Credit Derivatives & Synthetic Securitizations Under The Basel Proposal

Comments on the Basel Committee on Banking Supervision's proposed New Basel Capital Accord for banks are due on May 31. The proposed accord would include much more detailed treatment than current international risk-based capital standards for banks that offer or purchase credit derivatives, or that perform various roles in synthetic securitizations effected through credit derivatives. The Basel Committee is continuing to discuss many issues in these areas, particularly regarding synthetic securitizations.

Three Pillars

The New Basel Capital Accord would replace the current system of bank capital requirements with three pillars:

* Minimum capital requirements, including a refinement of the treatment of credit risk in the existing 1988 Accord. That document generally requires capital to be held against assets categorized by percentage risk weightings ranging from 100% to 0%, with off-balance sheet liabilities converted to on-balance sheet equivalents by different percentages.

* Supervisory review of capital adequacy.

* Market discipline, consisting of disclosure recomendations and requirements.

Minimum capital requirements addressing credit risk would consist of a standardized approach, for smaller banks with fewer risk-management resources, and an internal ratings-based ("IRB") approach, for banks with more advanced risk management capabilities. The accord would also have a capital requirement for operational risk.

Credit Derivatives Under Standardized Approach

Under the standardized capital requirements for a bank receiving the benefit of protection through a credit derivative on its banking book, the credit risk weighting of a provider of a credit derivative (or guarantee) could be substituted for the risk weighting of an obligor (on a loan, for example), if a bank regulator was satisfied that:

(1) the beneficiary bank fulfilled minimum conditions relating to risk management processes,

(2) the credit derivative was "direct, explicit, irrevocable and unconditional," as defined in the accord, and

(3) certain operational requirements were met. Credit events covered by the derivative would have to include, at a minimum, a specified list of events. The credit protection would have to be legally enforceable in all relevant jurisdictions. A grace period in the derivative could not be longer than the grace period in the underlying loan, and the determination of whether a credit event has occurred could not be the sole responsibility of the protection seller. Where there was an asset mismatch between the exposure and the reference asset, the reference and underlying assets would have to be issued by the same obligor, and the reference asset would have to rank pari passu with, or more junior than, the underlying asset. Only credit default swaps and total return swaps providing credit protection equivalent to guarantees would be eligible for recognition, and only when provided by sovereign or public sector entities, banks with a lower risk weight than the obligor, or corporate entities with an external credit rating of A (Standard & Poor's) or the equivalent, or better. Proportional or tranched treatment would be permitted for partial coverage of an exposure.

The accord would also add a capital floor, denoted w. For guarantees (but not for credit derivatives) provided by a sovereign entity, central bank or bank, w would be zero; for other guarantees and for all credit derivatives, w would be 0.15. The overview of the accord states that "in addition to maintaining banks' focus on the credit quality of the underlying borrower, the purpose of w in this context is to reflect the extent to which the enforceability of the documentation used has been upheld in practice."

The International Swaps and Derivatives Association has expressed concern about this inequality of treatment between credit derivatives and guarantees and its effective "introduction of a legal charge for credit risk mitigation instruments, in utter contradiction with the efforts made by a number of industry bodies, including ISDA itself, to ensure that collateral and credit derivatives documentation is enforceable and effective."

The Internal Ratings-Based Approach

Banks using the IRB approach would be required to categorize banking book exposures into six broad classes of assets with different underlying credit risk characteristics. For corporate, bank and sovereign exposures, there would be foundation and advanced methodologies for estimating risk components. The foundation approach would follow closely the standardized approach. Under the advanced approach, banks would use their own internal assessments of the degree of risk transfer from credit derivatives and guarantees, within supervisor-defined parameters. There would be no limits on the range of eligible guarantors, and a w factor would not be applied. Only banks meeting both requirements for a borrower rating system and specific minimum requirements for credit derivatives and guarantees could use the advanced approach.

Trading Book

For banks calculating capital requirements in a trading book, and receiving protection through credit default swaps and credit-linked notes with an exact match to the underlying exposure in terms of reference asset, maturity and currency, an 80% specific risk offset would be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side would be zero. For total return swaps, a matched position would be fully offset for regulatory capital purposes. For credit derivatives with a currency or maturity mismatch between the credit protection and the underlying asset (but not an asset mismatch between the underlying and the reference asset), the higher of the capital requirement applicable to the underlying and that applicable to the credit protection would apply.

Synthetic Securitizations

The proposed accord includes specific proposals on non-synthetic securitizations, including reliance for investing banks on external ratings (see chart on previous page). However, the Basel Committee is still working to address the use of credit derivatives to effect synthetic securitizations, and has said it will finalize its work on capital and operational requirements for synthetic securitizations in the near term. The Committee has noted, in a consultative document on securitization accompanying the revised proposed accord, that synthetic securitization "is a comparatively cost-effective mechanism for repackaging credit risk portfolios in response to incentives in regulatory capital requirements," but has suggested that this may change if a bank can use an IRB method in determining the amount of capital to hold:

"Under an internal ratings-based approach, the incentive to engage in synthetic securitizations may very well be mitigated since, in theory, the regulatory capital requirements would be closer to the economic capital actually required against the risk of the reference portfolio. Given the convergence of the two capital measures, the transaction costs also tend to reduce the incentive banks have to engage in a synthetic securitization in order to minimize their capital requirements."

However, the Committee noted that smaller banks not eligible for the IRB approach may wish to engage in synthetic securitizations, and that a treatment for synthetic securitizations could thus be needed under the standardized approach.

The Committee identified issues that it believes will need to be resolved in order to develop a consistent and comprehensive treatment of synthetic securitizations under both standardized and IRB approaches, including:

* whether the level of first-loss credit enhancement (including through payout clauses) retained by an originating institution should be restricted to ensure a reasonable degree of risk transference, or whether the proposed deduction of first-loss credit enhancement by sponsors of conduit programs from capital would negate the need for this.

* whether senior risk should be required to be transferred to an SPV and on to the market, or what principles and operational requirements should make it acceptable for the originating bank to retain the most senior exposure in a synthetic securitization.

* what requirements, in terms of a minimum transfer of risk to the market, should apply if an originator holds both senior and first-loss positions.

* whether particular structural (including ratings requirements, market practice for documentation, and legal opinions), risk management and disclosure criteria should be met in order to obtain a preferential capital charge.

This week's Learning Curve is by Conrad Bahlke, partner at Weil, Gotshal & Manges in New York.