Capital requirements under the new bank capital rules released by U.S. regulators will be computed based on three formulas, although U.S. banks are expected to mostly gravitate to only one.
At a conference call early this week, Bank of America Merrill Lynch analysts said that most of these institutions will likely use the simplified supervisory formula approach (SSFA), which incorporates an exposure's attachment and detachment points as well as underlying collateral performance instead of the external ratings that the Basel frameworks use.
The other two approaches are the supervisory formula approach (SFA), which is applicable primarily to positions that already use it, BofA Merrill analysts explained. They added that although the SFA formula is quite "straightforward", the data needed for the computations can be hard to get. The third one is a new weighting factor that is based on collateral performance and that allows banks to adjust capital requirements dynamically.
The problem is, as ABS strategist Theresa O’Neill said on the call, that data for some ABS asset classes might not be available to use under any of these three formulas.
She pointed to rate reduction bonds as an example, which she said is one of the highest-quality ABS assets out there, but do not have delinquency data even on the servicer reports. She said one has to look at regulatory Web sites to get information on the true-up mechanisms in these deals. The banks "are probably going to be stuck with dollar-to-dollar capital" since they will not be able to fit this asset class into any of the formulas, O'Neill noted.
The new regulations apply parts of the Basel capital rules except that Dodd-Frank replaced the
ratings-based approach for securitized products with a formula-based approach. Under the ratings-based approach, banks depended on credit ratings to determine quality. On the other hand, the formula-based approach balances operational liability and risk sensitivity to help determine an asset's credit quality.
“One of the challenges [of the formula-based approach] is that ratings, while there are a lot of issues with ratings, have a lot of value beyond a handful of quantitative measures," said Steve Friedman, a managing director at Enterprise Capital Management. "So that, unfortunately, will get lost in the shuffle to some extent and will have implications.”
He also explained that although the new rules will initially apply to the larger banks and the trading books as of January 1, 2012, they will also incorporate the proposed Basel III rules in the near future. This will have a significant impact on banking books of both larger and smaller banks, which indicates that applying the formula-based approach is bound to cause widespread changes for the entire market.
BofA Merill analysts said in their securitization alert on the new bank rules that generally the broad implications of the regulations is that higher capital will be needed for bonds with lower attachment points even if thee tranches are actually backed by high-quality product.
However, MBS/ABS strategist Chris Flanagan believes that ABS will ultimately not be detrimentally impacted in the longer term.
“These are high-quality assets, but we believe that most banks look at asset-backed securities as defensive positions," he said. "We would expect some spreads to be impacted initially, but over the longer term, we expect liquidity and spreads to move back to where they currently stand.”