For years, U.S. banks, and especially the largest ones, have dreaded the seemingly inevitable arrival of new and more burdensome regulatory capital requirements. U.S. banking regulators' proposal to revamp those requirements, issued in mid-June, should dispel many of their fears, although the proposal is likely to result in extra work for U.S. banks and may put them at a disadvantage to global competitors in the ABS market.

Comments on the 700-page proposal, which is split into three parts, are due by Sept. 7. While few industry comments have been filed, early observers are pleasantly surprised by the proposal's language.

"This is far more rational than either the initial formula the regulators proposed last year, or the ratings-based approach a while ago," said Laurie Goodman, head of Amherst Securities Group's RMBS strategy team.

Under the new formula, capital charges are based on the riskiest of the underlying loans in a securitization, the credit enhancement of the bonds and the portion of the deal the bond takes up relative to other deal tranches. Goodman said many higher-rated bonds in a securitization will face more punitive capital charges, and many lower-rated bonds will face less capital charges.

Focusing on CMBS, Deutsche Bank Securities research analysts David Zhou and Harris Trifon noted that risk weightings will be higher for all but the most subordinated bonds. In fact, the risk weighting for a 'BB'-rated CMBS increases to more than 600% under the proposal from the 200% imposed by the Basel I-based rules in use today, the widest risk-weighting difference between the two regulatory regimes (see chart on next page).

As a result, the capital charges for 'AAA'-rated CMBS originated since 2010 will average $447.43 million under current rules and $449.23 million under the proposal. As the rating drops, the proposal's capital charges increase to several times the current Basel I charges. The risk weightings for both sets of rules converge for 'B'-rated bonds at $3,181.15, and for lower-rated bonds the Basel I risk weightings start to exceed those under the proposal.

"Although the magnitude of the risk-weighting increases is severe for many legacy securities, the actual amount of additional capital that will need to be held is manageable given the size of the market," the analysts noted in a July 25 report.

The proposal's lesser capital charges for lower-rated ABS should result in banks shifting their investments to those securities and provide them with a significant pick up in yield for investing in those bonds, Goodman said.

In an analysis of the proposed rules published June 15, she noted three positive impacts. For one, they move banks away from relying on a ratings-based approach to determine regulatory risk capital and thus their reliance on the rating agencies, which have been criticized for their role in the recent financial crisis. In addition, the proposed rule would enable banks to hold "well-enhanced" securities with reasonable capital charges, without worrying about rating agency actions. And third, because the proposal imposes risk weightings for bonds rated less than 'BB' that are significantly less than the 100% risk weighting under the ratings-based approach, a bank selloff of those securities with large ratings-based capital charges is far less likely.

"I think this proposal removes that fear, which is very, very important," Goodman said, adding that such a selloff could drive down RMBS prices, even though it may make sense to hold those securities from an economic risk/return standpoint.

 Not a Slam Dunk

Nevertheless, there are bound to be challenges, some perhaps significant, that are buried deep in the proposal. For that reason, the American Bankers Association and the Financial Services Roundtable were quick to request a comment-period extension on June 22.

"These proposals would be the most material changes to U.S. capital standards since 1989 and will have significant immediate and ongoing impact on the nature of financial services in the United States...bankers need sufficient time to evaluate the operational complexities of the proposals and understand their significant impact," the two trade groups stated in a joint letter.

Some complications have already emerged. Alok Sinha, principal and leader of Deloitte & Touche's banking and securities practice, said there are a "couple of pretty significant implications" from the banking regulators' proposal. For one, as currently written, it would ramp up banks' compliance and monitoring obligations for activity in their trading books to levels resembling those in their banking book. That is a potentially difficult requirement given the likelihood of the short-term and more frequent nature of those trades.

"Banks typically don't have the same underlying compliance and monitoring processes on their trading book side, so putting those mechanisms in place would be challenging," Sinha said.

He added that increasing requirements for the trading book may be an attempt to reduce the regulatory capital arbitrage between holding the same assets in the trading book versus the banking book. However, if the change results in less trading book activity, "there may be lower liquidity, and it could be harder to price these transactions."

Sinha explained that the banking regulators' proposal is broadly aligned with the approach to Basel III implementation that regulators outside the U.S. are taking, although certain requirements emanating from Dodd-Frank impose some noteworthy and potentially problematic differences. For instance, the Dodd-Frank proposal imposes a 20% risk weighting floor, a requirement of Dodd-Frank as well as the Basel I rules, even for very highly rated securities that may otherwise warrant lower risk weightings. The proposal also disallows the use of ratings in determining capital requirements.

Basel III essentially retains the amended Basel II capital rules, commonly known as Basel 2.5. European regulators have been faster to adopt this version, which does not impose a floor and allows the use of third-party ratings in capital calculations.

As a result, the largest U.S. banks will have to calculate their capital requirements based on both the "standardized" and the "advanced" approaches - laid out respectively in the second and third parts of the proposal - to determine minimum regulatory capital requirements. Dodd-Frank then requires them to take the higher of the two.

"So Basel I effectively never goes away for U.S. banks," Sinha said, adding that running parallel regulatory-capital calculations will impose additional operational costs on U.S. banks and potentially higher capital costs as well. "If, over time, the actual capital requirements calculated using Basel 2.5 drop below the floor from Basel I or Basel III standardized approach, because the portfolio's risk is coming down, the bank's capital requirement won't be able to drop below that floor. So it could put them at a competitive disadvantage."

As a result of these changes, banks will almost certainly have to restructure their portfolios, and that will impact the prices of different ABS assets. BradHintz, an equity research analyst at Sanford Bernstein, said that as the pricing of assets holding higher regulatory capital weightings changes, the economics of investing in these assets will also change. However, banks will likely hold onto some low-return businesses to service clients who are also active in higher-return businesses.

It is still too early to forecast changes in market participants' behavior as a result of the proposed rules, Hintz said. "As prices change in the market place and weak competitors drop out of the business, there will almost certainly be a second and third round of adjustments," he said.

Nevertheless, the initial impact of proposed provisions that are statutorily mandated by Dodd-Frank is fairly clear. On the plus side, while the proposed rules do not necessarily lower capital requirements, they'll make ABS portfolios more manageable than the ratings-based approach because portfolio managers will no longer have to ascertain the perceptions of the rating agencies about a security, Amherst Securities noted. Instead, they will be able to focus more on its future performance.

The 20% floor, however, could be a disadvantage for the largest U.S. banks, since they are competing against financial institutions from outside the U.S. that will use the ratings-based approach and have no such floor. Those competitors may be able to hold less capital against assets with the same risk weightings.

 Collins Amendment

Another potentially problematic provision required by Dodd-Frank is referred to as the "Collins Amendment," named after Senator Susan Collins (R-Me.). The provision requires that capital requirements derived from the advanced approach are not less than the standardized approach - essentially the Basel I requirements - or quantitatively lower than the requirements in effect for the modified Basel I requirements for insured depository institutions when the bill was enacted.

Consequently, the largest banks must calculate their capital requirements using both the standardized and advanced approaches to determine which approach requires the greater amount of capital. If the more risk-sensitive advanced approach generates a lower requirement, then the amount of capital required by the standardized approach applies. The banks must opt for the capital required by the advanced approach if its tally is higher.

Jason Kravitt, a partner at Mayer Brown, said that to make the comparison between the two approaches, banks must calculate them from the "ground up" to all their assets. The Collins Amendment then requires them to compare the totals for regulatory purposes. However, banks must also choose the appropriate method for day-to-day business decisions, whether it's pursuing a certain deal or buying a new line of business.

"The dilemma for management is, How do we decide if we're going to do a deal ... which capital rule do we look at to decide whether it's too much capital or the right amount'?" Kravitt said.

One argument is that the two approaches should be compared when making a decision in every transaction, and in making the decision the method requiring the most capital should be chosen, Kravitt said. However, since the advanced approach is more risk-sensitive, it is arguably a more rational way to price products and make other business decisions, since it is a more accurate measure of risk and could result in a more efficient use of capital.

"Each bank will have to weigh the plusses and minuses of the two approaches," Kravitt said. It is likely that banks required to use the advanced approach will opt to utilize that method when making business decisions if early indications that the two approaches yield similar amounts prove to be the case. Kravitt explained that the fact that the advanced approach for securitization has the same 20% floor as the standardized approach reinforces the likelihood of this outcome. He added that in any case most banks will keep extra capital as a buffer in the event the approaches do yield different outcomes.

"If the standardized approach comes out a bit higher, it probably won't be that much higher, and adding some extra capital should take care of it," Kravitt said.

Higher Costs

Running parallel capital calculations in perpetuity for each of a bank's lines of business, portfolios or individual assets is bound to result in material operational costs. Although smaller banking institutions will use only the standardized approach, the biggest U.S. banks, which hold a majority of banks' assets in the U.S., are likely to see the cost of calculating regulatory capital remain at elevated levels.

Having more impact will be increases in the cost of regulatory capital and the risk-based capital charges assigned to both traditional and non-traditional banking activities. Economic capital has traditionally been the dominant factor for banks when evaluating whether to pursue transactions or make other decisions, such as when to grant loans or what investments to make, said Scott Stengel, a partner at King & Spalding and outside counsel for the American Securitization Forum's regulatory capital and liquidity committee.

"It is clear that while in the past economic capital received more emphasis than regulatory capital in a credit committee's decision making, looking ahead regulatory capital is going to occupy an equal if not more important position," Stengel said. "In addition, management will be focusing more and more on what revenues a business unit will be able to generate in order to justify the regulatory cost of capital associated with it."

According to Amherst Securities, there are other reasons the proposal could cause market participants some heartache, including the fact that it doesn't account for deal features such as overcollateralization, excess spread or payment priority, all of which could provide capital relief. However, Goodman and her colleagues wrote that they are sympathetic to regulators seeking to incorporate "complex structural issues in a simple formula."

Amherst also criticized the proposal for not taking into account the purchase price of a security. For example, if the security is purchased at a discount that effectively provides a cushion to absorb losses, that discount "should be counted as a credit enhancement and provide capital relief," the report said.

A third contention noted by Amherst is the proposal's harsh capital treatment of re-securitizations, which comprise portions of existing securitizations. Simple "re-REMICs" often have cash flows that could have been "created in the context or the original deal" and consequently deserve the same capital treatment, the brokerage firm noted.

"You're actually improving the credit quality of these securities through re-securitization, and there's no reason to penalize them as much as the proposal does," Goodman said.




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