BASEL II

A tax on securitization
Among its many effects on banks regulatory capital, Basel II might prove to be an additional capital tax on securitization

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

rom January 1 2010, Basel II will be in full effect. The new rules are scheduled to come into effect for all EU banks on January 1 2007. One year later, additional rules for advanced banks will come into effect, with a two-year transition period. These rules will make highly-rated asset classes more popular, could lead to the restructuring of many conduits and will act as an additional capital tax on securitization. Basel II will align bank regulatory capital requirements with the risk of exposure, reducing the amount of regulatory arbitrage that occurred under Basel I through transactions that did not change a banks risk profile but reduced its capital requirements. Basel II will, for the first time, permit banks to calculate required capital on the basis of an exposures rating. Advanced banks (those using their own, internal ratings-based (IRB) approach rather than the standard risk weightings) will also be permitted to calculate capital based on internal determinations of risk for all exposures except securitization. Securitization exposures will be subject to separate rules. Banks taking the standardized approach will generally determine capital on the basis of ratings for most securitization exposures. IRB banks can also determine capital using this ratings-based approach, but they will also have access to a special formula for securitization exposures known as the supervisory formula and an internal ratings capital calculation method known as the internal assessments approach. In each case, under Basel II a bank will assign a risk weight to each of its exposures and must hold 8% capital against all of its risk-weighted assets. In the case of offbalance-sheet exposures (including all commitments), the bank must assign a credit conversion factor (CCF) to the exposure. The CCF converts an unfunded commitment into a funded exposure for regulatory capital calculation. For example, a CCF of 100% means that the bank must hold regulatory capital against the unfunded commitment as if it were fully funded. For non-securitization positions held by

standardized banks, capital requirements will vary from a 20% risk weight for the most creditworthy exposures (that is, 1.60 of capital for each 100 of exposure) to a 150% risk weight for the least creditworthy exposures (12 of capital for each 100 of exposure). Securitization exposures held by standardized banks will vary from a 20% risk weight for the most creditworthy exposures to a 1,250% risk weight for unrated positions and other positions such as unearned interestonly strips (effectively 100 of capital for each 100 of exposure). Compared with standardized banks, IRB banks will have lower capital requirements for the most creditworthy exposures but higher requirements for the least creditworthy exposures. The most creditworthy nonsecuritization exposures will require as little as 0.15 of capital for each 100 of exposure, and the most creditworthy securitization exposures will require as little as 0.48 of capital for each 100 of exposure. At the other end of the spectrum, a risky exposure such as unlisted equities might require up to 40 of capital for each 100 of exposure depending on the model used, and an unrated junior securitization position to which neither the supervisory formula nor the internal assessments approach applies will require 100 of capital for each 100 of exposure.

Portfolio rebalancing Depending on the extent to which lending margins change to align themselves with revised regulatory capital burdens, Basel II might also prompt banks to rebalance their portfolios by shedding losers and keeping winners. Banks might be more willing to retain high-quality corporate exposures on their balance sheets because their capital costs would be lower than the cost of securitizing them while retaining the capital-heavy lower tranches. Banks might also be less willing to extend credit to lower-quality borrowers. It is possible that the lending market for small to medium-sized enterprises (SMEs) will be tiered: standardized banks would extend credit on a relationship basis to SMEs while IRB banks would extend credit on a credit score basis. Lastly, Basel II could trigger divestitures of regulatory capital-intensive businesses such as insurance and asset management. Effects on securitization As long as liquidity covers 100% of the assets of an asset-backed commercial paper conduit, and the conduit holds assets rated AA- or better, Basel II eliminates the regulatory capital benefits that an IRB bank sponsor obtains by operating such a conduit. If the conduits assets are rated lower than AA-, a conduit might still provide regulatory capital benefits depending on the nature of the assets and how the conduit is structured. For most conduits, the IRB bank sponsor must hold at least 56 basis points of capital against its liquidity support for the conduit, and more capital for its programme-wide credit enhancement support. One conduit sponsor can achieve a capital charge of 48 basis points as a result of the EUs proposed 6% risk weight for super-senior positions ranking senior to a AAA-rated tranche, but other conduits do not qualify for this preferential treatment. However, depending upon the credit

Winners and losers Basel II is expected to create classes of winners and losers. Some asset classes will gain popularity with bank investors because the new rules impose lighter capital burdens than Basel I, and some asset classes will lose favour because they are subject to heavier capital burdens. Spread tightening is expected to occur with respect to winners as regulatory capital burdens fall. Basel II winners will include securitization exposures rated BBB and higher, corporate exposures rated BBB or higher, and non-OECD sovereign exposures rated higher than BB+. 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 to their regulators for changes to their own more burdensome rules. This assumption certainly depends on the magnitude of the differences in national rules. 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 rules is required to know just how big the national differences are, this issue is one to watch.

Unfortunately, there are now almost as

many views of what significant means as there are regulators

quality of a conduits assets, an IRB bank might even have lower capital charges (15 basis points if the assets are corporate exposures held on balance sheet). The bank will have the same 56 basis point capital charge anyway, if the conduit holds only the most creditworthy securitization exposures (such as ABS). So in some cases banks will need more capital to securitize assets than to hold them on balance sheet. Bank sponsors are expected to continue to operate conduits for reasons other than regulatory capital arbitrage, but it also seems likely that there will be a series of conduit restructurings over the next few years, as well as an exploration of structured investment vehicles as the preferred mechanism for obtaining arbitrage profits. Restructurings will focus on reducing liquidity requirements, such as finding liquidity in the assets rather than a capital-heavy bank commitment, placing liquidity with non-banks, providing liquidity with instruments that attract lower capital requirements (such as issuer extendible commercial paper, investor extendible commercial paper, repos, or total return swaps held in the trading book), and structuring liquidity as an operating risk exposure rather than a credit risk exposure (as two conduits have done already). Banks could also explore the development of market-disruption-only liquidity, which attracts a lower 20% credit conversion factor for IRB banks. However, market-disruption liquidity must also qualify as eligible liquidity, which involves restrictions that a bank might not be willing to undertake in exchange for the capital relief.

available to IRB banks from January 1 2010. But these floors could create opportunities that will not exist after the transition period. It is expected that Basel II capital requirements will be lower than the floor, requiring banks to hold more capital than they need given their portfolios. As a result, it might make sense for banks to invest in higher-yielding assets during the transition, as the cost of incremental capital will be zero.

Late adoption The industry has raised a number of complaints about various aspects of the Basel II rules for a number of years, both with the Basel Committee and with the EU and member state regulators during implementation. With the deadline for implementation only months away, a surprising number of jurisdictions within the EU have not yet published their proposed capital rules. These regulators have presumably been coordinating with the banks they regulate, but distinctions between national rules will be important (see below) and can only be evaluated once the rules are publicly available. National inconsistencies Basel II will not be uniformly implemented from country to country, despite the intensive efforts of many regulators and market participants. Over 140 provisions in the Basel II Accord permit national regulators the discretion to adopt different rules, involving some material decisions. Neither the EU in its Capital Requirements Directive nor CEBS, the association of EU bank regulators, eliminated more than a handful of these discretions. If, as seems likely, banks regulated in different jurisdictions will have different capital charges for the same exposures, the question becomes whether those variations will cause a difference in bank behaviour. It seems most likely that banks in jurisdictions that impose higher capital charges for particular products will make every effort to price those products competitively with banks

Transition opportunity Artificial capital floors are imposed on IRB banks during the initial three years of Basel II. An IRB bank must hold at least 95% of the capital it would have held under Basel I during the first year of Basel II implementation, 90% in the second year and 80% in the third year. The full benefits of Basel II will only be

Risk transfer The Basel II rules require an originator to transfer significant risks to third parties before moving from the non-securitization rules to the securitization rules. During the Basel II negotiations, the meaning of the term significant risk transfer was not clear, except in Canada (where rules already contained such a requirement), whose regulators said that it was designed to enable them to ignore sham transactions in which no risk was transferred. Most securitization transactions executed by originators for funding purposes transfer only catastrophic risk (that is, unexpected losses that are highly remote). Most of these securitizations would satisfy the Canadian analysis, however, because the catastrophic risk transferred is certainly not insignificant and so not a sham. Unfortunately, there are now almost as many views of what significant means as there are regulators. The UK Financial Services Authority has taken the policy position that an originator will only obtain regulatory capital relief to the extent of risks transferred. The FSA is developing an approach that will permit banks to assess the risks transferred in a particular transaction on some sensible basis (such as comparing weighted interest rates of tranches sold to those retained). The FSA will also permit a safe harbour for any originator that deducts its retained positions. The Dutch National Bank in its early draft rules proposed another approach, prohibiting originators from retaining anything other than the AAA-rated positions. The German regulator adopted a rule somewhere in between, requiring that at least half of the mezzanine positions be sold to third parties. The net result of these rules is an additional capital tax on securitization. This is regrettable, but it appears unavoidable. Maturity mismatch One of the real sleeper issues during Basel II implementation is the severe haircut provided 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 default 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
IFLR/December 2006 19

The Swiss town of Basel, which has given its name to two accords on capital adequacy and so drawn the anger of banks worldwide

www.iflr.com

BASEL II
rules. The market might react to this development by pricing and writing evergreen options into contracts, leaving the protection purchaser to decide the most cost-effective way of managing its positions. can be replaced with an identical asset, particularly in cases such as CMBS or CDO transactions, where pools are limited and assets are not homogenous. On the other hand, in most cases substituting one asset for another simply means that the investors risks have changed, not necessarily improved, even where performance criteria have been maintained or improved. As a result, asset substitutions should be permitted at any time a transaction is not in default or if the performance criteria are more than an agreed cushion away from default, or if the substitution does not improve the transactions performance criteria by more than an agreed margin.

National
inconsistencies could mean that some banks become market leaders in certain products

Overlapping rules Not all of Basel II is set in stone. Even at this late date, a handful of areas are under discussion between industry participants and the regulators. Banks quickly realized that more than one set of the Basel II rules might apply to an exposure in certain situations. This typically arises in transactions involving a tranched exposure to an underlying financial asset, opening the possibility that both the securitization rules and the specialized lending rules apply. For example, should the specialized lending rules or the securitization rules apply to a B exposure to a commercial property once the A exposure has been securitized? So far, regulators seem willing to permit banks to apply the specialized lending rules in these cases. The US regulators in their recently proposed rules distinguish between exposures where all or substantially all of the underlying assets are financial assets (which will be treated under the securitization rules) and those that do not satisfy that test (which will be treated under the relevant specialized lending rules). This issue is likely to develop as the FAQ process conducted by national regulators addresses specific situations as they arise. Asset substitution Does asset substitution constitute prohibited implicit support of a transaction? Some national regulators worry that it might. Such a broad attack on asset substitution would throw many active securitization markets into disarray. Asset substitution occurs frequently during the revolving period of any securitization, particularly to replace underlying assets that have been prepaid. Moreover, rating agencies mandate that asset substitution must either maintain or improve a transactions performance criteria. There is a sensible middle ground if regulators elect to accept it. In reality, no asset

Liquidity exposure value Sponsors of asset-backed commercial paper conduits and third party banks provide liquidity to those conduits. Generally, the amount of liquidity that can be drawn is the lesser of the maximum unused commitment and the outstanding face amount of commercial paper. However, some regulators have suggested that banks hold capital against their entire undrawn commitment amount even though it might not, at a given time, be capable of being drawn. The US regulators have, however, implicitly accepted this lesser-of formulation in their recent proposals. It might be possible to resolve this issue simply by drafting. Modifying language in liquidity agreements to clarify that the banks exposure for capital purposes is the outstanding commercial paper amount, if less than the commitment amount, should help. More drastic drafting changes (to introduce floating commitment amounts, for example) would also solve this issue. Allocating credit enhancement ABCP conduits that acquire interests in trade receivables function as separate compartments, each containing a different customer transaction. Each transaction is supported by liquidity provided for that transaction, and by programme-wide credit enhancement (PWCE) provided for any and all transactions. However, conduit transactions do not cross-collateralize each other. The compartmentalization of conduits might not be relevant for liquidity from a capital perspective (it sits above PWCE in the waterfall and is linked to a particular transaction) but it is highly relevant for PWCE. Some regulators seem to be suggesting that PWCE should be given the risk weight of the least creditworthy asset in the pool, presumably because PWCE is most likely to be drawn if there is a default on those assets. This would be unnecessarily extreme and unjustified. The least creditworthy asset is no more guaranteed to default than the other assets are guaranteed to pay on time. A comparative risk-weighted approach to allocating risk weights to PWCE makes sense. The US regulators have made a sensible proposal in their 2005 weakest-link paper. Conduit sponsors would be required to map PWCE to the assets in the conduit in the

inverse order of creditworthiness, assigning PWCE a 1,250% risk weight (that is, full deduction) for all exposures rated less than BB-, a 200% risk weight for all exposures rated BB+ to BB-, and a 100% risk weight for all investment grade exposures. At worst, rating the PWCE (which would probably be investment grade) would eliminate any need for allocation.

It might make
sense for banks to invest in higheryielding assets during the Basel II transition

Trading book treatment Whether a position should be held in the banking book or the trading book (with the trading books more favourable capital treatment) is an issue that is not likely to be fully resolved. However, several issues are being discussed and might be resolved during the Basel II implementation process. First, some banks mistakenly believe that a position cannot be held in the trading book unless it is to be sold quickly. That is not the case. Positions can be held in the trading book if they are held with trading intent. Positions held with trading intent include those held intentionally for short-term resale, but also include those held with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, and may include proprietary positions, positions arising from client servicing (for example, matched principal broking) and market making. Second, there is some discussion regarding the calculation of the counterparty risk charge for swaps held by a bank in its trading book with a counterparty that is a securitization special purpose entity (SPE). Regulators have taken the position that the counterparty risk charge should be determined on the basis of the position of the swap in the waterfall. According to that view, the counterparty risk charge for an SPE if the swap is high in the waterfall will be lower than the counterparty risk charge if the swap is lower in the waterfall. This position might be sensible, but it will unfortunately be difficult to implement if for no other reason than, in most securitization transactions, certain swap termination payments are lower in the waterfall than the payments made while the swap is ongoing. By Mark Nicolaides of Latham & Watkins in London
www.iflr.com

20 IFLR/December 2006