The Basel Committee, representing the Group of Ten nations, sent shivers up the spines of bankers last December when it released its Basel III proposal requiring them to hold significantly more equity to meet higher capital requirements.
A July "annex" watered down the earlier version. However, it retained elements that many financial firms have never seen before, including a liquidity ratio that would require costlier liabilities to fund assets such as ABS.
More details on the Basel Committee's revised proposal are anticipated soon, although its effective date is currently slated for several years down the road.
Of more immediate concern to U.S. financial firms is the potent mixture of domestic regulations under consideration by the Securities and Exchange Commission (SEC) and new accounting standards. Combine those with the earlier Basel II capital requirements still being implemented in the U.S., and a "perfect storm" is in the making.
One component of that storm is the statement of financial accounting standards (SFAS) 166 and 167, which can require the underlying loans of a securitization to be consolidated on a firm's balance sheet.
Another component is the risk-retention provision of the recently passed Dodd-Frank Act, which requires issuers and loan originators to retain 5% of a deal's credit risk, a provision the financial regulators are in the process of defining in more detail.
Either requirement on its own can be dealt with by financial institutions, said Matthew Jozoff, an analyst at JPMorgan Securities. Taken together, however, they could result in severe pain for many financial institutions, since the risk retention requirement could in turn require financial institutions to consolidate assets on their balance sheets and hold capital against them.
Then the more burdensome existing capital requirements imposed by Basel II as well as requirements still in the works, potentially from the Federal Deposit Insurance Corp. or even Basel III, would "just makes it worse," Jozoff said.
He added that Basel II levies the higher requirements on non-investment grade securitizations and especially "re-securitizations," a common approach used today to repackage troubled existing deals.
For example, JPMorgan noted that 'BB'-rated securities now hold a risk weighting of 200% when they are held on banks' books, resulting in a capital charge of 16%. Under Basel II, the risk weighting jumps to 425% for securitizations, to 500% for senior tranches of re-securitizations to 650% for non-senior tranches. Investment grade portions of securitizations, on the other hand, typically see their risk weightings reduced. JPMorgan anticipates credit card securitization trusts, deals where the bank services and holds a significant portion of the risk, and bank-administered conduits to be among the most likely structures to require consolidation.
Basel II, which European banks have already implemented, goes into effect in stages in the U.S. over the next three years. The Basel Committee is meeting in mid-September to hammer out final details on Basel III, including how much capital banks should hold as a buffer against risk and the effective dates for complying with the rules.
Potentially exacerbating financial institutions' capital requirements, and so limiting their ability to fund loans and other investments, are the risk-retention rules. Required by the Dodd-Frank Act and also by an SEC proposal issued for comment in January, risk retention requirements hadn't yet been formulated when the Financial Accounting Standards Board approved SFAS 166 and SFAS 167 in June 2009. Depending on how regulators design the final risk-retention language, however, it could trigger massive consolidation of assets on financial institutions' balance sheets under the new accounting standards.
"If banks have to put all these things on balance sheet, it could increase capital requirements by multiples," Jozoff said.
Under the accounting rules, which became effective for annual reporting periods starting after Nov. 15, 2009, an institution must consolidate if it has the power to significantly impact the performance of a securitization, and if it has the right to receive benefits from the deal and the obligation to absorb losses.
The latter became very apparent during the recent financial crisis, when banks propped up structured transactions, such as SIVs and CDOs, by injecting them with capital.
James Mountain, professional practice director of Deloitte & Touche's securitization practice, said the SEC's proposed revisions to Regulation AB contain a risk-retention requirement of 5%. That percentage would be a pro rata slice of a securitization, across all of its various tranches. Mountain added that the SEC will oversee most of the rule making stemming from the Dodd-Frank Act.
Dodd-Frank also requires "any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party." And it specifies "not less than 5%" for certain securitizations.
The provision mandates the appropriate regulators to issue retention-related regulations no later than 270 days after the law was enacted July 21, and then provides a one-year transition period for MBS and two years for other ABS. However, it's unclear whether the SEC's proposal, for which comments were due Aug. 2, will satisfy the provision in Dodd-Frank.
Whether the 5% slice will prompt consolidation, however, remains unclear. Mountain said it is unlikely the SEC will clarify the issue before approving the Reg AB revisions. He noted that James Kroeker, the SEC's chief accountant, said recently that retaining 5% of a transaction - and virtually nothing else - would likely keep assets off balance sheet.
Considering the issuer likely holds residual interests or other exposures related to the transaction, however, not exceeding the 5% threshold may be difficult, Mountain said. He added, "So the question is how much does that 5% add to what you already have, and does that push you over some line?"
In addition, should another credit-related blow-up occur - along the line of structured investment vehicles (SIVs) or auction-rate securities - the SEC could demand even tougher capital requirements, and sooner than expected.
Maureen Young, a financial-services partner in Bingham McCutchen's San Francisco office, noted that Dodd-Frank creates an oversight council established by the financial services regulators. Its mandate is to identify and regulate "systemically significant" financial services institutions - besides banks with $50 billion or more in assets - that will be subject to the new capital requirements.
The regulatory council, in which the SEC will play a critical role, is also authorized to develop new rules, Young said, and could do so on an interim basis. It could then give final approval of the interim rules after it completes several studies it has been authorized to conduct over the next year and a half. Those studies focus on risk-based capital standards and the riskiness of different financial instruments such as ABS.
"Another crisis or a steep decline in the economy could push the council to act quicker and in a more stringent fashion," Young said.
If so, U.S. financial institutions may find themselves facing a more restrictive set of regulations than competitors outside the country. "Dodd-Frank was mostly a reaction to the financial crisis in the U.S., and legislators spend less time worrying about how a new and tougher financial regulatory regime may impact how U.S. banks are going to compete internationally," she said.
Peter Green, an attorney at Morrison & Foerster (MoFo), said that neither Basel II or Basel III contain risk-retention requirements, although the European Union's (EU) Capital Requirements Directive, which implements the Basel II rules in the EU, will require banks to invest only in off-balance sheet transactions where the originator of the underlying loans retains 5%. That differs from the U.S. rule, which directly requires the originator to retain 5%, Green said.
He added that the EU's risk-retention rule should not in itself require assets to be consolidated for accounting purposes. However, Germany's Bundestag, or lower house of parliament, passed legislation earlier this year imposing a 10% risk-retention requirement "and assuming it comes into force, it may make it very difficult to obtain off-balance-sheet treatment for transactions subject to such rules," Green said.
Given the central role securitization played in the financial crisis, Young said, U.S. regulators will be looking keenly at the risk characteristics of different types of ABS.
"There's a good possibility that if an institution has a concentration of these assets, it will be required to maintain more risk-based capital," Young said.
Young clarified that Basel rules focus on banking supervision, while Dodd-Frank rules will apply to any financial institution deemed systemically important, including brokers and insurance companies.
As financial institutions monitor in the months ahead their regulators' decisions regarding risk retention and capital, Basel III is stepping toward a final set of rules, including a paper expected in late September or October that will detail changes laid out in the annex.
Young said the Basel Committee's proposal as released in December 2009 was very stringent, taking a "countercyclical" approach to capital that aims to bolster capital even in strong economic times.
It also introduces the concepts of a net stable funding ratio to evaluate banks' access to liquidity over the long term and a shorter-term liquidity coverage ratio, as well as a leverage ratio. Needless to say, the banking industry was highly critical of the proposal, especially in light of ongoing economic and financial hurdles.
In response to concerns about a prolonged recession, the July annex deferred the effective dates of the net stable funding and leverage ratios to 2018, raising doubts about whether they will ever come to fruition.
The annex also weakens several provisions of the December proposal, such as one that restricted capital largely to common equity. Currently, certain hybrid instruments that hold features of both debt and equity are permitted as capital.
Rather than eliminating all non-equity assets from capital, the July version proposes to include them subject to a cap, such as no more than 15% of the bank's capital.
Despite some changes, MoFo noted, the annex maintains the Basel III proposal's original thrust in terms of more stringent capital and liquidity requirements. Although Basel III does not directly address securitization, its tougher requirements are bound to dampen banks' overall activities, including ABS.
For example, Basel III's liquidity coverage ratio, expected to become effective in two years, aims to encourage banks to have enough liquidity for at least a 30-day period of market distress.
Young said that during the financial crisis, regulators often took over banks not because they were critically undercapitalized but because their capital was impaired and their short-term funding sources dried up.
The liquidity coverage ratio prompts banks to extend their currently short-term liabilities used to fund illiquid assets - typically deposits, repurchase agreements and the like - to at least 30 days in maturity, to prevent a sudden run.
But by moving further out the yield curve, banks will have to pay more for those longer-term liabilities, which JPMorgan "conservatively" estimated at $5 trillion to $7 trillion. For example, moving from overnight funding to a three-month advance from the Federal Home Loan Banks would cost an additional 60 basis points, the bank says in a July report.
Higher-cost funding for illiquid assets will either tighten banks margins or push them to invest in higher-paying assets. Either way, "it's going to decrease banks' appetite for assets, whether securitizations or other assets, because they'll have to extend their liabilities out the curve," Jozoff said.