A Summary of The 2001 Basel Working Paper on Asset Securitisations

On October 12, the Basel Committee on Banking Supervision released a Working Paper on Asset Securitisations. The Working Paper supplements the Consultative Document on Asset Securitisation that the Committee published as part of its 500+ page consultative package on the proposed new Basel capital accord in January, 2001. You can download the papers at http://www.bis.org. The Committee has requested comments from interested parties by November 15, 2001. We have summarized the new Working Paper below.

The Committee consists 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. In 1988, the Committee published an Accord entitled International Convergence of Capital Measurement and Capital Standards. That accord formed the basis for the risk-based capital standards adopted by bank regulators in the U.S. and other member countries.

In June 1999, the Committee announced that it had decided to introduce a new capital adequacy framework to replace the 1988 Accord and sought views on the proposed new approaches. The January consultative package then provided interested constituencies with the first detailed look at the proposed new framework.

Despite its length, the January consultative package did not fully flesh out some important aspects of the new framework. The new Working Paper addresses two such aspects:

1. the application of an internal ratings-based capital approach to banks’ securitization activities; and
2. a risk-sensitive approach to synthetic securitizations.

The short timeframe for comments on the Working Paper reflects the Committee’s desire to quickly publish a second draft of the overall framework, after receiving feedback on the Working Paper and other related publications. Though delayed a year from the schedule announced in January, the Committee’s schedule is still ambitious: approval of a new Accord by the Committee by the end of 2002, and implementation in member nations by 2005.

The Working Paper draws heavily on three elements of the framework proposed in the January package.

• First, the proposal would replace the very broad risk categories used in the original Accord with a standardized approach that assigns particular corporate, bank or sovereign borrowers to varying risk weights based upon their credit ratings from well-recognized independent rating organizations (such as Fitch, Moody’s and S&P). The standardized approach is meant to be more risk sensitive than the current Accord, but is also meant as a stepping stone to the even greater risk sensitivity that the Committee expects from the other approach described next.
• Second, subject to overall regulatory approval of their methods, banks could determine appropriate capital levels based upon an internal ratings-based approach (or "IRB"). The January consultative paper described a proposed IRB approach to corporate, retail and some other exposure categories, but not securitization. The Working Paper now supplements the January package with a relatively detailed description of a securitization IRB. Both the January package and the Working Paper explicitly anticipate that the new framework will be designed to give banks incentives to move from the standardized approach to the IRB.
• Third, along with the more refined differentiation among obligor credit risks (based on external or internal ratings), the proposal gives credit for a wider variety of credit risk mitigation techniques, including credit derivatives.

In general, required capital under the proposed securitization IRB will be calculated based on the following considerations:

• whether a position has been externally rated (discussed further in Part A below),
• whether an "inferred rating" can be assigned to a position (discussed further in Part B below),
• whether a bank has sufficient information to calculate required capital for an unrated position in a non-revolving securitization using the proposed supervisory formula (discussed further in Part C below),
• whether a bank is an originating bank in a revolving securitization (discussed further in Part D below), and
• whether a bank is providing a liquidity commitment (discussed further in Part E below).

We have attached as Schedule 1 to this memorandum a copy of a flow chart decision tree included in the Working Paper to provide an overview of the application of the proposed IRB approach. We discuss the elements highlighted in that chart in more detail below.

The general rule under the proposed IRB is that if a position is externally rated, the required capital will be assigned based on that external rating. This emphasis on external ratings may seem surprising in the context of an internal ratings-based approach. The explanation for this apparent paradox seems to be that the Committee (a) is attracted to the objectivity and standardization that external ratings provide, and (b) believes that in most cases even IRB banks will not be able to apply the true IRB capital calculation (the supervisory formula described below) to securitization positions relating to assets originated and packaged by third parties. So under the "internal ratings based" approach to securitization it seems likely that generally only originating banks will set capital for securitization positions based on their own internal rating systems. Banks that invest in third party asset-backed securities will mostly set capital based on a grid driven by external ratings which is similar to the grid used in the standardized approach but will probably yield lower capital requirements than the standardized approach.

The exceptions to the general rule that external ratings trump internal ones are residual interests and retained subordinated tranches of a securitization. Originating banks must deduct these positions from capital (regardless of whether an external rating has been assigned) unless the bank qualifies to use the supervisory formula discussed in Part C below.

Table 1 on the next page (taken from the Working Paper) sets forth an example of the proposed methodology for assigning risk weights to externally rated positions.

Table 1 shows the proposed treatment for long-term external ratings. The Committee has indicated that it intends to develop a similar analysis for short-term external ratings. The far right column , the proposed risk weight for each rating category, is derived by multiplying the risk weight applicable to a comparable corporate exposure set forth in the middle column times the "ABS scaling factor" for the applicable rating category set forth in second column from the right.

Three points on the proposed methodology:

• Table 1 is not meant to replace the assignment of risk weights based on external ratings under the standardized approach for banks that do not qualify for an IRB approach. Rather, it is an alternative means of calculating required capital once a bank moves into the IRB Approach.
• The Committee has indicated that it is reexamining the proposed risk weights for corporate exposures which serve as the base for determining risk weights for securitizations and expect revisions to lower risk weights for corporate exposures, particularly those below investment-grade, which in turn would lead to lower risk weights for securitizations.
• The Committee believes that it is necessary to apply an ABS scaling factor to corporate risk weights in order to arrive at the corresponding ABS risk weight to address what they believe to be increased risks in lower tranches of securitizations. However, they indicate that they are considering either (x) a proposal that would not require an ABS scaling factor (under the theory that similarly rated exposures involve the same credit risk) or (y) modifying the proposed ABS scaling factors without eliminating them entirely.

Under the proposed IRB, an "inferred rating" can be applied to an unrated tranche of a securitization if there is a qualifying externally rated tranche that is subordinated to such unrated tranche and all other requirements described in the next paragraph are satisfied. If all requirements are satisfied, a bank would be permitted to assign the risk weight applicable to the externally rated subordinated tranche to the unrated more senior tranche. The inferred rating assigned to the unrated tranche would be tied throughout its term to the rating of the more subordinate position. If the subordinate position were downgraded the inferred rating for the unrated tranche would be correspondingly downgraded.

The requirements for assigning an "inferred rating" in a securitization are as follows:

• Banks may only rely on an inferred rating if the unrated tranche is part of a securitization transaction that contains externally rated tranches.
• The securitization must be subject to market discipline through the issuance of a significant amount of externally rated exposures to the capital market which are subordinate in all respects to the unrated position in question. The credit risk associated with the externally rated positions must be transferred to more than one counterparty.
• The exposures issued to the market must be rated by at least two external rating agencies.
• There must be an externally rated position subordinate in all respects to the unrated tranche which has a maturity equal to or longer than that of the unrated tranche.

The Committee has developed a supervisory formula that can be used by qualifying banks to calculate required capital for unrated exposures (whether retained by an originating bank or purchased by a third party bank) in non-revolving securitizations.

This approach would be applicable only if neither an external rating nor an inferred rating can be applied to determine regulatory capital for a position. An exception to this rule applies to positions held by originating banks that fall below "K_IRB" (as discussed below).

Under the supervisory formula approach, a bank would be required to calculate a reference capital level on the entire underlying pool of assets. This reference capital level (also referred to as "K_IRB") is the amount of capital that a bank would be required to hold against the pool if it were on its balance sheet. The amount of capital required against a position depends upon where the position falls in relation to K_IRB.

A bank would be required to deduct from capital all positions held by it that absorb credit losses between zero and K_IRB. For example, if the reference capital level is 3% on a $100 pool of assets, then the securitized risk positions that absorb any of the first $3 of loss would be deducted from regulatory capital. Banks that have purchased risk positions between zero and K_IRB would be permitted to rely on external ratings or inferred ratings when available to lower the capital requirement, but absent such ratings would also have to deduct these positions from capital. Originating banks are not given the option of using an external or inferred rating to set capital for retained positions that absorb losses between zero and K_IRB.

Originating banks would also be required to deduct from capital any capitalized excess spread and other forms of capitalized credit enhancements, including I/O strips, spread accounts, cash collateral accounts and similar assets that function as credit enhancements. Additionally, a bank would be required to treat the capitalized credit enhancement as a first loss position falling within the adjusted K_IRB when applying the supervisory formula.

For unrated tranches t of risk weights based on the subordination level of the tranche and its relative size to thethat exceed K_IRB, the Committee has specified a formula that produces a continuous se overall structure. The contemplated formula will be calibrated to ensure that the capital requirement does not fall precipitously against the riskier tranches just beyond the reference capital level, so as to avoid cliff effects. Schedule 2 to this memorandum illustrates the supervisory formula graphically.

Embedded in the supervisory formula is a premium factor of $ , which results in a capital charge equal to $ *K_IRB in the aggregate against tranches exceeding the reference capital threshold. For example, assume that: $ = 20%; the reference capital level is $3 on a $100 securitized asset pool; and the originating bank retains a $3.50 risk position. The bank would be required to hold a total of $3.34 on its $3.50 position. This is because the first $3 would be deducted from regulatory capital and, applying the supervisory formula, an additional $0.34 would be required on the $0.50 that exceeds the reference capital level. We refer you to Annexes 1 and 2 of the Working Paper which describe the supervisory formula in detail and provide several helpful hypotheticals to show the application of the formula to securitizations.

In addition to the premium factor, a capital floor is proposed, but not set forth, for inclusion in the supervisory formula approach. The floor is meant to ensure that banks hold some regulatory capital even against exposures of the highest quality as they continue to involve some credit risks. The Committee intends to calibrate the floor following consultation with the industry on the proposals set forth in the Working Paper.

Finally, the Committee has indicated that it is considering the possibility of capping the amount of capital required to be held by originating banks to K_IRB. Under the proposal as drafted, to the extent an originating bank held a retained interest exceeding K_IRB, its regulatory capital requirement would be greater using the supervisory formula than if the bank had not securitized the underlying assets.

In addition to satisfying the requirements for using the IRB approach generally, a bank will also have to satisfy its regulators that it has sufficient information available to determine the reference capital level for an asset type prior to being permitted to use the supervisory formula approach. Based on the January consultative package, this means that a bank will have to be able to perform a bottom-up analysis based on internal ratings of each individual obligor in the pool in order to qualify for the supervisory approach. Although this might be a difficult standard for any bank other than the originator to meet, we understand, based on discussions with the Committee’s staff, that an alternative IRB approach for asset-based financing (including some unrated securitizations) is being considered that might allow for a top-down or pool wide approach in determining required capital.

IRB Banks not qualified to use the supervisory formula for a particular unrated securitization position would be required to deduct the position from capital.

4. Originating Banks in Revolving Securitizations.

The Committee indicates that discussions with internationally-active banks that have sponsored revolving period securitizations suggest that some maintain roughly the same amount of capital that would have been required had the assets not been securitized. Thus, the Committee is considering adopting an approach (similar to the supervisory formula) which would require an originating bank to hold capital in an amount equal to the sum of (i) that which it would have held had it not securitized the assets plus (ii) the amount of any capitalized credit enhancement.

5. Liquidity Providers to Asset-Backed Commercial Paper Conduits.

The Working Paper does not set forth a definitive proposal for capital requirements under an IRB for banks providing liquidity to asset-backed commercial paper conduits. The three options that the Committee is considering are as follows:

• applying the supervisory formula to liquidity facilities, apparently assuming that the facility were fully drawn,
• treating liquidity facilities as commitments and using a not yet specified supervisory assumption as to the amount of the commitment that would be drawn at the time of any default, and
• allowing banks to assign an internal rating to second loss pool-specific liquidity facilities that are in a position above K_IRB.

Under any scenario, the Committee indicates that to qualify for liquidity treatment, a commitment must satisfy the minimum requirements set forth in the standardized approach. Those requirements are as follows:

• the facility must be an arms-length transaction provided to the SPV at a market rate and must be subject to a bank’s normal credit and approval process;
• the SPV must have a clear right to select third party providers of the facility;
• the facility must have a fixed amount and duration and not provide for recourse to the provider beyond the contractual obligations;
• the facility must specify and limit the circumstances under which it can be drawn and cannot be used to provide credit support, to cover losses or to act as a permanent revolving facility;

• payment to providers under the facility must not be subordinate to payment rights of investors and should not be subject to waiver or deferral; and
• the facility must include a reasonable asset test to prevent funding against deteriorated or defaulted assets or include a term requiring the termination or reduction of the facility for a specified decline in asset quality.

III. Synthetic Securitizations

"Synthetic securitizations" are transactions in which banks use credit derivatives (such as credit linked notes and credit default swaps) to tranche the credit risk of a specified pool of assets and transfer one or more tranches to third parties. Each tranche may either be "funded," meaning that the sponsoring bank receives cash upfront from the risk purchaser and can look to that cash to absorb losses on the specified assets, or "unfunded," meaning that the risk purchaser provides only a promise to make payments in the future to absorb losses when they occur. Each tranche may also either receive one or more explicit credit ratings from recognized rating agencies or not.

The Working Paper describes both standardized and IRB approaches to synthetic securitizations. The Working Paper also identifies a "supervisory concern" with synthetic securitizations: "the relative ease with which they permit banks to transfer the credit risk associated with higher quality assets while remaining exposed to those of higher risk."

For both the standardized approach and the IRB, the Working Paper focuses primarily on a paradigm "partially funded" transaction, in which a sponsoring bank:

• tranches the credit risk of a specified pool of assets;
• retains the most subordinated, or first loss, tranche;
• sells one or more mezzanine tranches to third party investors; and
• either (a) retains the most senior tranche, which is typically unrated, or (b) sells the most senior risk position to a third party on an unfunded basis.

The table below summarizes the treatment proposed in the Working Paper for each of these typical tranches under both the standardized approach and the IRB.

The "operational requirements" that a bank must satisfy to use either the standardized or IRB approach described above are as follows:

1. The transaction shall comply with the requirements set forth in paragraphs 117 through 127 of the New Basel Capital Accord of the January 2001 consultative package. These requirements include robust risk management, direct, explicit, unconditional and irrevocable protection, and other requirements specific to credit derivatives.
2. The synthetic securitisation must be subject to market discipline through the issuance of a significant amount of externally rated exposures to the capital markets, meaning that the credit risk must be transferred to more than one counterparty.
3. The exposures issued to the market must be rated by a minimum of two eligible ECAIs.
4. Retained senior unrated tranches will not benefit from capital relief unless external protection is obtained either from a recognised protection provider as defined in paragraph 129 of the New Basel Capital Accord, or is in the form of recognised collateral (see paragraphs 68 through 79 of the New Basel Capital Accord).
5. Where the transaction is conducted with credit linked notes, the Committee is considering the minimum requirements for recognizing the risk transference.
6. The remaining maturity of the subordinated position must be equal to longer than that of the unrated senior position.
7. The treatment of maturity mismatch is another area where the Committee is continuing its work.
8. Sponsoring banks must not reassume any credit risk associated with positions issued to the market from the investors through the issuance of another credit derivative or any other means.
9. The structure should not contain terms or conditions that would limit the credit protection provided against the underlying assets, such as:



• Credit performance contingent clauses, e.g. early amortization features, that would minimise the amount of explicit credit enhancements provided;

• Clauses to remove assets from the reference portfolio in order to improve the credit quality of the pool, including substitution due to re-negotiation of the terms of the original contract;

• An increase in the retained first loss in reference portfolio, which would increase the size of the first loss position after inception of the transaction; and

• Any other terms in the contract that would lead to a reduction in the degree of credit protection provided by investors in the synthetic securitization.

10. A legal opinion is required to ensure that the synthetic securitization structure transfers the risk for consideration by the banking supervisor and market participants.
11. With respect to disclosure, banks would be expected to satisfy the requirements pertaining to asset securitization. See the September 2001 Working Paper on Pillar 3 – Market Discipline for a discussion of the disclosure requirements proposed for asset securitizations.

If you have any questions with regard to the above memorandum, please feel free to contact Mary Barry (312/701-8460), Rob Hugi (312/701-7121), Jason Kravitt (212/506-2622 or 312/701-7015) or Mark Nicolaides (London, 207 246 6232).

Mayer, Brown & Platt Memoranda provide comments on new developments and issues of interest to our clients and friends. These memoranda do not purport to provide comprehensive coverage of the subject matter and are not intended to provide legal advice. Readers should seek specific legal advice before taking any action with regard to the matters covered.

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