Revised Basel Committee Proposals For Synthetic Securitizations

  • 09 Dec 2002
Email a colleague
Request a PDF

The Basel Committee on Banking Supervision has issued two working papers on securitizations, including synthetic securitizations, and has proposed minimum capital requirements for securitizations contained in Technical Guidance under the committee's "Quantitative Impact Study" ("QIS") 3. The second working paper ("WP2") and QIS 3 were released in October, and on Nov. 21, the committee issued a series of Frequently Asked Questions and responses regarding the revised capital standards for banks it proposed in January.

The Current Capital Proposal

Unlike traditional securitizations, synthetic securitizations "generally involve the transfer of credit risk through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit-default swaps) credit derivatives or guarantees that serve to hedge the credit risk to which the originator is exposed." In its QIS 3 Technical Guidance, the Basel Committee proposed minimum capital requirements for both traditional and synthetic securitizations. The QIS 3 guidance set forth operational criteria for banks to meet in order to exclude securitized exposures from risk-weighted assets, and in order to recognize credit risk mitigation through collateral, guarantees or credit derivatives. For exposures not excluded from risk-weighted assets, or mitigated, by these operational criteria, banks would be subject to different capital requirements depending upon whether they were subject to a "standardized" or an "internal ratings based" (IRB) approach.

Standardized Approach

Under the standardized approach, banks would be subject to different capital requirements for tranches of synthetic securitizations they originate or purchase. Generally, the amount of the relevant position would be multiplied by an assigned risk weight, which would correlate to the rating of the exposure. For off-balance sheet exposures, banks would apply a credit conversion factor and then risk-weight the resulting credit equivalent. Unrated positions, or positions with long-term ratings of B plus or lower, or short-term ratings other than A1/P1, A2/P2 and A3/P3, would be deducted from capital. For originating banks, all retained exposures rated below investment grade would be deducted from capital. Only third-party investors could recognize ratings equivalent to BB plus to BB minus for risk weighting purposes. There would be, however, certain circumstances where banks need not deduct unrated positions from capital.

One such exception would be for the most senior unrated position in the relevant pool of exposures, which would receive a "look-through" treatment. Under the look-through treatment, that senior position would be assigned the average risk weight assigned to the underlying credit exposures subject to supervisory review, provided the bank could both determine the underlying pool's composition at all times and assess the proper risk weights for the underlying exposures.

Another exception would involve exposures that are in a second-loss position or better in asset-backed commercial paper programs, provided certain protective conditions were met. Such second-loss positions would be assigned a risk weight that would be the greater of (a) 100% or (b) the highest risk weight that would be assigned to any exposure in the underlying credit pool. Favorable treatment would also be given to an off-balance sheet securitization exposure that qualified as an "eligible liquidity facility."

IRB Approach

Originating banks, or other banks that received supervisory approval to use the IRB approach for the type of exposure securitized (e.g., corporate or retail portfolios), would first set the IRB capital charge (KIRB) for the relevant pool of credit exposures. KIRB is a ratio of the IRB capital requirement for the underlying credit exposures to the notional amount of securitized exposures. Once KIRB is determined, a bank would need to compute the "enhancement level," comprised of the credit enhancement level ("L") (which depends on the amount of positions subordinate to the tranche held by the bank) and thickness ("T") (which is a ratio of the size of a tranche to the amount of securitized exposures). Positions retained or purchased by an originating bank with credit enhancement levels of less than or equal to KIRB would be deducted from regulatory capital. For positions higher than KIRB, an originating bank would be required to use the Ratings Based Approach ("RBA") when either an external or inferred rating is available. When such a rating was not available, the capital requirement would have to be determined using the Supervisory Formula Approach ("SFA"). Otherwise, the position would have to be deducted from capital.

This use of the RBA or SFA would also apply to banks, other than originators, that received supervisory approval to use the SFA for any portion of the securitization. Banks that were not originators would have to use the RBA for exposures for which a rating was available. Otherwise, the position would have to be deducted from capital or, with supervisory approval, the bank could use the SFA. For originators and other banks that received supervisory approval to use the SFA, the capital charge for all positions in the same transaction would be capped at KIRB (with one exception in the case of "capitalized assets," such as interest-only strips), assuming that KIRB can be calculated to the satisfaction of the bank's supervisor. This cap has been proposed based on perceptions that the Basel Committee's original proposal may have created a disincentive to securitize.

The RBA Approach

Under the RBA approach, the bank's capital charge for an exposure would be based on the risk weight assigned to the securitized tranche. The risk weight would, in part, correlate to the tranche's external or inferred rating. For external ratings, positions rated B plus or lower would be deducted from capital. Positions with ratings above B plus would be assigned risk weights. For originating banks, even positions with an external rating exceeding B plus would be deducted from capital if their credit enhancement level was below KIRB. The risk weights assigned would take into account many variables, such as the granularity of the underlying pool. The same risk weights would be applied to inferred ratings provided certain operational requirements were met.

The risk weights proposed by Basel are tentative and the committee is planning further consultations with the industry. In this regard, one proposal being considered is to set low capital requirements for a highly rated position if it is both highly granular and constitutes a "thick" position within the underlying pool of credit exposures. Highly granular pools of exposure would have at least 100 "effective" exposures (denoted as "N"). N is a measure of the "unique obligors" within a securitization structure. In general, as the granularity for a pool of exposures decreased, the risk weights would be adjusted upward.

The SFA Approach

Originating banks or other banks with supervisory approval to use this approach would use the SFA approach when external or inferred ratings are unavailable. Banks that do not have such supervisory approval would deduct unrated positions from capital. Under the SFA approach, banks would determine the capital requirement for a particular securitized position based on numerous inputs such as KIRB, L, T, N and the pool's exposure-weighted average loss-given-default (LGD). In order to limit the burden of calculating the N for some transactions, the committee is proposing a "safe harbor" for banks utilizing the SFA approach. Under the safe harbor, banks, subject to supervisory review, would be allowed to assume that pools of securitized retail loans were "infinitely" granular (meaning that N could be treated as infinite). Securitizations with non-retail loans would be subject to a simplified method to determine the pool's granularity so long as the single largest position in the underlying pool represents no more than 3% of the total exposure. In general, the required capital charge would adjust in tandem with the various considerations mentioned above and would be subject to a floor capital charge of 56 basis points (equivalent to a risk weight of 7%).

The committee is seeking further comments on this approach is also proposing a supervisory review component for securitizations that will oversee whether banks have adequately taken account of the economic substance of transactions in determining their capital requirements. The committee is seeking input on this supervisory review component.

 

This week's Learning Curve is written byConrad Bahlke, partner, andIsrael Weinberger, associate, atWeil, Gotshal & Manges.

  • 09 Dec 2002

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 24 Jul 2017
1 Citi 253,106.92 930 8.89%
2 JPMorgan 230,914.50 1036 8.11%
3 Bank of America Merrill Lynch 221,389.46 762 7.78%
4 Goldman Sachs 171,499.26 554 6.03%
5 Barclays 169,046.60 646 5.94%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 HSBC 27,039.93 106 7.36%
2 Deutsche Bank 25,125.19 81 6.84%
3 Bank of America Merrill Lynch 23,128.33 61 6.29%
4 BNP Paribas 19,315.94 110 5.26%
5 Credit Agricole CIB 18,706.93 106 5.09%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 13,488.13 59 8.47%
2 Citi 11,496.21 73 7.22%
3 UBS 11,302.86 45 7.09%
4 Morgan Stanley 10,864.95 59 6.82%
5 Goldman Sachs 10,434.21 54 6.55%