BASEL II

respect to losers as regulatory capital burdens increase. Basel II losers include lower-rated A tax on , corporate and ABS exposures, OECD sovereign exposures rated below AA- (although might hold them for liquidity purposes anyway), non-bank equities, and non-core, high operating cost activities such as asset management.

Among its many effects on banks’ regulatory capital, Basel II Portfolio rebalancing might prove to be an additional capital tax on securitization Depending on the extent to which lending margins change to align themselves with rom January 1 2010, Basel II will be in standardized banks, capital requirements will revised regulatory capital burdens, Basel II full effect. The new rules are scheduled vary from a 20% weight for the most might also prompt banks to rebalance their to come into effect for all EU banks creditworthy exposures (that is, €1.60 of portfolios by shedding losers and keeping on January 1 2007. One year later, capital for each €100 of exposure) to a 150% winners. Fadditional rules for advanced banks will come risk weight for the least creditworthy Banks might be more willing to retain into effect, with a two-year transition period. exposures (€12 of capital for each €100 of high-quality corporate exposures on their These rules will make highly-rated asset classes exposure). Securitization exposures held by balance sheets because their capital costs more popular, could lead to the restructuring of standardized banks will vary from a 20% risk would be lower than the cost of securitizing many conduits and will act as an additional weight for the most creditworthy exposures to them while retaining the capital-heavy lower capital tax on securitization. a 1,250% risk weight for unrated positions tranches. Banks might also be less willing to Basel II will align bank regulatory capital and other positions such as unearned interest- extend credit to lower-quality borrowers. It is requirements with the risk of exposure, only strips (effectively €100 of capital for possible that the lending market for small to reducing the amount of regulatory arbitrage each €100 of exposure). medium-sized enterprises (SMEs) will be that occurred under through Compared with standardized banks, IRB tiered: standardized banks would extend transactions that did not change a bank’s risk banks will have lower capital requirements for credit on a relationship basis to SMEs while profile but reduced its capital requirements. the most creditworthy exposures but higher IRB banks would extend credit on a credit Basel II will, for the first time, permit banks requirements for the least creditworthy score basis. to calculate required capital on the basis of an exposures. The most creditworthy non- Lastly, Basel II could trigger divestitures of exposure’s rating. Advanced banks (those securitization exposures will require as little as regulatory capital-intensive businesses such as using their own, internal ratings-based (IRB) €0.15 of capital for each €100 of exposure, insurance and asset management. approach rather than the standard risk and the most creditworthy securitization weightings) will also be permitted to calculate exposures will require as little as €0.48 of Effects on securitization capital based on internal determinations of capital for each €100 of exposure. At the As long as liquidity covers 100% of the assets risk for all exposures except securitization. other end of the spectrum, a risky exposure of an asset-backed commercial paper conduit, Securitization exposures will be subject to such as unlisted equities might require up to and the conduit holds assets rated AA- or separate rules. Banks taking the standardized €40 of capital for each €100 of exposure better, Basel II eliminates the regulatory capital approach will generally determine capital on depending on the model used, and an unrated benefits that an IRB bank sponsor obtains by the basis of ratings for most securitization junior securitization position to which operating such a conduit. If the conduit’s assets exposures. IRB banks can also determine neither the supervisory formula nor the are rated lower than AA-, a conduit might still capital using this ratings-based approach, but internal assessments approach applies will provide regulatory capital benefits depending they will also have access to a special formula require €100 of capital for each €100 of on the nature of the assets and how the conduit for securitization exposures known as the exposure. is structured. supervisory formula and an internal ratings For most conduits, the IRB bank sponsor capital calculation method known as the Winners and losers must hold at least 56 basis points of capital internal assessments approach. Basel II is expected to create classes of winners against its liquidity support for the conduit, In each case, under Basel II a bank will and losers. Some asset classes will gain and more capital for its programme-wide assign a risk weight to each of its exposures popularity with bank investors because the credit enhancement support. One conduit and must hold 8% capital against all of its new rules impose lighter capital burdens than sponsor can achieve a capital charge of 48 risk-weighted assets. In the case of off- Basel I, and some asset classes will lose favour basis points as a result of the EU’s proposed balance-sheet exposures (including all because they are subject to heavier capital 6% risk weight for super-senior positions commitments), the bank must assign a credit burdens. ranking senior to a AAA-rated tranche, but conversion factor (CCF) to the exposure. The Spread tightening is expected to occur with other conduits do not qualify for this CCF converts an unfunded commitment into respect to winners as regulatory capital preferential treatment. a funded exposure for regulatory capital burdens fall. Basel II winners will include However, depending upon the credit calculation. For example, a CCF of 100% securitization exposures rated BBB and means that the bank must hold regulatory higher, corporate exposures rated BBB or capital against the unfunded commitment as higher, and non-OECD sovereign exposures if it were fully funded. rated higher than BB+. For non-securitization positions held by Spread widening is expected to occur with

“Such a broad attack on asset substitution would throw many active securitization markets into disarray”

18 IFLR/December 2006 www.iflr.com BASEL II

in jurisdictions that have more favourable capital rules, while at the same time applying Unfortunately, there are now almost as to their regulators for changes to their own “ more burdensome rules. This assumption certainly depends on the many views of what significant means as magnitude of the differences in national rules. there are regulators It is also possible that, due to differences in ” capital rules, some banks might become market leaders in certain products. Given that a thorough understanding of the national quality of a conduit’s assets, an IRB bank available to IRB banks from January 1 2010. rules is required to know just how big the might even have lower capital charges (15 But these floors could create opportunities national differences are, this issue is one to basis points if the assets are corporate that will not exist after the transition period. watch. exposures held on balance sheet). The bank It is expected that Basel II capital will have the same 56 basis point capital requirements will be lower than the floor, Risk transfer charge anyway, if the conduit holds only the requiring banks to hold more capital than The Basel II rules require an originator to most creditworthy securitization exposures they need given their portfolios. As a result, it transfer significant to third parties before (such as ABS). So in some cases banks will might make sense for banks to invest in moving from the non-securitization rules to need more capital to securitize assets than to higher-yielding assets during the transition, as the securitization rules. During the Basel II hold them on balance sheet. the cost of incremental capital will be zero. negotiations, the meaning of the term Bank sponsors are expected to continue to significant risk transfer was not clear, except in operate conduits for reasons other than Late adoption Canada (where rules already contained such a regulatory capital arbitrage, but it also seems The industry has raised a number of requirement), whose regulators said that it was likely that there will be a series of conduit complaints about various aspects of the Basel II designed to enable them to ignore sham restructurings over the next few years, as well rules for a number of years, both with the Basel transactions in which no risk was transferred. as an exploration of structured investment Committee and with the EU and member state Most securitization transactions executed vehicles as the preferred mechanism for regulators during implementation. by originators for funding purposes transfer obtaining arbitrage profits. Restructurings With the deadline for implementation only only catastrophic risk (that is, unexpected will focus on reducing liquidity requirements, months away, a surprising number of losses that are highly remote). Most of these such as finding liquidity in the assets rather jurisdictions within the EU have not yet would satisfy the Canadian than a capital-heavy bank commitment, published their proposed capital rules. These analysis, however, because the catastrophic placing liquidity with non-banks, providing regulators have presumably been coordinating risk transferred is certainly not insignificant liquidity with instruments that attract lower with the banks they regulate, but distinctions and so not a sham. capital requirements (such as issuer extendible between national rules will be important (see Unfortunately, there are now almost as commercial paper, investor extendible below) and can only be evaluated once the many views of what significant means as there commercial paper, repos, or total return swaps rules are publicly available. are regulators. The UK Financial Services held in the trading book), and structuring Authority has taken the policy position that liquidity as an operating risk exposure rather National inconsistencies an originator will only obtain regulatory than a exposure (as two conduits Basel II will not be uniformly implemented capital relief to the extent of risks transferred. have done already). from country to country, despite the intensive The FSA is developing an approach that will Banks could also explore the development efforts of many regulators and market permit banks to assess the risks transferred in of market-disruption-only liquidity, which participants. Over 140 provisions in the Basel a particular transaction on some sensible basis attracts a lower 20% credit conversion factor II Accord permit national regulators the (such as comparing weighted interest rates of for IRB banks. However, market-disruption discretion to adopt different rules, involving tranches sold to those retained). The FSA will liquidity must also qualify as eligible liquidity, some material decisions. Neither the EU in its also permit a safe harbour for any originator which involves restrictions that a bank might Capital Requirements Directive nor CEBS, the that deducts its retained positions. not be willing to undertake in exchange for association of EU bank regulators, eliminated The Dutch National Bank in its early draft the capital relief. more than a handful of these discretions. rules proposed another approach, prohibiting If, as seems likely, banks regulated in originators from retaining anything other Transition opportunity different jurisdictions will have different than the AAA-rated positions. The German Artificial capital floors are imposed on IRB capital charges for the same exposures, the regulator adopted a rule somewhere in banks during the initial three years of Basel II. question becomes whether those variations between, requiring that at least half of the An IRB bank must hold at least 95% of the will cause a difference in bank behaviour. It mezzanine positions be sold to third parties. capital it would have held under Basel I during seems most likely that banks in jurisdictions The net result of these rules is an additional the first year of Basel II implementation, 90% that impose higher capital charges for capital tax on securitization. This is in the second year and 80% in the third year. particular products will make every effort to regrettable, but it appears unavoidable. The full benefits of Basel II will only be price those products competitively with banks Maturity mismatch One of the real sleeper issues during Basel II The Swiss town of Basel, which has given its name to two accords on implementation is the severe haircut provided capital adequacy and so drawn the anger of banks worldwide under the Basel II rules for credit risk mitigation (CRM) instruments whose maturities are shorter than those of the underlying exposure they support. Industry has argued that a three-year credit swap written to support a seven-year leveraged loan can be drawn upon until the day it expires and, accordingly, no haircut is justified. Unfortunately, this argument seems to have fallen on deaf ears, as neither the EU nor national regulators seem willing to change the www.iflr.com IFLR/December 2006 19 BASEL II rules. The market might react to this can be replaced with an identical asset, development by pricing and writing evergreen particularly in cases such as CMBS or CDO options into contracts, leaving the protection transactions, where pools are limited and purchaser to decide the most cost-effective way assets are not homogenous. On the other of managing its positions. hand, in most cases substituting one asset for “National another simply means that the investors’ risks Overlapping rules have changed, not necessarily improved, even inconsistencies Not all of Basel II is set in stone. Even at this where performance criteria have been late date, a handful of areas are under maintained or improved. As a result, asset could mean that discussion between industry participants and substitutions should be permitted at any time the regulators. a transaction is not in default or if the some banks become Banks quickly realized that more than one performance criteria are more than an agreed set of the Basel II rules might apply to an cushion away from default, or if the market leaders in exposure in certain situations. This typically substitution does not improve the arises in transactions involving a tranched transaction’s performance criteria by more certain products exposure to an underlying financial asset, than an agreed margin. ” opening the possibility that both the securitization rules and the specialized Liquidity exposure value lending rules apply. For example, should the Sponsors of asset-backed commercial paper inverse order of creditworthiness, assigning specialized lending rules or the securitization conduits and third party banks provide PWCE a 1,250% risk weight (that is, full rules apply to a B exposure to a commercial liquidity to those conduits. Generally, the deduction) for all exposures rated less than property once the A exposure has been amount of liquidity that can be drawn is the BB-, a 200% risk weight for all exposures securitized? lesser of the maximum unused commitment rated BB+ to BB-, and a 100% risk weight for So far, regulators seem willing to permit and the outstanding face amount of all investment grade exposures. banks to apply the specialized lending rules in commercial paper. However, some regulators At worst, rating the PWCE (which would these cases. The US regulators in their have suggested that banks hold capital against probably be investment grade) would recently proposed rules distinguish between their entire undrawn commitment amount eliminate any need for allocation. exposures where all or substantially all of the even though it might not, at a given time, be underlying assets are financial assets (which capable of being drawn. The US regulators Trading book treatment will be treated under the securitization rules) have, however, implicitly accepted this lesser-of Whether a position should be held in the and those that do not satisfy that test (which formulation in their recent proposals. banking book or the trading book (with the will be treated under the relevant specialized It might be possible to resolve this issue trading book’s more favourable capital lending rules). This issue is likely to develop simply by drafting. Modifying language in treatment) is an issue that is not likely to be as the FAQ process conducted by national liquidity agreements to clarify that the bank’s fully resolved. However, several issues are being regulators addresses specific situations as they exposure for capital purposes is the discussed and might be resolved during the arise. outstanding commercial paper amount, if less Basel II implementation process. than the commitment amount, should help. First, some banks mistakenly believe that a Asset substitution More drastic drafting changes (to introduce position cannot be held in the trading book Does asset substitution constitute prohibited floating commitment amounts, for example) unless it is to be sold quickly. That is not the implicit support of a transaction? Some would also solve this issue. case. Positions can be held in the trading book national regulators worry that it might. Such a if they are held with trading intent. Positions broad attack on asset substitution would throw Allocating credit enhancement held with trading intent include those held many active securitization markets into ABCP conduits that acquire interests in trade intentionally for short-term resale, but also disarray. Asset substitution occurs frequently receivables function as separate compartments, include those held with the intent of during the revolving period of any each containing a different customer benefiting from actual or expected short-term securitization, particularly to replace transaction. Each transaction is supported by price movements or to lock in arbitrage underlying assets that have been prepaid. liquidity provided for that transaction, and by profits, and may include proprietary Moreover, rating agencies mandate that asset programme-wide credit enhancement (PWCE) positions, positions arising from client substitution must either maintain or improve a provided for any and all transactions. However, servicing (for example, matched principal transaction’s performance criteria. conduit transactions do not cross-collateralize broking) and market making. There is a sensible middle ground if each other. Second, there is some discussion regarding regulators elect to accept it. In reality, no asset The compartmentalization of conduits the calculation of the counterparty risk charge might not be relevant for liquidity from a for swaps held by a bank in its trading book capital perspective (it sits above PWCE in the with a counterparty that is a securitization waterfall and is linked to a particular special purpose entity (SPE). Regulators have transaction) but it is highly relevant for taken the position that the counterparty risk It might make PWCE. Some regulators seem to be charge should be determined on the basis of “ suggesting that PWCE should be given the the position of the swap in the waterfall. risk weight of the least creditworthy asset in According to that view, the counterparty risk sense for banks to the pool, presumably because PWCE is most charge for an SPE if the swap is high in the likely to be drawn if there is a default on those waterfall will be lower than the counterparty invest in higher- assets. This would be unnecessarily extreme risk charge if the swap is lower in the and unjustified. The least creditworthy asset waterfall. This position might be sensible, but yielding assets is no more guaranteed to default than the it will unfortunately be difficult to implement other assets are guaranteed to pay on time. A if for no other reason than, in most during the Basel II comparative risk-weighted approach to securitization transactions, certain swap allocating risk weights to PWCE makes sense. termination payments are lower in the transition The US regulators have made a sensible waterfall than the payments made while the ” proposal in their 2005 weakest-link paper. swap is ongoing. Conduit sponsors would be required to map By Mark Nicolaides of Latham & Watkins in PWCE to the assets in the conduit in the London

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