International bank regulators finalized changes Thursday that will greatly diminish the role of external ratings agencies in weighting the risk of securitized assets in capital requirements.
The Basel Committee on Banking Supervision's move capped years of work on how to correct the significant flaws of the 2004 Basel II securitization framework. Those rules relied on external ratings agencies and assigned "excessively low" risk weights to highly-rated securities, while assigning unnecessarily high risk weights to low-rated senior securitization exposures, according to the committee.
"The revised securitization framework addresses a number of shortcomings of the securitization market revealed in the financial crisis, and represents a significant improvement to the Basel II framework," said Basel Committee Chairman Stefan Ingves. "The Committee has developed a risk sensitive and prudent framework, while also reducing complexity and a mechanistic reliance on external ratings."
The new framework instead favors regulator-approved internal ratings, followed by external ratings and a standardized approach for less sophisticated banks. The new rules also require external rating agencies to include certain risk drivers in their assessments. Additionally, they do away with the Basel II practice of assigning risk weights depending on whether the bank is an originator or investor in the security.
Mayra Rodríguez Valladares, principal at MRV Associates, said the revised framework is among the most important products the Basel committee has produced this year, next to new liquidity rules it recently finalized. The revised framework is also consistent with the Basel committee's broader policy goals of making international standards simple and comparable from one jurisdiction to another — a policy some analysts refer to as "Basel IV."
"This is an example of putting that philosophy into practice," Valladares said. "I would say this new securitization framework is the Basel committee demonstrating that it can put into practice the idea that ratios can be simplified so the ratios can be comparable."
The next step for U.S. banks is for the Federal Reserve Board to issue its own version of the rule. The Fed's version will likely adhere fairly closely to the Basel version, Valladares said, in large part because the Fed was so instrumental in guiding the Basel move. A Fed spokesman did not immediately comment by presstime.
The Basel committee last week said in its compliance report card that the U.S. was "materially noncompliant" with the Basel securitization rules, but the Fed said in its response that it was waiting for Basel's revised framework to be complete before it issued its own rules.
The process for creating and risk-weighting securities was one of the major causes of the financial crisis. Banks created and sold mortgage-backed securities — traditionally reliable financial instruments — whose underlying mortgages were often financially shaky. Banks often held no interest in the securities themselves and so had little incentive to ensure their viability, and held little capital against the risk to the securities they did hold because external rating agencies determined that the securities were virtually risk-free. When the housing bubble burst in 2007, the securities' value plunged, causing a cascade of devaluations and lost liquidity.