Basel II Big Bang: Full Implementation of the CRD
2007 was a transitional year for implementation of the Capital Requirements Directive (CRD), the EU legislation that has implemented the revised framework for the International Convergence of Capital Measurement and Capital Standards (known as Basel II) on a statutory basis within EU member states.
A two-stage process for the national implementation of the CRD began with the bulk of the rules taking effect on 1 January 2007 (for optional ‘early adoption’ during 2007 and full adoption on 1 January 2008), and the remainder of the rules taking effect on 1 January 2008. Firms were able to elect to remain on the Basel I framework throughout 2007 and, in practice, the majority of firms chose to do so, while preparations for full implementation were being put in place.
Now that the brave new world of Basel II/the CRD is finally here, all affected banks, investment firms and other financial institutions across Europe (referred to as firms) are subject to the full scope of the CRD, as implemented in national legislation and supervisory rules, from 1 January 2008.
While 1 January 2008 represented the latest date for firms’ implementation of the Pillar 1 approaches to measuring credit, market and operational risks, it was also the earliest date for use of the advanced approaches to measuring both credit and operational risk. The full menu of approaches to measuring risks is now available, although regulatory approval for use of the most advanced approaches must be sought.
For credit risk, the basic Standardised Approach, which uses the external credit assessments of rating agencies, or External Credit Assessment Institutions (ECAIs) to calculate the risk-weighted exposure amount of a securitisation exposure or position is now supplemented by the alternative Internal Ratings-Based (IRB) approach. Firms must apply either the Standardised or IRB approach to securitisation exposures in accordance with the approach applied to the underlying exposure type. The IRB approach is the more attractive option since it allows a greater refinement of the calculation and resulting lower risk weights. Under the IRB approach, originating/sponsoring firms must use the Ratings-Based Approach for rated exposures and the Supervisory Formula Method for unrated exposures, or the Internal Assessment Approach for asset-backed commercial paper (ABCP) programmes. Investors or third party credit providers in ABCP programmes can also use the Supervisory Formula Method where permission has been granted by the relevant supervisor.
Significantly, the requirement for firms to have in place an operational risk strategy and calculate a capital charge for operational risk from 1 January 2008, is another key aspect of Pillar 1 and one that is expected to significantly increase the capital held by firms, albeit relative to less quantifiable risks.
Supervisory review of firms’ internal capital assessment processes and overall risk management frameworks is a key element of Basel II. The CRD contains little detail as to how this is to be achieved, however, beyond requiring national supervisors to conduct a ‘review and evaluation’ of firms’ arrangements, strategies, processes and mechanisms for risk management. Each firm must review and assess its own capital adequacy calculations and internal processes by way of an individual Internal Capital Adequacy Assessment Process (ICAAP).
In the UK, the Financial Services Authority (FSA) requires ICAAPs to be finalised and documented by 1 January 2008. The ICAAP in turn provides key input to the Supervisory Review and Evaluation Process (SREP), by which supervisors assess each firm’s ICAAP and can impose additional capital requirements where Pillar 1 levels are deemed insufficient.
Among the risks firms must identify and manage under Pillar 2 is securitisation risk. Supervisors will now examine whether ‘significant risk transfer’ has been achieved when considering whether a securitisation transaction has achieved a reduction in a firm’s capital requirements. In addition, the question of whether ‘implicit support’ has been provided to a securitisation transaction will be monitored. With strict sanctions for non-compliance (regulators can deny capital relief for failure to transfer significant risk and require a firm to hold capital against all of the underlying exposures as if they had not been securitised where implicit support is found), the potential significance of Pillar 2 should not be underestimated.
The FSA’s Integrated Regulatory Reporting (IRR) project is a revised reporting framework that has harmonised within one system the plethora of private reports UK firms must make to the FSA on a wide range of matters, from balance sheet asset-breakdowns to large exposures. Although IRR does not deal solely with reporting requirements under the CRD, certain capital-related data items must be submitted to the FSA from 1 January 2008 including those on capital adequacy and credit risk. A new standardised reporting form (FSA046) for securitisation transactions has been introduced, although the latest indications are that firms will not be required to submit these until 30 September 2008.
While a number of the requirements will be familiar to firms that were already required to report data on securitisation transactions, there has been much speculation as to whether the FSA is likely to expect even more detailed information about securitisation transactions in future. Although the FSA proposes to supplement securitisation reporting with the proactive review of offering documents and investor reports, it remains to be seen whether this will be considered sufficient in the current market conditions. The reporting of more detailed information to supervisors, even if on a confidential basis, could potentially give rise to calls for greater public disclosure under Basel II’s third pillar.
The disclosure requirements under Pillar 3 of Basel II represent a significant increase in the amount of information firms must make publicly available. National supervisors have refined the CRD’s flexible timetable, which allows firms to make their first disclosures anywhere between 2007 and 2009, and the disclosure aspects of Pillar 3 are among the key provisions in application from 1 January 2008 in many member states including the UK. Designed to improve market discipline through effective ‘qualitative’ disclosures on risk management processes and procedures and ‘quantitative’ disclosures on actual risk exposures, Pillar 3 complements the minimum capital and supervisory review rules of Pillars 1 and 2 in a ‘mutually reinforcing’ framework. Indeed, sufficient disclosure is a prerequisite for supervisory approval of firms’ use of the advanced approaches to risk measurement.
Disclosures are required to be made on at least an annual basis, and many firms are expected to co-ordinate Pillar 3 disclosure with the preparation of similar disclosures required to be made under International Financial Reporting Standards (IFRS). In fact, many IFRS disclosures will satisfy the Pillar 3 requirements. However, the CRD provides a 16-point list of disclosures for securitisation transactions (including the total amount of securitisation exposures, breakdowns by exposure type, losses recognised, retained/purchased exposures) that go beyond what is typically included in offering materials and financial statements.
Disclosure and transparency in securitisation transactions has become a key focus as a result of the recent market turmoil, which has affected the entire asset-backed securities market and not just those backed by sub-prime mortgages. The European Commission is currently engaged in discussions with one of the key securitisation industry associations, the European Securitisation Forum (ESF), as to whether the Basel II/CRD framework provides for sufficient disclosure of securitisation transactions or whether additional disclosures should be made.
The Commission’s view is that there is insufficient disclosure of firms’ securitisation activity generally (including their use of offshore special purpose vehicles), as well as a great deal of uncertainty about firms’ individual exposures to securitisation transactions. Also under debate is the question of whether any additional disclosures should be made to the public, to ‘the market’ (as distinguished from individual investors in a securitisation transaction) or simply to regulators. This is a crucial question given that selective disclosure risks falling foul of EU market abuse legislation while blanket disclosure may compromise the confidentiality of ABCP conduits. Despite the need to allow firms to fully implement Pillar 3 before any revisions are made (not least to avoid imposing any unnecessary costs on firms), what is clear is that securitisation transactions will be subject to much greater scrutiny in future.
With rating agencies under heavy criticism for the supposed failures of their ratings models and assumptions to predict the sub-prime mortgage market collapse and ensuing liquidity crisis, questions have been raised as to whether their ratings should in fact be used as the benchmarks for Basel II/CRD calculations. The EU Commission and the US Securities & Exchange Commission (SEC) have been investigating the role of rating agencies, which may lead to the introduction in Europe of SEC-style regulation, and perhaps even further extension of the US regime.
European Finance Ministers are poised to examine the issue of transparency in financial markets, so some attempt to legislate at EU level seems likely. Indeed, numerous regulatory and quasi-supervisory bodies have also provided input with suggested plans to review whether the entire structured finance industry would benefit from increased oversight. In recent weeks, the Financial Stability Forum, the International Organisation of Securities Commissions, the Institute of International Finance and even the European Central Bank have all announced plans to consider regulatory solutions to the sub-prime crisis.
The ESF is taking the lead in proposing a set of industry-led solutions that seek as a minimum to prevent the imposition of even more top-down legislation by the Commission. European securitisation market participants are expected to strongly reject the introduction of any legislation governing securitisation transactions that would attempt to standardise 27 national regimes, as having the potential to stifle competition and innovation, as well as undermine the numerous legislative frameworks for securitisation already in place across Europe.
Although the implementation of Basel II in the US is now underway, with the final US implementing rule released in November 2007, the delay to the first phase of US implementation until 2009 gives rise to another set of implications for global and cross-border institutions. Phased implementation across jurisdictions creates uncertainty for firms subject to multiple rule interpretations and implementation deadlines, as well as placing significant cost burdens upon firms and creating practical difficulties for international home/host supervisors.
Furthermore, two-tier implementation in the US, with mandatory adoption for some (essentially, the largest) banks, and optional adoption for others, is likely to distort the local playing field in the US. Any pricing advantages between EU and US firms could lead to the regulatory arbitrage that Basel II was expected to abolish, however, the competitive advantage that could be gained by European firms by being two or three years ahead of the game may be significant.
In the UK, the FSA has been hard-selling its new ‘principles-based regulation’ – essentially, the move away from detailed, prescriptive rules to more flexible principles designed to give firms scope as to how they achieve certain required outcomes, rather than regulatory box-ticking. However, creating this dichotomy between detailed rules on the one hand, such as those implementing the CRD (which have been largely copied-out from the CRD by the FSA and other national supervisors), and loosely-defined principles may leave the sort of gaps and grey areas that regulators are now trying to plug in response to the current market conditions.
There is undoubtedly a period of uncertainty to come for all firms subject to the Basel II/CRD rules as they adjust to the new regime. In addition to Basel II/CRD compliance, numerous other regulatory and legislative measures such as IFRS, the ongoing issues presented by the Market Abuse Directive and other recent and forthcoming European legislative changes (including the review of the Large Exposures regime) leave firms juggling various regulatory deadlines and potentially exposed to an uneven playing field for their EU-wide operations.
The EU Markets in Financial Instruments Directive, whose 1 November 2007 implementation date allowed it to come into force just ahead of the CRD, is arguably the single greatest change for investment firms in over a decade. Viewed in this context, the big bang of the Basel II/CRD rules is arguably just one element of a growing regulatory assault, much of which comes from previously disinterested sources and appears to be aimed squarely at the securitisation industry.
This article was originally published in Baker & McKenzie’s Securitisation & Structured Capital Markets Newsletter – Edition 5, 2008.