What follows is the second installment of a two-part series on the potential impact of the new Basel on the structured finance market. See ASR 5/26 for Part I.
Basel's third consultative paper has been circulating since the end of April, and discussion is beginning to move from the technical to the political sphere. CP3 is currently about one-third of the way through the 90-day commentary period.
"Although the third consultative paper probably draws to an end the work that the Securitization committee has done with respects to the technical aspects of securitization, the final implementation of the new capital accord for European banks still has to come from the EU's Capital Adequacy Directive (CAD)," explained Kevin Ingram, a partner at law firm Clifford Chance.
"This is by no means the end of the story," Ingram adds. "We are expecting representations to be made by the local regulators, and a lot of political lobbying to take place on certain aspects of Basel II particularly in the context of CAD. Although I would not expect any of the more technical aspects to be changed by the securitization committee of Basel at this stage."
The decision by the U.S. regulators to apply Basel II to only a limited number of U.S. banks has, in a sense, raised challenges for the European regulators. Ingram expects there to be a substantial change of gear in the political process relating to the implementation of Basel II through the CAD, where there could be representations made by local regulators in terms of what works or does not work in the European context.
Continuing from last week's commentary (May 26), which summed up the proposed risk weightings and the idea that some tiers of ABS could be penalized, this second installment focuses on the Internal Ratings Based Approach for the capital treatment of securitization exposures: This includes the supervisory formula approach (SFA) and the ratings-based approach (RBA).
The securitization RBA is the equivalent of the foundation IRB approach for corporates. According to Alexander Batchvarov of the ABS research group at Merrill Lynch, "Securitization Ratings Based Approach is a further development of the standardized approach, meant to fine-tune the risk weightings according to credit ratings and other factors to determine the risk characteristics of a securitized pool of assets, such as its granularity (number of assets in the pool), the thickness/thinness of the respective securitization tranche (relative share in the overall capital structure)."
The Securitization Supervisory Formula Approach is used instead of the advanced IRB approach for corporates. Batchvarov notes that it is the first time the regulators allow banks to determine the value for inputs when assessing risk capital for securitization exposures. Under the SFA, the capital charge for a securitization tranche depends on five bank-supplied inputs: Kirb, or the IRB capital charge if the underlying exposures had not been securitized; the tranche's credit enhancement level; the tranches thickness; the pool's effective number of loans; and the pool's exposure weighted average loss given default. These are then applied to a formula.
Aside from the increasing complication of the capital calculation, the next question, says Batchvarov, is "Who uses which method?"
SFA is meant to be used in the case of unrated exposures by the originating banks. The investing banks are required to use the RBA unless they receive the supervisory permission to use the SFA and have access to Kirb information.
An important new feature of the RBA, argues Fitch Ratings in its report Basel II Securitization Proposals: Primer and Observations, is that three different capital charges can apply for tranches rated single-A and above, based on the granularity and thickness of the tranches. The more granular (more loans in the pool) and the thicker (larger in size), the lower the capital treatment.
Establishing a granularity adjustment for higher-rated securitization tranches under the RBA is redundant because the diversification level of the underlying pool and the number of exposures in the pool are all taken into account when assigning a rating, Fitch said.
In terms of calibrating capital levels, the highly granular set of risk weights should be applied to tranches rated single-A and above, and therefore it supports applying the lowest set of risk weights to these tranches.
Under the IRB, there is a distinction between the capital treatment of securitization exposure that is retained by the originating banks and those that are purchased by investing banks.
While there is a cap for the retained securitizations of the originating banks, the same is not true for securitization exposures purchased by investing banks.
Fitch says that levying a large premium on investing banks, over and above the amount of capital that an originating bank would be expected to hold for the same assets, is not capital-neutral.
Fitch also points out that, relative to the IRB approach, the revised standardized approach levies a higher capital requirement on most investment-grade tranches and lower capital requirements on non-investment-grade tranches. Fitch believes that this difference may lead to new gaming techniques, in which standardized banks sell high-quality tranches to IRB banks and purchase lower quality ones from IRB banks. They say that this could result in erosion of the asset quality of the revised standardized banks.
As for consequences of the new capital treatment, from a capital relief perspective, the bank originator using the IRB approach will have less incentive to securitize. Since, to a large degree, a bank can influence the assumptions used in determining its capital requirements, and because such assumptions depend on the type of exposures to be securitized, a bank can effectively achieve regulatory capital treatment with an unsecuritized pool similar to that after securitization of the same pool, Merrill's Batchvarov contends.
Batchvarov adds that regulatory capital relief is likely to be smaller for retail exposures, but attractive for special lending exposures. This suggests that there may be a decrease in residential mortgage securitization but an increase in commercial mortgage securitization. Alternatively, this may stimulate more residential whole loan portfolio sales.
From the perspective of bank investors, the gap between senior/secured corporate and non-investment grade securitization exposure risk weightings widens even further, which could create a larger disincentive for IRB banks to invest in subordinated tranches.
As Kevin Ingram at Clifford Chance notes, "Securitization will continue to exist post-Basel."
However, there are some concerns. Issues include the risk weightings applied to the more subordinated tranches; the impact on synthetics in terms of the treatment of the super-senior tranche; and the pricing of conduit transactions and revolving credits. In addition, there is the overall discrimination towards securitization in terms of risk weightings, when compared to those of corporates.
Ingram further expects that post-Basel II there will be a more focused use of conduits. Conduits will be used more for bridging and warehousing rather than for trade receivables financing, noting. "In terms of revolving deals, I don't expect there to be any significant impact on credit card transactions, which should be able to benefit from better capital treatment, although some structural changes may be needed, particularly in the U.S., " Ingram said. "However, I expect corporate revolving structures to be more penalized."
Ingram adds that, overall, it seems the Basel committee's treatment has a bias toward retail homogeneous credit, and less so for the wholesale assets where the regulators have been tougher, especially in revolving credits. More junior tranches will be impacted. It remains to be seen in which way these effects will be played out in the post-Basel landscape of 2007.