro rata share (i.e., the par value of the organization’s exposure as a percentage of the par value of the entire tranche of which the exposure is a part); (iii) the enhanced amount (i.e., the par value of all the tranches that are more senior to the tranche of which the exposure is a part); and (iv) the applicable risk weight (i.e., the weighted average of the risk weights of the assets underlying the securitization as calculated under the standardized approach). A banking organization calculates the credit equivalent amount of its exposure by adding the amount of its direct exposure to the product of the enhanced amount, the pro rata share, and the applicable risk weight, provided, as noted above, that the risk weight may not be less than 20%. 

Commenters expressed concern regarding the potential differences in risk weights for similar exposures when using the gross-up approach as compared to the SSFA and the resulting potential for capital arbitrage.17 In response, the Agencies stated that arbitrage opportunities were significantly reduced by the requirement in the Rule that banking organizations apply either approach consistently across all of its securitization exposures. Further, according to the Agencies, frequent changes in the approach used should be unnecessary absent significant changes in the nature of a banking organization’s securitization activities, and they expected banking organizations to provide upon request a rationale for any change they may make.

ABCP Programs

The Rule provides a different treatment of securitization exposures for asset-backed commercial paper (“ABCP”) programs. An ABCP program is defined as “a program established primarily for the purpose of issuing commercial paper that is investment grade and backed by underlying exposures held in a securitization SPE.”18 Under the Rule, when calculating the amount of a banking organization’s off-balance sheet exposure to an ABCP program, such as through a liquidity facility provided to support such a program, the notional amount of its exposure may be reduced to the maximum potential amount that the banking organization could be required to fund given the ABCP program’s current underlying assets. Thus, as the Rule illustrates in an example, if the maximum amount that could be drawn due to the current volume and credit quality of the program’s assets is $100, but the maximum amount that could be drawn against the same assets could increase to as much as $200 based on a change in credit quality, then the exposure amount is $200.19

Due Diligence Requirements

Regulators have argued that, during the financial crisis, many banks relied excessively on ratings issued by rating agencies and did not perform adequate internal credit analysis of their securitization exposures. As a result, the Rule requires banks to satisfy specific due diligence requirements for securitization exposures. Consistent with the NPR, a banking organization must demonstrate, to the satisfaction of its federal supervisor, a comprehensive understanding of the features of a securitization exposure that would materially affect its performance. 

In performing its due diligence review of a securitization exposure, a banking organization must consider the following: (i) structural features of the securitization that materially impact the performance of the exposure (e.g., cash-flow waterfalls, waterfall-related triggers, and deal-specific definitions of default); (ii) information regarding the performance of the underlying credit exposures; (iii) relevant market data for the securitization (e.g., sales price and volatility, trading volume, market rating, and size, depth and concentration level of the market for securitization); and (iv) for resecuritization exposures, performance information on the underlying securitization exposures (e.g., issuer name and credit quality and the characteristics of the securitization exposure). If an organization fails to satisfy these requirements for a securitization exposure, the Rule imposes a 1,250% risk weight on the exposure by default. An organization may review ratings issued by ratings agencies, but may not rely on them to satisfy its due diligence requirements.

Commenters expressed concern that a banking organization may be unable to meet the due diligence requirements due to a lack of available data and proposed that the risk weight be increased progressively based on the severity and duration of an organization’s failure to perform due diligence. Commenters also raised concerns that supervisors may apply the due diligence requirements unevenly. The Agencies, however, determined that the data requirements and the 1,250% risk weight requirement were appropriate “given that such information is required to monitor appropriately the risk of the underlying assets.”20 

Effective Dates

While many commenters expressed concerns about the potential costs, complexity and burdens of implementing the proposed changes in the NPR and asked for additional time to transition to new requirements, the Agencies stated that the Rule addressed significant weaknesses exposed during the financial crisis and would help banking organizations to be able to absorb losses and continue lending during future periods of economic stress. According to the Agencies, the benefits of a safer, more resilient and more stable banking system should substantially outweigh any short-term costs of implementing the Rule. The compliance deadline is January 1, 2014 for advanced approach banking organizations (unless the organization is a savings and loan holding company) and January 1, 2015 for all other covered banking organizations.

Footnotes

1 The three Agencies are the Board of Governors of the Federal Reserve System (“FRB”), the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”). The FRB adopted a final rule on July 2, 2013. The OCC adopted a final rule and the FDIC adopted an interim final rule on July 9, 2013. The FDIC has published its interim final rule in the Federal Register; as of the date of this OnPoint, the FRB and the OCC have not. All citations herein are to the published FDIC interim final rule. 

2 See Basel Committee’s Proposed Revisions to the Securitization Framework, DechertOnPoint (May 2013). 

See Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule, 78 Fed. Reg. 55340, 55482 (Sept. 10, 2013). 

4 Id. at 55430.

5 Id. at 55430-55431.

6 Id. at 55431.

7 Id.

8 Id.

9 Id. at 55430.

10 Id. at 55431. 

11 Id.

12 Id.

13 Id. at 55432.

14 Id. at 55437.

15 Id.

16 Id. at 55435.

17 Id. at 55434. 

18 Id. at 55435.

19 Id.

20 Id. at 55433.

 

Topics:  Banks, Basel III, Compliance, Dodd-Frank, New Regulations, NPR, Securitization

Published In: Finance & Banking Updates, Securities Updates

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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