Securitisation and the New Basel Capital Accord

1
Securitisation and the New Basel Capital Accord
Mayer, Brown, Rowe Maw

• Mayer, Brown, Rowe Maw LLP
• October 2004

2
Introduction

• What is the Basel Committee on Banking
  Supervision?
• It is a committee of senior representatives of
  bank supervisory authorities and central banks
  from Belgium, Canada, France, Germany, Italy,
  Japan, Luxembourg, the Netherlands, Sweden,
  Switzerland, the United Kingdom and the United
  States
• What is Basel I (or the 1988 Accord)?
• A document entitled International Convergence of
  Capital Measurement and Capital Standards
  serving as the basis for risk-based capital
  standards adopted by national bank regulators in
  over 100 countries
• What is Basel II?
• A new Accord introduced in June 1999 designed to
  bring regulatory capital more closely in line
  with the risks of the positions supported by such
  capital

3
Introduction (contd)

• More Complexity
• Basel II is significantly more complex than the
  current rules
• Incorporating the Accord into local law may
  introduce additional complexity 85 items in the
  Accord have been left to national discretion
• Greater Impact
• By reallocating capital burdens among banks and
  asset classes, the Accord will change the types
  of assets that banks originate and hold on their
  balance sheets
• By more closely aligning regulatory capital with
  the actual risks of exposures, the Accord will
  alter originator motivations and securitisation
  transaction structures
• Changes will start right away

4
Basel I
5
Existing Regulatory Capital Rules
Basel I Summary

• Summary
• In effect since 1988 and now adopted by national
  bank regulators in over 100 countries
• Very simple in application
• 8 capital against funded exposures (4 for loans
  secured by residential real estate)
• 0 capital against unfunded commitments under one
  year
• Deduct retained first loss positions
• Separate treatment of synthetics, with national
  variations
• Simplicity of Basel I permits regulatory capital
  arbitrage
• Originators achieve significant regulatory
  capital reduction with little transfer of credit
  risk
• Regulators proposed Basel II to combat this
  arbitrage and to match regulatory capital more
  closely with the actual risks of exposures

6
Basel II
7
Timing
Basel II overview

• June 1999
• Basel Committee introduces new capital framework
  to replace 1988 Accord
• Mid-2004
• Basel Committee publishes final Accord
• mid-2004 to end-2006
• National regulators implement new Accord in
  national regulations
• 1 January 2007
• Scheduled effective date of standardised approach
  and foundation IRB approach
• 1 January 2008
• Scheduled effective date of additional rules for
  advanced IRB banks
• However
• The new Accord will likely be adopted prior to
  the deadlines in some countries, at least in part
• Banks will alter their behaviour before the
  deadlines in anticipation of the new Accord
• US regulators have reserved the right to propose
  changes after internal US publication of proposed
  rules and comment period

8
Table of Contents

• Overview 12
• Three Pillars approach
• Overall capital requirements
• Types of banks
• Standardised banks
• IRB banks
• Capital Requirements for
• Non-Securitisation Exposures 16
• Standardised Banks
• IRB Banks
• Credit Risk Mitigation (CRM)

9
Table of Contents (contd)

• Securitisation Framework Generally 29
• Securitisation Framework - Standardised
  approach 39
• Risk weights
• Below investment grade exposures
• Unrated most senior positions
• Second loss or better positions
• Liquidity facilities
• Conversion factors
• Eligible liquidity
• Market disruption liquidity
• Overlapping exposures

10
Table of Contents (contd)

• Securitisation Framework - Internal Ratings
• Based (IRB) Approach 48
• Scope
• Definition of KIRB
• Hierarchy of approaches
• Maximum capital requirement
• Ratings based approach (RBA) and risk weights
• Use of inferred ratings
• Internal Assessments Approach (IAA)
• Supervisory formula approach (SFA)
• Liquidity commitments
• Overlapping exposures

11
Table of Contents (contd)

• Early Amortisation Structures 63
• Operational Capital 69
• Disclosure 71
• Observations 74

12
Basel IIOverview
13
Three Pillars forHealthy Banks
Basel II Overview

• Pillar 1
• Required Capital

Pillar 2 Supervisory Review
Pillar 3 Market Discipline

• Pillar 1 - Capital Capital requirements will be
  based on market, credit and operational risk.
  Capital reduces the risk of failure by acting as
  a cushion against losses and by providing access
  to financial markets to meet liquidity needs and
  provides an incentive for prudent risk
  management.
• Pillar 2 - Supervision Regulators will conduct
  qualitative supervision of internal process of
  risk control and capital assessment process.
• Pillar 3 - Market Discipline Active involvement
  of the financial markets, for example through
  disclosure requirements, will bring discipline to
  member institutions.

14
Overall Capital Requirements
Basel II Overview
Total
Capital Credit
Market Operational Capital Ratio
Risk Risk Risk
(8 required) Revised
Unchanged New

• The new Accord modifies only the denominator
  (risk-weighted assets).
• The definition of and requirements for Tier 1 and
  Tier 2 capital remain unchanged
• Specific provisions and write-offs offset
  required capital excess general provisions may
  also offset capital in certain circumstances

15
Categories of Banks
Basel II Overview

• Basel II will recognise two categories of banks
  those that adopt the Standardised Approach
  (Standardised Banks) and those that adopt the
  more advanced IRB Approach (IRB Banks)
• Most European and Japanese banks will be
  Standardised Banks
• Standardised banks will measure credit risk in a
  standardised manner supported by external credit
  assessments
• A few banks will be IRB Banks
• IRB banks will measure credit risk using more
  sophisticated, and in some cases internal, rating
  systems
• In the US, however, regulators believe that there
  will only be from 10 to 20 IRB banks at the time
  the Accord is adopted
• A bank must adopt the standardised or IRB
  approach for most of its exposures, including its
  securitisation exposures
• A transition period (of 2 to 3 years) to full IRB
  status will be permitted
• Most of a banks exposures probably means 85
  or more

16
Basel IICapital Requirements for
Non-Securitisation Exposures
17
Capital Charges for Standardised Banks In a
Nutshell
Basel II non-securitisation exposures

• Capital Charge
• Equals (a) risk weight times (b) amount of
  exposure times (c) 8
• Risk Weights
• Banks Either (at supervisors election) (a) one
  level below sovereign rating, or (b) based on
  banks own rating 20 for AAA to AA-, 50 for
  A to BBB-, 100 for BB to B-, 150 for below B-
  and 50 for unrated
• Corporates Either (at supervisors election)
  (a) 20 for AAA to AA-, 50 for A to A-, 100
  for BBB to BB-, 150 for below BB-, and 100 for
  unrated, or (b) 100 for every corporate exposure
  irrespective of rating
• Retail 75 if eligible and not in default
• SME 75 if under 1 million and treated as
  retail or guaranteed by an individual, otherwise
  corporate risk weight (100 for unrated
  exposures)
• Residential Real Estate 35 if fully secured by
  residential property
• Commercial Real Estate generally 100, but 50
  for tranche not greater than lower of 50 of
  market value and 60 of mortgage lending value
  subject to strict conditions (including losses on
  tranche not in excess of 0.3 in any year and
  losses from all commercial real estate not in
  excess of 0.5 in any year)
• Off-balance sheet commitments generally 20 if
  one year or less
• Floor
• Effective floor of 160 basis points for AAA rated
  exposures

18
Exposures and Risk WeightsStandardised Banks
Basel II non-securitisation exposures

• Claims on Sovereigns
• risk weights for exposures to sovereigns are as
  set out in the following chart
• Risk weights also possible based on ECA risk
  scores
• Claims on non-central government public sector
  entities based on corporate exposures
• Claims on multilateral development banks 0 if
  conditions are met, including (i) majority of
  MDBs ratings are AAA, (ii) significant portion
  of shareholders are AA- or better rated
  sovereigns, (iii) funding is in the form of
  paid-in equity with little or no leverage, and
  (iv) conservative lending criteria

19
Exposures and Risk Weights (contd) Standardised
Banks
Basel II non-securitisation exposures

• Claims on Banks
• 2 options, selected by national regulator to
  apply for all banks in a jurisdiction
• Option 1 all banks are assigned a risk weight
  that is one category below that of the sovereign
• Option 2 risk weights are assigned based on the
  banks own ratings (with one category more
  favourable if claim is lt 3 months)

20
Exposures and Risk Weights (contd) Standardised
Banks
Basel II non-securitisation exposures

• Claims on Corporates
• Generally risk weights for exposures to
  corporates are as set out in the following chart
  (but supervisory authorities may increase the
  100 risk weight for unrated corporates where
  warranted by higher default rates)
• Alternative at national discretion, supervisory
  authorities may permit a bank to risk weigh all
  corporate claims at 100 without regard to
  external ratings

21
Exposures and Risk Weights (contd) Standardised
Banks
Basel II non-securitisation exposures

• Retail Claims
• Generally 75 risk weight if
• The exposure is to an individual or small
  business
• The exposure takes the form of revolving credits,
  lines of credit, personal loans, leases, or small
  business facilities (mortgage loans are excluded
  to the extent otherwise covered (see below))
• The portfolio is sufficiently diversified
  (granular) the Accord suggests that sufficient
  granularity could be achieved if no aggregate
  exposure to any one counterparty exceeds 0.2 of
  the overall portfolio
• Maximum aggregate exposure to any one
  counterparty cannot exceed 1 million
• Past due the unsecured portion of any exposure
  that is past due for more than 90 days, net of
  specific provisions, will be risk-weighted as
  follows
• 150 when specific provisions are less than 20
  of the outstanding amount of the loan
• 100 when specific provisions are no less than
  20 of the loan
• 100 when the specific provisions are no less
  than 50 of the loan, with supervisory discretion
  to reduce the risk weight to 50

22
Exposures and Risk Weights (contd) Standardised
Banks
Basel II non-securitisation exposures

• Residential Real Estate
• 35 risk weight for exposures fully secured by
  mortgages on residential property that is or will
  be occupied by the borrower or that is rented
• Strict prudential criteria (including loan to
  value ratios) are to be determined by national
  regulators
• Supervisors may require a bank to increase its
  risk weight if appropriate
• Commercial Real Estate
• Generally 100 risk weight, given experience in
  numerous countries with troubled credits over the
  past few decades
• However, 50 risk weight possible in certain
  markets if (among other conditions) (i) tranche
  not greater than lower of 50 of market value and
  60 of mortgage lending value, (ii) losses on
  tranche do not exceed 0.3 in any year, and (iii)
  overall losses from commercial real estate do not
  exceed 0.5 in any year

23
Exposures and Risk Weights (contd) Standardised
Banks
Basel II non-securitisation exposures

• Higher-risk categories
• The following exposures will be risk weighted at
  150 or higher
• Sovereigns, banks and securities firms rated
  below B-
• Corporates rated below BB-
• Past due loans (weighted as per page 21)
• Other exposures
• Generally 100 risk weighted
• Securitisation exposures dealt with separately
  (see below)
• Commitments and other off-balance sheet items
• Off-balance sheet exposures will be converted
  into credit exposures using a credit conversion
  factor (CCF)
• There will be a 20 CCF for commitments with an
  original maturity of up to one year
• There will be a 50 CCF for commitments with an
  original maturity of more than one year

24
Capital Charges for IRB Banks In a Nutshell
Basel II non-securitisation exposures

• Summary
• IRB banks use formulas, not ratings, to calculate
  capital charge for each asset (bottom-up
  approach) pursuant to specified inputs
• Advanced IRB banks can determine all inputs
  internally foundation IRB banks must use
  supervisory values for some inputs (e.g., LGD of
  45 for senior positions and 75 for subordinated
  positions)
• Formulas vary depending on asset class
  sovereign bank corporate retail equity
  purchased receivables
• SME exposures (under 50 million) receive extra
  formula adjustment
• Expected IRB Capital Requirements
• Required capital for foundation IRB banks is
  expected to be significantly lower than capital
  for standardised banks for the same exposures
  required capital for advanced IRB banks is
  expected to be significantly lower than capital
  for foundation IRB banks
• Effective floor of only a few basis points for
  the safest exposures, even if unrated

25
Exposures and Risk WeightsIRB Banks
Basel II non-securitisation exposures

• Treatment of Expected/Unexpected Losses
• The IRB capital charge covers unexpected losses
  (UL), with expected losses (EL) treated through
  reserves
• Treatment under 1988 Accord to include general
  provisions in Tier 2 capital is withdrawn
• Under Basel II, IRB banks must generally deduct
  the amount by which total eligible provisions
  fall short of the total expected loss amount
• Calculation of Capital
• IRB banks will calculate their required
  regulatory capital on the basis of certain risk
  components and risk weight functions (i.e.,
  formulas) for each exposure (i.e., a bottom-up
  approach)
• Foundation IRB banks will determine some of the
  risk components internally and will use a
  supervisory value for others
• Advanced IRB banks will determine all of the risk
  components pursuant to their own internal systems

26
Exposures and Risk WeightsIRB Banks
Basel II non-securitisation exposures

• Calculation of Capital (contd)
• Risk components include probability of default
  (PD), loss given default (LGD), exposure at
  default (EAD) and effective maturity (M)
• Risk components and risk weight functions vary
  depending on asset class
• Sovereigns
• Banks
• Corporate Treated differently are SME exposures
  and specialised lending exposures (project
  finance, object finance, commodities finance,
  income-producing real estate and high-volatility
  commercial real estate)
• Retail (defined differently than for standardised
  banks residential mortgages, revolving retail of
  100,000 or less, all other retail)
• Equity

27
Transition PeriodIRB Banks
Basel II non-securitisation exposures

• Capital Floor
• During the first year following implementation
  (2007), the IRB capital requirements for credit
  risk, operational risk and market risk may not
  fall below 95 of the current minimum required
  for credit and market risks
• During the second year following implementation
  (2008), the IRB capital requirements for credit
  risk, operational risk and market risk may not
  fall below 90 of the current minimum required
  for credit and market risks
• During the third year following implementation
  (2009), the IRB capital requirements for credit
  risk, operational risk and market risk may not
  fall below 80 of the current minimum required
  for credit and market risks
• If problems emerge during the transition period,
  the floor may be kept in place if necessary

28
Credit Risk Mitigation (CRM)
Basel II non-securitisation exposures

• Standardised Banks
• Simple Approach
• The risk weight for the collateral is substituted
  for the risk weight of the unsupported exposure,
  with a floor of 20, 10 or 0 depending on the
  collateral
• For synthetic securitisations, that means the
  super-senior piece receives a 20 risk weighting
• Comprehensive Approach
• Banks use haircuts to adjust both the amount of
  the exposure and the value of collateral received
• Further adjustments for maturity mismatches
  (square root of time formula) and currency
  mismatches
• VaR models permitted
• On-balance sheet netting recognised
• IRB Banks
• Collateral reduces PD or LGD input (thereby
  reducing required capital)

29
Basel IICapital Requirements for
Securitisation ExposuresOverview
30
Securitisation Framework In a Nutshell
Basel II securitisation exposures

• Standardised banks
• Calculate capital based on external ratings
• Unrated positions must generally be deducted
• Capital floor of 160 basis points
• IRB banks
• Calculate capital based on either external
  rating, internal assessments approach (IAA) or
  supervisory formula (SF)
• unrated positions must generally be deducted if
  IAA or SF unavailable
• Capital floor of 56 basis points
• Originators
• Must meet operational requirements to move assets
  off balance sheet for regulatory capital
  purposes, including significant risk transfer and
  no increase in deal support upon asset
  deterioration
• If standardised bank, originator is discriminated
  against vis-à-vis investors for BB to BB-
  exposures
• Capitalised assets
• On balance sheet capitalised assets (such as I/O
  strips) are always deducted
• Cap
• An IRB originator is not required to hold more
  capital after securitisation than the capital it
  would have held had the pool not been securitised

31
When does the Accords Securitisation Framework
Apply?
Securitisation Framework - Generally

• The framework applies to exposures arising from
  securitisations
• A securitisation is a transaction involving one
  or more underlying credit exposures from which
  stratified positions or tranches are created that
  reflect different degrees of risk
• The framework does not apply to specialised loan
  transactions
• Specialised loan transactions include project
  finance, object finance, commodities finance,
  income-producing real estate or high-volatility
  commercial real estate transactions
• Focus on economic substance not legal form

32
Investing or Originating Bank?
Securitisation Framework - Generally

• Investing Bank
• Any bank other than the originator, sponsor or
  servicer of a securitisation that assumes the
  economic risk of a securitisation exposure
• Originating Bank
• Any Bank that originates, directly or indirectly,
  exposures included in the securitisation
• Any Bank that serves as a sponsor of an ABCP
  conduit or similar program that acquires credit
  exposures from third parties, including any bank
  that
• manages or advises the program
• places securities on the market
• provides liquidity and/or credit enhancement

33
Operational Requirementsfor Cash Transactions
Securitisation Framework - Generally

• A bank originator may exclude securitised
  exposures from its regulatory capital calculation
  in a traditional (cash) transaction if
• significant risk is transferred to third parties
• the bank does not maintain effective or indirect
  control over the transferred exposures
• the assets are legally isolated from the
  transferor, supported by a legal opinion
• the transferee is an SPE and the holders of its
  beneficial interests have the right to pledge or
  transfer them without restriction
• the securities issued by the SPE are not
  obligations of the bank
• the transaction documentation does not contain
  clauses (i) requiring the transferor to improve
  the quality of pool over time, (ii) increasing
  the first loss position or credit enhancement or
  (iii) increasing the yield paid to investors in
  response to a deterioration of the credit quality
  of the pool
• qualifying clean-up calls are permitted

34
Operational Requirementsfor Synthetic
Transactions
Securitisation Framework - Generally

• A bank originator may exclude securitised
  exposures from its regulatory capital calculation
  in a synthetic transaction if
• significant risk is transferred to third parties
• credit risk mitigants comply with Section II.D of
  the Accord
• eligible collateral is limited to cash, gold and
  debt or equity securities meeting specified
  criteria as to credit quality or marketability
• eligible guarantors are limited to core market
  participants (SPEs are not recognised, but
  eligible collateral provided by SPEs is
  recognised)
• the transaction documentation does not contain
  terms (i) materially limiting the credit
  protection, (ii) requiring the originating bank
  to alter the underlying pool, (iii) increasing
  the cost of the banks credit protection, (iv)
  increasing the yield to investors, or (v)
  increasing the first loss position
• legal opinions must confirm contract
  enforceability
• qualifying clean-up calls are permitted

35
Operational Requirements for External Ratings
Securitisation Framework - Generally

• Regulators will permit a bank to determine
  regulatory capital based on an exposures
  external rating if
• the rating reflects the entire amount of the
  credit exposure
• the rating is from an eligible external credit
  rating agency recognised by the banks banking
  supervisor
• the rating is publicly available and included in
  the agencys transition calculations (i.e., no
  private ratings)
• if a credit risk mitigant is applied to a
  specific exposure and not to the SPE generally,
  the exposure must be treated as if it is unrated
  and the credit risk mitigation rules must be
  applied instead
• the bank relies on only one agencys rating to
  determine capital for all tranches it holds in a
  transaction (and not one agency rating for one
  tranche and another agencys rating for other
  tranches of the same transaction)
• If two ratings exist, the bank must use the
  higher risk weight if three or more ratings
  exist, the bank must use the higher of the two
  lowest risk weights.

36
Clean-up Calls
Securitisation Framework - Generally

• Regulatory capital need not be held against an
  exposure subject to a call option over the
  securitised exposures if
• Its exercise is not mandatory, in substance or
  form
• It is not structured to avoid allocating losses
  to credit enhancement providers or investors, and
  is not otherwise structured to provide credit
  enhancement
• It may only be exercised when 10 or less of the
  original underlying portfolio or reference
  portfolio value remains
• If the call does not meet the above conditions,
  the underlying exposures will be treated as if
  they were not securitised and the originating
  bank must hold capital against the entire amount
  of the securitised exposures

37
Implicit Support
Securitisation Framework - Generally

• What is implicit support?
• Implicit support is support provided by a bank
  in excess of its predetermined contractual
  obligation
• What if a bank provides implicit support?
• If a bank provides implicit support it is
  required, at a minimum, to hold capital against
  all of the exposures associated with the
  securitisation transaction as if they had not
  been securitised
• In addition, the bank would be required publicly
  to disclose (1) that it provided non-contractual
  support to a transaction, and (2) the capital
  impact of doing so

38
Deductions from capital
Securitisation Framework - Generally

• When deducting a securitisation position from
  regulatory capital, a bank must deduct
• 50 from Tier 1
• 50 from Tier 2
• Exception for Capitalised Assets
• Banks will be required to deduct entirely from
  Tier 1 capital any expected future margin income
  (e.g. an interest-only strip) that has been
  capitalised and carried as an asset on the
  balance sheet and recognised in regulatory capital

39
Basel IIStandardised Approachfor Securitisation
40
Securitisation Framework Standardised Approach

• What is the standardised approach?
• It is a method of determining regulatory capital
  based on the ratings of securitisation tranches
  provided by qualified external rating agencies
• When must a bank use the standardised approach?
• Banks that apply the standardised approach to
  measure credit risk for the type of exposures
  underlying a securitisation transaction must
  apply the standardised approach under the
  securitisation framework
• The proposed risk weights for exposures with
  long-term ratings and short-term ratings are on
  the following pages

41
Risk Weightslong-term ratings
Securitisation Framework Standardised Approach
42
Risk Weightsshort-term ratings
Securitisation Framework Standardised Approach
43
Risk Weights (contd)
Securitisation Framework Standardised Approach

• Only investing banks may use the 350 risk weight
  for exposures in the BB to BB- range
• Standardised originating banks (including conduit
  sponsors and dealers) must deduct all retained
  exposures that are rated below BBB-
• However, IRB originating banks are now entitled
  to rely on a BB to BB- rating to avoid deduction
• Subject to certain exceptions mentioned below,
  unrated positions must be deducted from capital
• Deduction is equivalent to a 1,250 risk
  weighting
• An unrated corporate exposure held by a bank has
  only a 100 risk weighting, not full deduction

44
Exceptions to Deduction of Unrated Positions
Securitisation Framework Standardised Approach

• Most senior securitisation exposures
• If the most senior tranche is unrated, the bank
  that holds or guarantees that position may look
  through to the underlying pool to determine the
  risk weight (and may assign a risk weight equal
  to average of risk weight assigned to exposures
  in underlying pool), provided that the
  composition of the pool is known at all times
• Second loss positions or better
• Qualifying exposures provided by sponsor banks in
  ABCP programs that are in second loss position or
  better may apply a risk weight equal to the
  greater of (x) 100 and (y) the highest risk
  weight assigned to any exposure in underlying
  pool, but only if
• The first loss position provides significant
  credit protection
• The associated credit risk is investment grade or
  better
• The bank holding the exposure does not hold the
  first loss position

45
Liquidity Commitments
Securitisation Framework Standardised Approach

• Credit conversion factors
• Generally
• 20 for eligible liquidity commitments with an
  original maturity of one year or less
• 50 for eligible liquidity commitments of more
  than one year
• 100 for all other liquidity commitments
• This is an increase from 0 under the 1988 Accord
• Regulators believe that liquidity commitments
  absorb more than just liquidity risks, and want
  banks to hold capital against those risks
• A credit conversion factor of 0 is theoretically
  possible if
• The commitment qualifies as eligible liquidity
• It can only be drawn in event of general market
  disruption (i.e., where more than one SPE across
  different transactions is unable to roll over
  maturing commercial paper i.e., not as the
  result of impairment in the credit quality of the
  SPE or its pool)
• It must be secured by the underlying assets and
  rank pari passu with the securities

46
Liquidity Commitments (contd)
Securitisation Framework Standardised Approach

• Eligible Liquidity In order to qualify as
  eligible liquidity
• The documentation must identify and limit
  circumstances of draw, and amounts drawn must be
  limited to the amount that is likely to be repaid
  from underlying assets and seller-provided credit
  enhancement
• No incurred losses should be covered and draw
  should not be automatic
• Asset quality test should not cover defaulted
  assets as defined in paragraphs 452-459
  (including receivables more than 90 days past due
  unless extended up to 180 days by national
  regulators) if funding is based on a rated
  underlying exposure, it must be rated at least
  investment grade
• The facility cannot be drawn after all applicable
  credit enhancement to which the liquidity
  facility has access has been exhausted
• Repayment of draws must not be subordinated to
  the interests of any noteholder in the programme

47
Overlapping Exposures
Securitisation Framework Standardised Approach

• For example, if a bank sponsor provides
  programme-wide liquidity and credit enhancement
  to an ABCP conduit
• If funding one exposure precludes funding the
  other exposure, the bank need not hold capital
  against both exposures
• Instead, for the overlapping portion the bank
  should hold capital against the exposure with the
  highest credit conversion factor
• Query how to allocate partial credit enhancement

48
Basel IIInternal Ratings-Based Approachfor
Securitisation
49
Internal Ratings-Based Approach
Securitisation Framework IRB Approach

• Scope
• The IRB calculates capital on the basis of either
  
• external ratings pursuant to a ratings based
  approach (RBA)
• inputs into a supervisory formula (SF) approach
• the internal assessments approach (IAA)
• A bank may not use the IRB for its securitisation
  exposures unless it has supervisory approval to
  use the IRB for the underlying assets
• Definition of KIRB
• KIRB is the ratio (expressed as a decimal) of
• the IRB capital requirement for the underlying
  exposures in the pool to
• the notional amount of such exposures
• For structures involving an SPE, all assets of
  the SPE must be included in the pool when
  determining KIRB, including assets in which the
  SPE may have a residual interest (such as a cash
  collateral account)
• Reserves against assets in the pool do not reduce
  the notional amount of the pool in determining
  KIRB, but can count as credit enhancement

50
IRB Capital Calculation(Hierarchy of Approach)
Securitisation Framework IRB Approach

• Generally
• An IRB bank must use the RBA to calculate capital
  if an external rating or inferred rating is
  available
• Where the RBA is not available, the bank may use
  the SF or the IAA if available
• Where neither the RBA nor the SF or IAA are
  available, the bank may use the look-through
  approach (see below) in paragraph 639
• Otherwise, the position must be deducted
• If a bank using the IRB would have more capital
  under IRB than had the positions not been
  securitised, it may use the IRB capital
  requirement for the underlying exposures

51
RBA Risk Weights
Securitisation Framework IRB Approach

• The RBA risk weight of a position depends on
• the external or inferred rating of the position
• whether the rating is short-term or long-term
• the granularity of underlying pool (meaning the
  effective number of credits in pool, denoted as
  N)
• whether the position has the most senior claim
  against the pool
• Risk weights per table on following page
• If the position is senior (generally meaning the
  most senior), then use the more favourable column
  2
• if N is less than 6, then use the less favourable
  column 4
• in all other cases, use column 3
• Risk weights under the standardised approach are
  provided for comparison in column 5

52
RBA Risk Weightsshort-term ratings
Securitisation Framework IRB Approach
53
RBA Risk Weightslong-term ratings
Securitisation Framework IRB Approach
54
Inferred Ratings
Securitisation Framework IRB Approach

• When the following conditions are met, a bank
  must attribute an inferred rating to an unrated
  position
• The reference rated position must be subordinate
  in all respects to the unrated position
• Credit enhancements must be taken into account in
  determining subordination (for example, if the
  reference position benefits from a third party
  guarantee but the unrated position does not, then
  the latter may not be assigned an inferred
  rating)
• The maturity of reference position must be equal
  to or longer than that of the unrated position
• Any inferred rating must be updated continuously
  to reflect changes in the external rating of the
  reference position
• The external rating must satisfy the general
  requirements for the recognition of external
  ratings in securitisation transactions

55
Internal Assessment Approach
Securitisation Framework IRB Approach

• A bank may use its internal assessments of the
  credit quality of its securitisation exposure to
  ABCP programmes (e.g., both liquidity and credit
  enhancement) if its internal processes meet the
  operational requirements described below
• Each internal assessment is then mapped to the
  equivalent external ECAI rating and the notional
  amount is risk-weighted accordingly
• Conditions
• The ABCP issued by the conduit must be externally
  rated
• The internal assessment must be based on ECAI
  criteria for the asset type and be the equivalent
  of investment grade when the exposure is to be
  funded the bank must otherwise also qualify for
  the IRB approach
• The banks supervisors must be satisfied the ECAI
  meets required criteria in paragraphs 90-108 and
  with the ECAI criteria at issue
• The bank must show that its criteria matches the
  ECAI criteria
• A supervisor may, if warranted, disallow any
  seller provided recourse, guarantees or excess
  spread or any other first loss enhancement
• The internal assessment must identify gradations
  of risk that can be mapped to ECAI gradations

56
Internal Assessment Approach (contd)
Securitisation Framework IRB Approach

• IAA Conditions (contd)
• The internal assessment process, and particularly
  stress factors, must be at least as conservative
  as publicly available ratings criteria from the
  ECAIs rating the ABCP
• The bank must choose the most conservative of two
  or more criteria if two or more ECAI criteria
  apply
• Banks must not choose only ECAIs with less
  restrictive methodologies to rate their ABCP
  Programme and must keep up with methodology
  changes
• A bank cannot use a non-public ECAI methodology
  but may consider more conservative non-publicly
  available methodology
• For new or unique transactions, a bank may
  discuss applying the IAA with its regulators.
• Internal and external auditors, an ECAI, or the
  banks internal credit review or risk management
  function must perform regular reviews of the
  internal assessment process if internal reviews
  are used, they must be independent of the ABCP
  business line

57
Internal Assessment Approach (contd)
Securitisation Framework IRB Approach

• IAA Conditions (contd)
• A bank must track and adjust its internal
  processes over time
• The ABCP programme must have credit and
  investment guidelines (which should cover listed
  items)
• A credit analysis of the sellers risk profile
  must also be performed
• The Programme must have minimum asset eligibility
  criteria that exclude defaulted assets, limit
  concentrations, limit asset tenor, etc.
• The Programme should have collections processes
  established that consider the operational
  capability and credit quality of the servicer,
  lockbox arrangements, etc.
• All sources of risk must be considered (including
  credit and dilution)
• Structural features must be included such as wind
  down events
• A supervisor can suspend the IAA until a bank
  corrects deficiencies

58
Supervisory Formula
Securitisation Framework IRB Approach

• The SF is an alternative to the RBA and the IAA
• The capital charge under the SF depends on five
  bank-supplied inputs
• The regulatory capital of the position if held on
  balance sheet (KIRB)
• The degree of credit enhancement supporting the
  position (L)
• The positions thickness (T)
• The effective number of exposures in the
  securitised pool (N)
• The pools exposure-weighted average loss given
  default (LGD)
• The capital charge under the SF is the greater of
  
• the amount determined pursuant to the SF
• A floor of 56 basis points times the notional
  amount of the position

59
Top-Down Approach
Securitisation Framework IRB Approach

• Generally
• The top-down approach may be used provided the
  banks programme complies with the criteria for
  eligible receivables and minimum operational
  requirements
• Intended mainly for asset-backed securitisation
  exposures, but may also be used for appropriate
  on-balance sheet exposures
• Eligible Corporate Receivables
• Eligible corporate receivables must satisfy the
  following conditions
• The bank has not directly or indirectly
  originated the receivables (and has purchased
  them from unrelated third parties)
• The receivables must be generated on an arms
  length basis (and not subject to inter-company
  contra accounts)
• The purchasing bank must have a claim on all
  proceeds from the pool or a ratable interest
• National supervisors must develop concentration
  limits
• Recourse to the seller does not automatically
  disqualify the transaction as long as cash flows
  from assets are the primary source of repayment
  (plus some other requirements)

60
Top-Down Approach (contd)
Securitisation Framework IRB Approach

• Determination of capital
• The actual rules for calculation are set out in
  paragraphs 363-368 for default risk, 369-370 for
  dilution risk, 371-372 for use of purchase
  discounts as credit protection and 373 for
  recognition of credit risk mitigates (such as
  recourse or guarantees)
• After banks study these new rules, we will give
  you their views
• Purchased retail receivables are also eligible
  for the top-down procedure, but subject to
  different conditions

61
Liquidity Commitments
Securitisation Framework IRB Approach

• Conversion Factors
• Eligible liquidity facilities that may only be
  drawn in the event of a general market disruption
  (defined as above) have a 20 CCF
• Otherwise, all liquidity facilities have a CCF of
  100
• The 100 CCF means that IRB banks may provide
  multi-year liquidity or structured liquidity
  without additional capital requirements
• Determination of capital
• If the facility is externally rated, the bank may
  rely on the rating provided it uses a 100 CCF
• If the facility is not rated, the bank must
  determine KIRB either using the bottom-up
  approach or the top-down approach and then use
  the SF if the facility doesnt qualify for the
  IAA

62
Liquidity Commitments (contd)
Securitisation Framework IRB Approach

• Overlapping Exposures
• Same treatment as for standardised banks
• Look-Through Procedure for Eligible Liquidity
• Where it is not practical for a bank to use
  either the bottom-up or the top-down
  procedures for calculating KIRB, the bank may, on
  an exceptional basis and subject to supervisory
  approval, temporarily be permitted to apply the
  highest risk weight of the pool under the
  standardised approach to any of the individual
  exposures covered by an eligible liquidity
  facility
• In such a case, the bank must use the following
  CCFs
• Eligible liquidity 50 for commitments of one
  year or less and 100 for commitments in excess
  of a year
• Market disruption liquidity 20

63
Basel IICapital Charges for Early Amortisation
64
Early Amortisation Structures
Securitisation Framework Standardised/IRB
Approach

• Originating banks are required to hold capital
  against investors interests in a securitisation
  when
• It sells assets into a structure containing an
  early amortisation feature and
• The exposures sold are of a revolving nature
• Banks are not required to apply the early
  amortisation rules to
• Replenishment structures where the underlying
  exposures do not revolve and the early
  amortisation ends the banks ability to add new
  exposures
• Transactions of revolving assets containing early
  amortisation features that mimic term structures
  (i.e., where the risk does not return to the
  originating bank)
• Structures securitising credit lines where the
  investors remain liable to fund future draws by
  borrowers after amortisation events
• The early amortisation clause is triggered solely
  by events unrelated to the performance of the
  pool or the originator

65
Early Amortisation Structures (contd)
Securitisation Framework Standardised/IRB
Approach

• Applicable capital charge
• equals (1) the notional amount of the investors
  interest times (2) the applicable credit
  conversion factor times (3) the risk weight for
  the underlying credits
• but capitalised assets (such as future margin
  income) are treated separately and will typically
  be deducted from capital
• Capped at the greater of
• the capital required for retained securitisation
  exposures
• the capital required had the exposures not been
  securitised
• Applicable credit conversion factor based on
  whether
• the amortisation is controlled or
  non-controlled
• the securitised exposures are (i) uncommitted
  retail credit lines that are unconditionally
  cancellable or (ii) any other type of exposure

66
Early Amortisation Structures (contd)
Securitisation Framework Standardised/IRB
Approach

• A controlled amortisation must meet the
  following conditions
• The originator has in place a capital/liquidity
  plan to ensure it has sufficient capital and
  liquidity if early amortisation occurs
• Throughout the transaction, including the
  amortisation period, there is a pro rata sharing
  of interest, principal, expenses, losses and
  recoveries based on the balances of receivables
  outstanding at the beginning of each month
• The amortisation period fixed by the bank is
  sufficient for 90 of the total debt outstanding
  at the beginning of the period to have been
  repaid or to have been recognised as in default
• The pace of repayment is not any more rapid than
  would be allowed under straight-line amortisation
  over the period fixed as described above

67
Early Amortisation Structures (contd)
Securitisation Framework Standardised/IRB
Approach

• Credit conversion factors (CCF)
• For structures with controlled amortisation
• 0 to 40 for uncommitted retail lines (see next
  page)
• 90 for committed retail lines
• 90 for all non-retail lines (whether committed
  or uncommitted)
• For structures with non-controlled early
  amortisation
• 0 to 100 for uncommitted retail lines (see next
  page)
• 100 for committed retail lines
• 100 for all non-retail lines (whether committed
  or uncommitted)
• For uncommitted retail credits
• Calculate two points
• The point at which the bank is required to trap
  excess spread (or 4.5 above the early
  amortisation trigger if no trapping)
• The three month average excess spread for the
  transactions
• Divide the excess spread level by the trapping
  point and look up the CCF for the transaction on
  the following page

68
Early Amortisation Structures (contd)
Securitisation Framework Standardised/IRB
Approach

69
Basel II Capital Requirements for Operational
Risk
70
Capital Charges for Operational Risk
Securitisation Framework Operational Capital

• Basic Indicator Approach
• 15 of banks average annual gross income over
  previous three years
• Standardised Approach
• Capital charge for each of 8 business lines
  calculated against average annual gross income
  for that business line times
• 18 for corporate finance
• 18 for trading and sales
• 12 for retail banking
• 15 for commercial banking
• 18 for payment and settlement
• 15 for agency services
• 12 for asset management
• 12 for retail brokerage
• Advanced Measurement Approach
• Calculated on the basis of an internal
  operational risk management system approved by
  the national regulator

71
Basel IIDisclosure Requirements under the
Securitisation Framework
72
Disclosure
Securitisation Framework Disclosure

• Objective
• Impose market discipline on banks by requiring
  disclosure of key information relevant to banks
  capital adequacy
• Qualitative Disclosures for Securitisation
• Banks objectives for, and the roles it plays in,
  the securitisation process
• Banks accounting objectives for securitisation
• Whether sales are treated as or financings
• Whether the bank recognises gain on sale
• Key assumptions used by the bank for valuing
  retained interests
• The banks treatment of synthetic securitisations
• The names of the rating agencies used by the bank
  and the types of exposures rated by each agency

73
Disclosure (contd)
Securitisation Framework Disclosure

• Quantitative Disclosures for Securitisation
• The total outstanding exposures securitised by
  the bank and subject to the securitisation
  framework
• For exposures securitised by the bank and subject
  to the framework (in each case broken down by
  exposure type)
• The amount of impaired/past due assets
• Losses recognised by the bank during the current
  period
• The aggregate amount of securitisation exposures
  retained or purchased (broken down by exposure
  type) by the bank
• The aggregate amount of securitisation exposures
  retained or purchased, broken down by a
  reasonable number of risk bands (deducted
  exposures to be disclosed separately)
• The aggregate amount of securitised revolving
  exposures segregated by the originators interest
  and the investors interest
• A summary of the current years securitisation
  activity, including the aggregate amount of
  exposures securitised and the gain or loss on
  sale by asset type

74
Observations
75
Observations

• Basel II effect on ABCP
• Motivation to use ABCP because of off balance
  sheet funding for risk-based capital purposes not
  as strong under Basel II
• Query whether IAA is so attractive that there is
  still a risk-based capital advantage to funding
  through ABCP conduits
• Query whether combination of SF and top-down
  approaches have any advantages over on-balance
  sheet funding of customers assets
• How practical are the operational requirements
  for the IAA?
• How practical are the eligibility requirements
  for the standardised approach?
• How much of an impact will the new risk weights
  for short-term exposures have when compared to
  the old 0 risk weight for liquidity plus 8 risk
  weight for credit enhancement?

76
Observations (contd)

• How might Basel II affect banks generally?
• Less overall capital for banks in North America
  and Northern Europe, and more overall capital for
  banks in Latin America and Eastern Europe
• More overall capital for standardised banks and
  less overall capital for advanced IRB banks
  (essentially the same overall capital for
  foundation IRB banks)
• Migration toward certain asset types (retail,
  residential real estate, SME loans) and away from
  other asset types (emerging market
  sub-sovereign project finance venture capital
  lower-rated securitisation tranches)
• Higher capital costs for off-balance sheet
  exposures
• Adoption by banks of more sophisticated risk
  modelling and management tools in order to move
  to advanced IRB if possible
• More competition and further consolidation in the
  banking sector

77
Observations (contd)

• How might Basel II affect the securitisation
  markets?
• May slow growth of all securitisation (by
  reducing economic incentive to securitise), and
  particularly CDOs and synthetic securitisation
  (by requiring more capital against the former,
  and by discriminating against the latter)
• Impede banks ability to disperse credit risks
  throughout the financial system due to higher
  costs
• Motivate banks to securitise higher risk weighted
  assets and keep lower risk weighted assets
• Shift placement of lower-rated exposures to
  non-regulated investors
• Make bank investors less willing to invest in
  lower-rated securitisation exposures and more
  willing to invest in like-rated sovereign, bank
  and corporate exposures
• Widen spreads on lower-rated tranches and tighten
  spreads on highly-rated tranches

78
Observations (contd)

• Basel II effect on securitisation (contd)
• Motivate banks to reduce traditional liquidity
  where possible and develop alternative forms of
  liquidity where price-effective
• Possibly motivate standardised banks to hold more
  securitisation risks than they do now, because