The new year has rung in the much-anticipated regulatory capital changes under the new Basel II accord, with the first wave of European banks having already implemented the standardized approach. A second wave of banks that would adopt the internal ratings-based approach will follow at the start of 2008. Initial reaction to the implementation process indicates that everything is going well. However, despite the efforts of many regulators and market participants, there are still a few of discrepancies that need to be worked out.

For banks in the European Union, much of the guidelines were codified into law through the Capital Requirements Directive (CRD). Securitization comes up prominently, having its own section for regulatory framework. One of the bigger issues still under discussion is the U.K. regulator Financial Service Authority's (FSA) approach toward asset substitution. According to Mark Nicolaides, a partner from the London office of Latham & Watkins, the FSA is concerned that asset substitution would constitute prohibited implicit support of a transaction.

If regulators had their way, securitization structures would have to do away with asset substitution. Securitization without substitution means prepayments would be passed through to investors, causing costs to go up. Asset substitution occurs frequently during the revolving period of any securitization, particularly to replace underlying assets that have been prepaid. Furthermore, rating agencies mandate that asset substitution must either maintain or improve a transaction's performance criteria. Nicolaides said industry players have suggested that a more suitable solution would be to permit asset substitution any time a transaction is not in default, if the performance criteria are at an agreed upon level well-cushioned from default, or so long as the substitution does not improve the transaction's performance criteria by more than an agreed upon margin. Adding an implicit recourse provision would allow for asset substitution but would also give regulators the room to deal with banks on a case-by-case basis, thus preventing any misuse of the provision.

Liquidity facility exposure

Another issue that remains unresolved is the exposure value for liquidity facilities. Generally, the amount of liquidity that can be drawn is the lesser of the maximum unused commitment and the outstanding face value of commercial paper. Some regulators have said that banks must hold capital against their maximum commitment amount, even though they may not be able to draw it down, Nicolaides said. For example, if a bank's commitment is 100% but the exposure is only 80%, there is no way that the bank's liquidity facility would go over 80%. Nicolaides said that it is possible to resolve this issue simply by drafting appropriate language for the transaction's liquidity agreements, clarifying that the bank's exposure for capital purposes would be the outstanding commercial paper amount, if it were less than the commitment amount.

Also up for discussion is whether swaps are to be considered as banking book or trading book positions in securitization transactions. The CRD and the FSA allow banks to hold swaps with ABS vehicles, which results in less capital where justified. Swaps with securitization can be held in a bank's trading book, but they are still considered a securitization position and are required to hold a counterparty risk charge. Regulators have taken the position that this charge should be determined on the basis of the position of the swap in the waterfall. According to Nicolaides, the counterparty risk charge will be lower for an SPE if the swap is high in the waterfall. But though this position might be more favorable, it will be difficult to implement: In most securitization transactions, certain swap termination payments are lower in the waterfall than the payments made while the swap is ongoing.

The FSA and other European regulators, Nicolaides said, continue to maintain an open dialogue with market participants by encouraging players to submit opinions on implementation concepts. The intention is to make the rules more consistent, and players say that with initial implementation, the market is clearly moving in that direction already.

"I don't think we will ever see a uniform implementation of the rules - some differences will exist but it won't affect the way the banks do business," Nicolaides said. "I would guess regulators will do their best to create convergence where possible and stick to the rules."

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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