Basel II: A Cul-de-sac for Securitization?
In the era of synthetic securitization, credit derivatives and regulatory capital arbitrage, came the second accord from the Basel Committee in 2001, the Basel II Accord (see also link to 6130). The first Consultative Paper (CP1) issued in 1999 did not talk about securitization except in the context of regulatory capital arbitrage. The second Consultative Paper (CP2, January 2001) talked about certain broad guidelines for capital adequacy for securitization. In CP2, there were no detailed formulations for calculating regulatory capital for securitization.
The third Consultative Paper (CP3, March 2003) incorporated fundamental models of credit risk in securitization tranches. It unearthed a realization that rating alone cannot capture the true credit risk of securitization. It also led to a better understanding of relative risks between senior and junior tranches.
There are basically two frameworks for securitization – the Standardized approach and the Internal Ratings Based (IRB) approach. The Standardized approach will measure credit risk in a standardized manner, supported by external credit assessment. Banks that apply the Standardized approach to credit risk, for the type of underlying exposures securitized, must also use the Standardized approach under the securitization framework.
For institutions that will use the Standardized Approach, Basel II Accord proposes a change to the risk weights of the different tranches. Earlier, for the investing banks, the risk weight of any security was 100 per cent, even if it was very safe. Under the new Accord the tranche will have ratings and the risk weight will be lower for high-grade tranches. It will be as low as 20 per cent for issues rated AAA to AA- and 50 per cent for those rated A+ to A-. Lower grade securities will attract higher risk weight, BB+ to BB-, weighted at 150 per cent and issues rated at or below B+ deducted from capital. This will make the high-grade papers more attractive to investors. Spreads on lower grade securities, therefore, will have to increase to compensate for the additional capital cost of holding investments of this kind.
The alternative available to banks that use the IRB approach for underlying exposure is to apply the IRB approach for securitization also. The IRB approach includes two potential approaches:
To be eligible for the IRB, a bank will be required to meet certain minimum disclosure and get explicit approval from the banking supervisors. The variables, which the bank would have to measure to get the regulatory capital, are: probability of default (PD), loss given default (LGD) and the exposure at default (EAD). All IRB banks will have to estimate the PD using their own models.
The securitization charges for IRB banks depend on whether the position held has a credit rating from a recognized credit rating agency. If the securitization tranches have an external credit rating, IRB banks must use RBA. For unrated securitization exposures, IRB banks must use the SFA approach. In the SFA approach, the formula for calculating the capital charge is provided by the Basel II committee and is based on structure and risk associated with the underlying assets. The formulation is very complex and is dependent on various attributes, such as the IRB charges on the underlying pool of assets (also known as KIRB under the Basel II securitization rules), the level of enhancement supporting the tranche, the thickness or relative size of the tranche, and the granularity or number of exposures in the pool.
The regulator gives an incentive for implementing IRB. Capital charges for senior tranches are generally set higher in the standardized approach as compared to IRB. For example, an AA rated tranche will require more capital if held by a standardized bank than by an IRB bank. But to implement the IRB approach, banks would have to employ very sophisticated models for risk measurement.
When BankOne and First Union Bank found out that their securitized credit card receivables were defaulting they saw it as a dent to their reputation. To save their reputation they replenished the SPV with good quality receivables. Although the banks did not hold any responsibility for the receivables, they had a ‘moral obligation’ to save the SPV. The banks had been enjoying, in the meanwhile, the exemption in regulatory capital due to this off-balance sheet activity. It is to be noted that the real risk was not transferred; the banks were still carrying it.
Regulators found that it was not a one-off phenomenon but a rather widespread one. Various banks that had securitized their assets were chipping in money to ensure that the quality of the assets did not deteriorate. Any downgrade in their asset quality would have affected their ability to raise money through securitization in the market.
Basel II deals with this problem with an iron fist. Any explicit or implicit support from the bank for securitizations in which it has no legal obligation is considered a breach of the utmost kind. The Basel II Accord has laid down harsh punishments for any such transgression. The bank stands to lose all the capital relief that it has gained for a particular vehicle if it supports it beyond its contractual obligations. A second offence will attract the exemption of all capital relief on any of the securitization done by the bank for a minimum period, as decided by the regulator. This will remove the implicit support that a bank’s securities enjoyed vis-à-vis another financial institution’s securities. The highly rated securities will not be affected by the harsh strictures of Basel II because they will not need support. But the spreads and the volatilities in low-rated securities should rise.
Securitization has grown into a huge market over the last two decades and the risk associated with securitization is by no means less important. Securitization tranches whether issued by a bank or used in investment are covered by Basel II norms. The current Basel II Accord covers securitization in its various forms, whether it is traditional or synthetic. The formulation of rules in Basel II for securitization has brought out the true drivers of credit risk in securitization tranches. The differences between securitization tranches and corporate bonds are now better understood in the light of new models developed in the period between CP2 and CP3. The important risk drivers that have been identified are the credit quality, asset correlation, thickness of tranche, rating of tranche and the underlying pool’s granularity. The challenge ahead is developing a framework that captures everything and yet is not too complex.