Basel II Implications for Structured Finance
Basel II is the new regulatory framework that will apply to banks worldwide from 2007. The Capital Requirements Directive is the legal text that will give force to Basel II in the EU and on which discussions should start very soon at the European Parliament. Basel I was instrumental in the development of securitisation and more generally of structured finance. Under Basel I, securitisation had become a classic technique that allowed banks to decrease the amount of regulatory capital for some assets on their balance sheets, while not reducing the economic capital (designed to capture the true economic risks associated with those assets) to the same extent. As Basel II aims to better align regulatory capital with economic capital, one of the key drivers of securitisation may disappear and one should legitimately question whether securitisation and structured finance still make sense in the context of Basel II.
One major change introduced by Basel II compared with Basel I deals with the introduction of new approaches to determining regulatory capital charges. Capital charges for market risk will not change, whereas the capital charges for credit risk and operational risk will. Operational risk is a new type of risk that was not considered under Basel I and refers to the risk of direct losses resulting from fraud, technology failures, legal risks or trade settlement errors, among other things.
In contrast to the situation under Basel I, credit risk capital charges will become much more risk-sensitive as they will be linked to credit ratings. Banks will either use public ratings published by rating agencies under the simplest approach or the standardised approach or they will use their own internal ratings under the more advanced internal ratings-based (IRB) approaches.
Credit charges for securitisation exposures are, however, treated somewhat differently from corporate loans or bonds; rather more conservatively, in fact. Under the standardised approach, risk weights are much more conservative for non-investment grade or unrated exposures. For instance, a securitisation originator retaining a Ba2 tranche should “deduct” the amount of the tranche from its regulatory capital: this is the “one-for-one” rule (one euro of capital for one euro of exposure) which corresponds to a risk weight of 1/8 per cent which equals1250 per cent. In comparison, a bank investor buying a Ba2 corporate bond should apply a risk weight of 100 per cent, corresponding to a capital requirement of 8 per cent of the amount of their investment.
The same difference in treatment for securitisation exposures also applies to banks using the IRB approaches. Indeed, Basel II does not recognise internal ratings determined by banks for securitisation exposures. Referring to the “internal ratings-based” approach in the case of securitisation exposures is therefore somewhat misleading. Instead of using internal ratings, IRB banks may only use public ratings by rating agencies for rated tranches (ratings-based approach – RBA), or a regulatory formula (supervisory formula) for unrated tranches. However, to be perfectly fair, recognition of internal assessments does occur in the very specific case of liquidity lines or credit enhancements extended by sponsor banks to ABCP conduits.
Under the RBA, there are three different sets of risk weightings (linking risk weightings and public ratings) that may be used depending on the granularity of the underlying pool of assets and the seniority of the considered tranche. The lowest risk weights will be achieved for senior tranches backed by granular pools (residential mortgages or retail assets).
What are the likely implications of these new rules for securitisation issuers and investors? Basel II has in fact already had an impact on issuers, with banks having been active in setting up special task forces to adapt their IT infrastructures and processes. The implementation costs of Basel II have been estimated at between €100m and €200m for each large bank.
Beyond this transitional phase, the key beneficiaries of Basel II will be those banks that hold a majority of high-grade or retail assets, while those banks that hold a majority of low-grade assets are likely to lose out as a result of the changes. According to the findings of the Quantitative Impact Study that the Basel Committee asked banks to complete in 2003, more credit capital will be needed globally for banks’ lending to sovereigns, small banks and corporates, or for specialised lending (project finance) exposures. Less credit capital will be needed for portfolios of SMEs, residential mortgages, retail assets and credit cards. Those banks that specialise in consumer lending are therefore more likely to benefit from Basel II than those with a different focus.
To what use will the beneficiaries of Basel II put their gain in regulatory capital? They may use the extra cushion to reduce their capital (through share buybacks, for instance), boost loan origination, develop new activities, or even buy or merge with those entities that suffer from the Basel II changes, depending on market conditions. Ultimately, Basel II may well encourage banking consolidation or even cross-border mergers in Europe.
Coming back to securitisation, it still seems to make sense for banks to securitise low-grade assets to ensure that regulatory capital remains at an acceptable level and to shift risks off their balance sheets. Nonetheless, banks may be less incentivised to securitise high-grade or retail assets as these assets will attract a lower level of regulatory capital if they retain them on the balance sheet. They may, however, use them as collateral for on-balance-sheet financings, such as covered bonds, structured covered bonds, or other types of collateralised issuances or secured fundings.
Basel II is likely to have an impact on other structured finance instruments, namely credit derivatives and synthetic securitisation, (structured) covered bonds or ABCP programmes. The current Basel II treatment for credit derivatives is somewhat conservative. For both single-name and portfolio credit derivatives, Basel II capital charges are not determined by reference to a double default of the underlying reference obligor or portfolio and the derivative counterparty, but look solely to the counterparty.
In the case of synthetic securitisation, special purpose vehicles (SPVs) are generally not recognised as eligible protection providers, even in a case where they are fully collateralised. These current conservative rules for credit derivatives and synthetic securitisation may force issuers to restructure current or future deals or even to stop issuance. Note, however, that the Basel Committee and the International Organisation of Securities Commissions (IOSCO) are jointly working on refining these rules and other trading book issues. Current Basel II rules may well change very soon.
Basel II may also impact covered bonds, structured or plain covered bonds. Strictly speaking, their regulatory treatment is not directly addressed within the Basel II accord, but through the Capital Requirements Directive in Europe. Basel II risk weights for (structured) covered bonds will be determined by reference to the bank issuing the covered bonds, rather than by reference to the legal or structural protection of the covered bonds themselves. These rules will on balance benefit highly rated banks and may reduce the incentives to issue structured covered bonds with dynamic structural protections.
Beyond that, some banks, especially residential mortgage banks, will have to decide which way to go for funding: issue covered bonds or securitise? There seems to be no clear advantage for one solution or the other from a pure Basel II perspective, although on a case-by-case basis one may be preferred to another. The choice will certainly be driven by other considerations: spread and cost of funding of covered bonds versus Aaa MBS; liquidity; and the need to maintain different funding sources. Regulation may also influence the issuers’ decision, for instance, the FSA in the UK has adopted a soft rule asking UK banks to provide justification in the event that they issue covered bonds for more than 4 per cent of their assets.
ABCP programmes are also likely to be impacted by Basel II, with potentially fewer bonds being stored in ABCP conduits. The margin derived from this activity will be squeezed by the potentially increasing costs of liquidity lines extended by sponsor banks (more regulatory capital will be needed for those liquidity lines) and the potentially decreasing spreads on the (investment-grade) bonds stored in those conduits (less regulatory capital will be required for those bonds). In addition, ABCP conduits may purchase more trade receivables: Basel II will somewhat increase regulatory capital for IRB banks lending to small and medium-sized enterprises (SMEs), which may translate into increased funding costs for those SMEs. Securitising trade receivables through ABCP programmes may therefore prove an attractive source of funding for them.
Basel II will also lead to the restructuring of liquidity lines provided by ABCP sponsor banks. Pure liquidity lines or alternative forms of liquidity lines relying on market mechanism will be put in place to achieve the lowest risk weights. In the event that this proves impossible, liquidity lines may conversely be simplified to cover other risks than pure liquidity risk (typically credit risk of the underlying assets). Finally, Basel II may well lead to more fully supported ABCP programmes.
Bank investors will also be impacted by Basel II and will have to take a fresh look at their investment strategies for securitisation. Which regulatory approach should they apply – standardised or IRB? And why? Which securities should they buy, hold and sell? What will be the changes in the investor base, the liquidity, the spreads? Many such questions need to be addressed by bank investors.
One particular issue, that of securitisation tranches rated Ba and below, is worth examining. Such tranches attract very high risk weightings for bank investors. As a consequence, a bank investor may well decide not to buy these tranches and they may end up being sold outside the Basel II sphere. Conversely, a bank investor may well accumulate those tranches, repackage them as a CDO of Ba-rated tranches, sell the senior CDO tranche and keep the equity tranche. This equity tranche will be deducted from its capital, but the economics might turn to be highly profitable.
Regulatory arbitrages may well also develop for securitisation exposures. Banks running the standardised approach are in a stronger position than banks running the IRB approach when holding Ba-rated tranches, while the contrary is the case when holding senior tranches. In this context, why not contemplate “regulatory swaps” between an IRB bank and a standardised bank whereby each bank exchanges the total returns on the tranches they hold for the other bank? However, it is not crystal clear how such swaps would be addressed by Basel II, if addressed at all.
Basel II is a complex accord that will undoubtedly reshape the structured finance market in the years to come. Globally speaking, regulatory capital arbitrage is unlikely to be a key driver of structured finance issuance, as may have been the case under Basel I. Other elements such as the diversification of funding sources and, increasingly, the cost of funding are more likely to become key structured finance drivers. Finally, Basel II should be somewhat good news for issuers, investors and other market participants. Structured finance and, above all, those structured finance techniques which allow issuers to achieve Aaa ratings appear to be here to stay. Basel II should create new opportunities for all players, provided they anticipate the changes and adapt to them.