United States: Revisions To Basel Securitisation Framework – Second Consultative Document

Keywords: revision, Basel securitisation framework, BCBS, credit risk, capital requirements

In December 2013 the Basel Committee on Banking Supervision (BCBS) published a second consultation paper (BCBS 269)1 on its proposed changes to the international model rules for banks' calculation of credit risk capital requirements for exposures to securitisation transactions (Revised Proposal). The Revised Proposal follows the BCBS's first consultative document on this subject (BCBS 236) published in December 2012 (First Proposal),2 and includes the proposed text of the revised securitisation framework. Comments on the Revised Proposal are due 21 March 2014.

The Revised Proposal carries forward the objectives and some basic elements of the First Proposal, including increasing risk weights for highly-rated securitisation exposures, decreasing risk weights for lower-rated securitisation exposures and varying risk weights according to tranche contractual maturity. However, BCBS has adjusted the modelling and calibration so that risk weights for high quality securitisation exposures, while higher than under the Basel II capital requirements framework as amended,3 would be significantly lower than under the First Proposal.

Highlights of the Revised Proposal are as follows:

  • BCBS proposes a simplified hierarchy of approaches under which banks would apply (depending on satisfaction of conditions described below):
    • an Internal Ratings-Based Approach (IRBA) based on the internal ratings-based approach (IRB) capital charge for the underlying securitised exposures (Kirb), in place of the modified supervisory formula approach (MSFA) in the First Proposal;
    • where permitted under the laws of the relevant jurisdiction, either an External Ratings-Based Approach (ERBA), which is a slightly simpler version of the Revised Ratings-Based Approach (RRBA) set out in the First Proposal, or, at the bank's option in the case of exposures to asset-backed commercial paper (ABCP) conduits, the Internal Assessments Approach (IAA) from the Basel II IRB; or
    • a Standardised Approach (SA), which is similar to the Simplified Supervisory Formula Approach (SSFA) set out in the First Proposal.

If the bank was not able to apply any of these approaches to a particular securitisation exposure, it would assign a 1250% risk weight to the exposure. The Revised Proposal does not include the backstop concentration ratio approach (BCRA) set out in the First Proposal.

  • Though the MSFA no longer appears in the hierarchy, an adjusted form of the MSFA was used to calibrate the IRBA and other approaches. BCBS adjusted the calibration and some of the assumptions of the MSFA based on comments received on the First Proposal and results of its related quantitative impact study (QIS).
  • Regardless of the approach used, the capital requirement for any securitisation exposure would be subject to a 15% risk weight floor. This compares to the 7% risk weight floor for a high quality, senior, granular securitisation position under the Basel II IRB and the 20% floor proposed in the First Proposal and already in effect in the US bank capital rules (US Rules)4 and under the Basel II SA.
  • Under both the IRBA and the ERBA, and as set out in the First Proposal under the MSFA and the RRBA, risk weights would vary according to maturity of the securitisation exposure, with a minimum of one year and a maximum of five years. For this purpose, the tranche maturity would be determined based on mandatory contractual cash flows of the securitisation tranche rather than contractual or expected cash flows of the underlying assets.
  • Based on the ERBA risk weights and other statements set out in the Second Proposal, risk weights under the revised framework for relatively high quality securitisation tranches (and especially those not having short contractual maturities) would still be substantially higher than under the Basel II IRB, but would also be significantly lower than under the First Proposal.
  • Operational conditions for use of the IRBA would incorporate the same flexibility allowed in relation to the supervisory formula approach (SFA) under Basel II as implemented, and the IRBA could be used under some conditions for "mixed pools" where the bank could determine KIRB for the predominant share but not all the exposures in the underlying pool. The Revised Proposal thus allows more flexibility than the First Proposal in application of the most advanced approach.
  • Following the Revised Proposal comment period and a second QIS, BCBS intends to publish the revised securitisation framework within an appropriate timeframe, providing enough time for implementation without grandfathering of existing positions.

Hierarchy of approaches

Under the Revised Proposal's hierarchy of approaches, for a bank to determine the risk weight of any securitisation exposure:

  • If the bank had supervisory permission and sufficient information to determine KIRB for the pool of underlying exposures, it would apply the IRBA. Banking supervisors would be allowed, however, to restrict or prohibit use of the IRBA for certain structures or transactions.5
  • If the bank could not use the IRBA, then, if permitted in the relevant jurisdiction, the bank would apply the ERBA (or, at the bank's option, the IAA for exposures to ABCP conduits).
  • If the bank was not able to apply the IRBA, the ERBA or the IAA, then it would apply the SA.
  • If the bank was not able to apply any of the IRBA, the ERBA or the IAA, or the SA, it would assign a risk weight of 1250%.

The Revised Proposal's modified risk weight methods are as follows:

Internal Ratings-Based Approach (IRBA)

The IRBA would use a formula similar to the SSFA to derive the capital requirement for a securitisation position based on KIRB for the underlying securitised exposures as well as the attachment point (A) and detachment point (D) of the securitisation position and other factors. A capital surcharge parameter (p) would determine the overall amount of capital required for positions above KIRB based on a number of variables, including tranche contractual maturity (M), loss given default (LGD), KIRB, number of loans (N), whether the position is in the most senior tranche and whether the underlying exposures are wholesale (and granular or non-granular) or retail.

Like the current SFA, the IRBA could be used only by banks having an IRB risk weight model approved by their banking supervisors, as well as information sufficient to determine Kirb for the underlying pool exposures. In calculating KIRB, banks would need to apply the minimum standards set out in the Basel II IRB framework, but could also use practices and standards currently in place, and BCBS expresses the intention that supervisors and banks take a flexible approach such that IRBA can be applied to all asset classes (other than re-securitisations). Where a bank could determine IRB parameters for the predominant share but not all of the underlying pool of exposures, it could apply the IRBA provided that it assigned a risk weight of 1250% to those exposures for which it could not apply the IRB.

External Ratings-Based Approach (ERBA)

The ERBA is a slightly simplified version of the RRBA set out in the First Proposal. Like the RRBA and the Basel II IRB ratings-based approach (RBA), it would assign risk weights to rated securitisation exposures based in part on qualifying credit rating agency (CRA) ratings. Like the RRBA and unlike the Basel II RBA, the ERBA would take into account not only the exposure's credit rating and whether the exposure was in the most senior tranche, but also the exposure's thickness (in the case of a non-senior tranche, the ratio of the tranche amount to the sum of all tranches in the securitisation) and its maturity (between one and five years as in the IRBA), and would make no distinction between granular and non-granular exposures. Under the ERBA, unlike the RRBA, due to some simplifications, rather than using a set of tables and equations, banks would use a single look-up table, together with interpolation for tranche maturities between one and five years and adjustment for thickness of non-senior tranches, to determine risk weights. Banks would use the same ERBA whether they used the SA or the IRB to determine risk weights for the underlying exposures.

BCBS has also dropped the proposal (set out in the First Proposal) to require at least two qualifying CRA ratings for ERBA. In the case of an unrated exposure that was senior to a rated exposure, a bank (whether it used the SA or the IRB for the underlying exposures) could use an inferred rating under the same conditions as in the Basel II IRB.

The lowest risk weight under the ERBA, as under the revised framework generally, would be 15%, rather than 7% as under the Basel II RBA or the controversial 20% floor under the First Proposal. As in the First Proposal, but to a lesser degree, risk weights would be higher for tranches with longer tenors (for example, 25% for a senior AAA-rated tranche with maturity of five years or more, rather than 15% for a one-year maturity under the Revised Proposal and 58% for a five-year maturity under the First Proposal). For lower-rated positions, the decrease in risk weights from the First Proposal's RRBA to the Revised Proposal's ERBA is less dramatic, but, for positions rated below investment grade and not below "CCC-", the ERBA, like RRBA, would give lower risk weights than those in the Basel II RBA.

Standardised Approach (SA)

The SA is similar to the SSFA included in the US Rules and the First Proposal. It would determine the risk weight of a securitisation exposure using a formula based on the weighted average capital charge determined under the SA for the underlying exposures (KSA), the ratio of delinquent underlying exposures to their ending balance (w), the attachment point of the securitisation exposure (at which losses would first be allocated to the exposure), its detachment point (at which the exposure would be a total loss), and a supervisory calibration parameter (p). BCBS proposes to set the parameter p at 1.0, which would result in higher capital requirements than in the US capital rules (in which p equals 0.5 for ordinary securitisation exposures and 1.5 for re-securitisation) but lower than in the First Proposal (in which p was set at 1.5 for ordinary securitisation exposures). BCBS says the SA is designed and calibrated to produce capital requirements broadly in line with those of the ERBA.6

For re-securitisation exposures, none of the other methods would apply, and capital requirements would have to be determined according to the SA except that (a) they would be based on risk weights determined under the revised securitisation framework (which would not have separate SA and IRB rules for securitisation risk weights), (b) delinquencies (w) of underlying securitisation exposures would be treated as zero, and (c) the factor p would equal 1.5 rather than 1.0.

Other changes and clarifications

The Revised Proposal also includes the following further changes and clarifications carried over from the First Proposal:

  • The IRBA and ERBA would take into account maturity (M) of a securitisation exposure based on contractual cash flows of that exposure and not according to performance of (or contractual cash flows of) the underlying assets. For a pass-through tranche, M would equal the legal final maturity (but not less than one year nor more than five years). For committed facilities related to a securitisation exposure, M would equal the term of the commitment plus the maturity of the exposure. For certain types of credit enhancement facilities that are exposed to losses only during the stated commitment period, M would be the commitment period.
  • The revised framework would eliminate certain special provisions of the Basel II securitisation framework, namely the SA look-through approach for second loss positions in ABCP programmes,7 the IRB limited look-through for ABCP liquidity facilities,8 the SA 50% conversion factor for "eligible" liquidity facilities,9 and the early amortisation provisions for revolving credit pools10 (which the framework would treat as non-securitised).
  • Write-downs and purchase discounts would be addressed by using the carrying value rather than the notional amount of an exposure as the amount to be risk-weighted, but would not be deducted directly from a bank's capital requirement.

The Revised Proposal also includes the following relatively favourable changes carried over from the First Proposal:

  • A bank's capital requirement for a retained securitisation exposure will not be higher than the amount of capital it would be required to maintain if it held all the underlying exposures directly. As under the First Proposal, this maximum capital requirement rule would apply not only (as under the Basel II IRB11) to banks using the IRB when acting as originators, sponsors or investors, but also to banks using the SA when acting as originators or sponsors (but not when acting as investors). BCBS is also considering whether to allow banks to apply the capital cap on a proportional basis, based on the largest percentage of any tranche that the bank holds in the securitisation.12
  • For a senior securitisation exposure, a bank could apply a look-through approach to determine the maximum risk weight based on the weighted average risk weight of the underlying exposures. While this look-through exists in the Basel II SA,13 under the revised framework it would apply to rated as well as unrated securitisation exposures, and whether the risk weights of the underlying exposures were calculated under the IRB or the SA.
  • Where either the capital requirements cap or the risk weight cap applies, if the risk weight resulting from the cap is lower than the 15% risk weight floor, the lower risk weight resulting from the cap should be used.
  • Any bank (whether it used the SA or the IRB to determine risk weights of underlying exposures) could use inferred ratings (credit ratings of a junior rated tranche)14 to determine the risk weight of a more senior unrated securitisation exposure.
  • An originator would no longer be required (as under the Basel II SA)15 in all cases to deduct below-investment-grade retained exposures.

Assumptions and calibration

BCBS stated that it revised the calibration and certain assumptions in the MSFA which was used to calibrate the IRBA and other approaches in the Second Proposal.16 However, apparently BCBS does not intend to publish a technical paper (as it did for the First Proposal) explaining the adjustments in detail. The adjustments are summarised as follows:

  • BCBS relaxed its initial assumption that no future margin income (excess spread) would be available to cover expected losses beyond one year. In particular, for senior tranches, the model recognises 80% of future income.17
  • BCBS introduced an intra-pool risk factor which characterises asset correlations among exposures within a pool and effectively reallocates pool capital between senior and junior tranches.18
  • BCBS changed the risk metric from expected shortfall19 back to value-at-risk, which provides greater consistency with the IRB approach.
  • To simplify the modelling, BCBS adjusted the model to assume that loan defaults in a securitisation occur at maturity of the securitisation, rather than after one year and at maturity.20

Consultation and QIS to follow

Beginning during the comment period for the Revised Proposal, BCBS will conduct a second QIS, including the collection of loan level data for securitisation positions, to assess the effects of proposed changes to calibrations in the Revised Proposal. Following the comment period and QIS, BCBS intends to publish the final revised framework in an appropriate timeframe, allowing time for implementation without grandfathering of existing positions.

Footnotes

1. BCBS, Revisions to the Basel Securitisation Framework – Consultative Document (Dec. 2013), available at http://www.bis.org/publ/bcbs269.pdf.

2. BCBS, Revisions to the Basel Securitisation Framework – Consultative Document (Dec. 2012), available at http://www.bis.org/publ/bcbs236.pdf. Our summary of the First Proposal is available at http://www.mayerbrown.com/revisions-basel-framework/.

3. BCBS, Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework – Comprehensive Version (Jun. 2006), available at http://www.bis.org/publ/bcbs128.pdf (BCBS 128); BCBS, Enhancements to the Basel II framework (Jul. 2009), available at http://www.bis.org/publ/bcbs157.pdf (BCBS 157) ; BCBS, Revisions to the Basel II market risk framework – final version (Jul. 2009), available at http://www.bis.org/publ/bcbs158.pdf (BCBS 158).

4. The US Rules were adopted by the Department of the Treasury, Office of the Comptroller of the Currency (OCC), and the Board of Governors of the Federal Reserve System (FRB), 78 Fed. Reg. 62018-62291 (Oct. 11, 2013; OCC and FRB rules published jointly, to be codified separately in CFR), available at http://www.gpo.gov/fdsys/pkg/FR-2013-10-11/pdf/2013-21653.pdf , and by the Federal Deposit Insurance Corporation (FDIC), 78 Fed. Reg. 55340-55598 (interim final rule Sep. 10, 2013), available at http://www.gpo.gov/fdsys/pkg/FR-2013-09-10/pdf/2013- 20536.pdf, with substantially similar texts. Our legal update on the securitization provisions of the US Rules is available at http://www.mayerbrown.com/Securitization-Provisions-Contained-in-Final-Rule-to-Implement-Basel-III-Regulatory-Capital-Framework-in-the-United-States-07-23-2013/.

5 BCBS 269 footnote 9.

6. BCBS 269 page 17.

7. Basel II paras. 574-75.

8. Basel II para. 639.

9. Basel II paras. 576, 579.

10. Basel II paras. 590-605.

11. Basel II para. 610.

12. BCBS 269 pages 18-19 footnote 20 and accompanying text and Question 3.

13. Basel II paras. 572-73.

14. Basel II paras. 617-18.

15. Basel II paras. 569-70.

16. BCBS 269 page 10.

17. BCBS 269 page 10 footnote 17 and accompanying text.

18. BCBS 269 page 10 footnote 18 and accompanying text.

19. See BCBS, Foundations of the Proposed Modified Supervisory Formula Approach – Working Paper No. 22 (Jan. 2013), available at http://www.bis.org/publ/bcbs_wp22.pdf.

20. Cf. WP 22 page 16 para. 44.

Originally published on 22 January 2014

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