The four principal U.S. banking regulators (the Federal Reserve Board, Office of Thrift Supervision, Comptroller of the Currency and Federal Deposit Insurance Corporation; collectively, the "Agencies") proposed on March 8 important changes to their risk-based capital standards that could affect the market for--and pricing of--securitizations and related credit derivatives. This Learning Curve explains why the risk-based capital rules are important to banks and why the proposed changes are also important to them.
CAPITAL REGULATIONS
U.S. bank holding companies and banks must hold capital against their assets and off-balance sheet liabilities. In the U.S., banks have a leverage capital requirement based on a ratio of capital to balance-sheet assets. However, their principal capital requirement is the risk-based capital ratio, a calculation in which a bank determines its total risk-based assets by assigning risk weight percentages specified by the Agencies to each class of assets and off-balance sheet exposures. A banking organization must maintain a minimum ratio of capital to risk-based assets of 8 percent. The Agencies, except the Office of Thrift Supervision, have also issued rules to incorporate a measure for market risk in the trading books of banks with substantial trading activity.
CURRENT AND PROPOSED TREATMENT OF LOSS POSITIONS IN SECURITIZATIONS
Current Treatment Banks are required to risk-weight liabilities in securitizations identically, regardless of their actual level of risk. The Agencies have noted that each loss position in an asset securitization structure functions as a credit enhancement for the more senior loss positions in the structure, and that the current capital standards do not recognize differences in risk associated with different credit enhancements or loss positions in securitizations.
Proposed Treatment The Agencies have proposed a multi-level, ratings-based approach to assess capital requirements on senior and subordinated securities in asset securitizations, using credit ratings from the rating agencies and, to a limited extent, banking organizations' internal risk ratings. The proposed approach would also apply to the recourse obligations and direct credit substitutes discussed below.
Under the proposal, risk weightings for banks' obligations in securitizations would be determined according to the table at center.
CURRENT AND PROPOSED TREATMENT OF RETAINED AND PURCHASED RECOURSE
Current treatment Under current banking book guidelines, banks must continue to hold capital against the full amount of assets transferred with recourse, regardless of whether the transaction is reported as a financing or a sale of assets under regulatory accounting principles, subject to a low-level recourse rule, which provides that the dollar amount of risk-based capital required for assets transferred with recourse should not exceed the maximum dollar amount for which a bank is contractually liable. However, banks must hold capital against only the dollar amount of off-balance sheet direct credit substitutes, such as a financial standby letter of credit provided for third-party assets. If a direct credit substitute covers less than 100% of the potential losses on the assets enhanced, the current capital treatment results in a lower capital charge for a direct credit substitute than for a comparable recourse arrangement. Similarly, a bank that retains a subordinated interest in a securitization involving the transfer of its own assets is considered to have transferred the assets with recourse, so that it must hold capital against the carrying amount of the retained subordinated interest as well as the outstanding amount of all senior interests that it supports, subject to the low-level recourse rule. By contrast, a purchased subordinated interest is treated as the equivalent of an off-balance sheet direct credit substitute.
Proposed Treatment The Agencies point out that banks are taking advantage of the different treatments of retained recourse and purchased recourse by, for example, providing first-loss letters of credit to asset-backed commercial paper conduits. The Agencies propose to equalize these treatments by applying the more conservative capital requirement to both types of recourse. The Agencies would calculate the credit equivalent amount of a recourse obligation or direct credit substitute as "the full amount of the credit enhanced assets from which risk of credit loss is directly or indirectly retained or assumed." The Agencies propose to define "recourse" as any arrangement in which a bank retains, in form or in substance (that is, including implicit recourse), any risk of credit loss directly or indirectly associated with a transferred asset that exceeds a pro rata share of the bank's claims on the asset, and to define a direct credit substitute similarly as an arrangement in which a bank assumes any risk of credit loss associated with a third party asset or claim that exceeds the bank's pro rata share of the asset or claim. Thus, "a bank that extends a partial direct credit substitute, for example, a financial standby letter of credit, that absorbs the first 10 percent of loss on a transaction, must maintain capital against the full amount of the assets being supported. Furthermore, for direct credit substitutes that are on-balance sheet assets, for example, purchased subordinated securities, banks must maintain capital against the amount of the direct credit substitutes and the full amount of the assets being supported, that is, all more senior positions."
The Agencies note that the proposed definitions would also cover credit derivatives to the extent that a bank's credit risk exposure through, for example, a credit default option, exceeded its pro rata interest in the underlying obligation. The Agencies requested comments on the coverage of credit derivatives by these revisions, as well as on the definition of a credit derivative contained in the proposal.
NON-TRADED RECOURSE; INTERNAL RATINGS; AMORTIZATION PROVISIONS
The Agencies would also permit a bank to obtain a rating for a non-traded recourse obligation or direct credit substitute, provided that: (a) it qualifies under ratings obtained from two different rating agencies; (b) the ratings are publicly available; and (c) the ratings are based on the same criteria used to rate securities sold to the public. A bank with a qualifying internal risk rating system could also use that system to apply the ratings-based approach to the bank's unrated direct credit substitutes in asset-backed commercial paper programs. Finally, the Agencies are proposing to assign to the 20% risk category securitized receivables of a bank sponsoring securitizations that incorporate early amortization provisions.
This week's Learning Curve was written by Conrad Bahlke, partner at Weil, Gotshal, & Mangesin New York.
