New Capital Treatment for Securitisations
Snappily entitled “International Convergence of Capital Measurement and Capital Standards, A Revised Framework”, the volume runs to nearly 250 pages and represents the end of a long process involving a large number of commentators and market participants that will now set the approach to capital for international banks and financial institutions. Timed to coincide with the Basel II process, the European Commission has also issued draft amendments to the existing Capital Adequacy Directive and Banking Consolidation Directive that will implement the Basel II rules. The ‘re-cast’ directives (the “Directives”) are intended to take effect by the end of 2006 and will have the force of law for all affected financial institutions in all 25 member states of the EU. The Directives will implement the Basel II rules by revising and supplementing the text of the original directives, thus fitting the new rules into an already familiar framework and enabling the changes to be made without the need for a self standing amending directive.
Previous issues of International Securities Quarterly have focused specifically on the Basel II rules, however, publication of the Directives represents the first real opportunity to examine exactly how the new rules will apply to affected financial institutions in Europe. This article focuses on the framework of the Directives and the method used to implement the Basel II rules, as they will apply to securitisation transactions. References in this article to “Chapters”, “Sections”, “Articles” and “Annexes” are to the Chapters, Sections, Articles and Annexes of the Directives.
By way of overview, the Directives deal comprehensively with the requirements for each of the Standardised Approach (Articles 78-83) and the Internal Ratings Based (IRB) Approach (Articles 84-89) to credit risk, together with the detailed rules (Articles 81-83 and Annex VI) for the recognition of “External Credit Assessment Institutions” (ECAIs), ie, the internationally recognised rating agencies, and the mapping of their credit assessments (for which read ratings) to the numbered credit quality steps contained in the risk weight tables used for assessing the risk weights applicable to exposures, in particular securitisation exposures (see below). The use of terms that do not correspond to the various rating symbols used by the rating agencies neatly sidesteps the need to reflect each rating agency’s individual annotations and should make the mapping process generic and fair.
Whilst the Standardised Approach is based on the framework contained in the existing Basel Accord, there are changes to applicable risk weights generally (eg, residential mortgages will attract a 35 per cent risk weight) as well as the ability to use external ratings to assign risk weights where appropriate. The IRB Approach allows institutions to use their own calculations for certain risk factors applicable to exposures and provision is made for roll-out on a transitional basis across business lines. The method for calculating operational risk, credit risk mitigation, monitoring, sanction and disclosure requirements are also dealt with in detail in the Directives.
Section 4 (Articles 102 and 105) and Annex X set out the way in which capital charges will be allocated for operational risk in the Basic Indicator and Advanced Measurement Approaches. In summary, the Basic Indicator is a set percentage (15 per cent) of the rolling average of the institution’s past three years’ income which will be applied to a further percentage figure applicable to relevant business lines (eg, services relating to underwriting carry an 18 per cent percentage capital requirement). The Advanced Measurement Approach allows for internally supplied calculations, following rigorous testing by the competent authority.
Section 3, subsection 4 (Articles 94 to 101) and Annex IX in the Directives contain the primary principles in relation to securitisations which each competent authority will be required to incorporate into its supervisory principles (eg, for the UK Financial Services Authority the rules will be contained in the Prudential Sourcebook for Banks).
An originator or sponsor may not provide support to a securitisation “beyond its contractual obligations” (note the term used is slightly different from that used in the Basel II rules which is “implicit support”). The sanctions for breach of this rule remain the same. At a minimum, the offending institution will be obliged to take the exposures back on its balance sheet and also disclose publicly the fact that it has done so.
The minimum requirements for excluding securitised exposures from the calculation of risk weighted exposure/expected loss amounts for securitisation and synthetic securitisations are set out in Annex IX, Part 2. These largely follow the equivalent Basel II requirements (ensuring clear transfer of credit risk and requirements for a special purpose entity transferee), but have been made clearer in some areas (eg, it is clarified that a legal opinion confirming enforceability of the credit protection in all relevant jurisdictions is required for the purposes of satisfying the basic synthetic securitisation criteria).
The use of eligible ECAIs is formalised in Articles 80 to 83, and Annex IX Part 3 sets out the requirements for recognition of an eligible ECAI for the purpose of assessing securitisation exposures in the Standardised or IRB Approach, as well as the methodology to be employed for mapping the credit assessment of an eligible ECAI to the credit quality steps set out in the relevant tables (see further below).
The calculation of risk weighted exposure amounts relating to securitisation positions under the Standardised Approach for long term and short term credit assessments will be made according to the tables below:
| Credit quality step | 1 | 2 | 3 | 4 | 5 and below |
|---|---|---|---|---|---|
| Risk weight | 20% | 50% | 100% | 350% | 1250% |
| Credit quality step | 1 | 2 | 3 | All other credit assessments |
|---|---|---|---|---|
| Risk weight | 20% | 50% | 100% | 1250% |
A credit institution may nominate one or more ECAIs for the purpose of making the above calculations (Annex IX, part 3, paragraph 2), but where two are used, the less favourable credit assessment will apply. Second loss or better facilities to assetbacked commercial paper (ABCP) programmes will attract a risk weighting of the greater of (i) 100 per cent and (ii) the highest of the risk weights that would be applied if the exposures were held by the institution.
As expected in the Standardised Approach, unrated eligible liquidity facilities meeting the specific conditions identified (set out in Annex IX, Part 4, paragraph 14 of the Directives and essentially designed to exclude disguised credit enhancement facilities) will attract a credit conversion factor of 20 per cent or 50 per cent to be applied to the nominal amount of the liquidity facility depending on whether maturities are one year or less or more than one year respectively. The risk weight to be applied is the highest risk weight which would be applicable under general principles as if the liquidity provider were itself holding the relevant exposure (ranking from 100 per cent to 0 per cent depending upon the exposure concerned).
The treatment of securitisations under the IRB approach is somewhat diverse, although the minimum risk weight across the various methods permitted within the IRB Approach remains at the 7 per cent or minimum 56 basis points capital charge (ie, 7 per cent x 8 per cent minimum capital).
In summary, where a securitisation position is rated (or the conditions for an inferred rating are satisfied – basically that the rated/reference position is subordinate to the unrated position in respect of which an inferred rating is sought) then the Rating Based Method should be utilised.
Under the Ratings Based Method, the risk weighted exposure amount of a securitisation position is calculated by applying the risk weight associated with the credit quality step to the related exposure value, as shown in the tables below.
| Credit Quality Step (CQS) | Risk weight | ||
|---|---|---|---|
| A | B | C | |
| CQS 1 | 7% | 12% | 20% |
| CQS 2 | 8% | 15% | 25% |
| CQS 3 | 10% | 18% | 35% |
| CQS 4 | 12% | 20% | 35% |
| CQS 5 | 20% | 35% | 35% |
| CQS 6 | 35% | 50% | 50% |
| CQS 7 | 60% | 75% | 75% |
| CQS 8 | 100% | 100% | 100% |
| CQS 9 | 250% | 250% | 250% |
| CQS 10 | 425% | 425% | 425% |
| CQS 11 | 650% | 650% | 650% |
| Below CQS 11 | 1250% | 1250% | 1250% |
| Credit Quality Step (CQS) | Risk weight | ||
|---|---|---|---|
| A | B | C | |
| CQS 1 | 7% | 12% | 20% |
| CQS 2 | 12% | 20% | 35% |
| CQS 3 | 60% | 75% | 75% |
| All other credit assessments | 1250% | 1250% | 1250% |
In each of the tables, column “A” represents the position in the most senior tranche of a securitisation and column “C” must be utilised where the effective number of exposures securitised is less than six, multiple exposures to one obligor being treated as one exposure for these purposes. In all other situations, column “B” sets the applicable risk weight.
For unrated positions, either the Supervisory Formula Method (the much maligned KIRB formula) or, for ABCP programmes, the Internal Assessment Approach (IAA), introduced by the paper on the treatment of securitisation released by the Basel Committee in January 2004, is to be used. The Supervisory Formula method may only be used by credit institutions who are not originators or sponsors (eg, investors or third party credit providers) with the approval of the relevant competent authority. An institution intending to apply the IAA for ABCP programmes will also require approval of the relevant competent authority which will then allow a “derived rating” to be applied to the relevant positions. However, the requirements which must be fulfilled (set out in Annex IX, paragraphs 42 and 43) are rigorous and require detailed reviews, assessments and monitoring of the portfolio of the ABCP conduit and minimum underwriting and eligibility standards to be pre-approved. Where the resultant derived rating at the inception of the securitisation is investment grade or better, it shall be considered the same as an eligible credit assessment by an eligible ECAI for the purposes of calculating risk weighted exposure amounts.
Chapter 5 (Articles 145 to 149) sets out the general requirements for institutions to publish and disclose detailed information about their business on an annual, or potentially more frequent, basis. Specific technical criteria on disclosure
are set out in Annex XII and securitisation-specific items in paragraph 13 of the Annex. Thus reporting institutions will be required to set out in publicly available materials key data relating to the institution’s securitisation activities, including the total amount of securitisation exposures, breakdowns by exposure type, losses recognised etc., which will in turn require internal reporting systems to be set up to capture all of this data.
With the Basel II rules and the text of the Directives now finalised, the consultation process is officially over. Institutions expecting to continue to use securitisation for the purposes of their own balance sheet management and to advise on or arrange transactions for other regulated institutions will need to familiarise themselves with the new requirements sooner rather than later. Since the IAA allowing for “derived ratings” applicable to ABCP conduit programmes is only available to banks which have received approval generally to use the IRB Approach, and then only to those who have further satisfied the technical requirements which are pre-conditions to the use of this approach, conduit sponsors would be well advised to ensure that processes are either already in hand or soon will be in order to obtain such approval. The amount of data required to be collated in order to take advantage of this approach is detailed and will require some time and resources to produce. Since the alternative, in the absence of an approval to apply the Supervisory Formula or the IAA to a relevant securitisation exposure, could lead to a risk weight of 1250 per cent being attributed to the relevant exposure, there is now a very real incentive to be prepared.