A Summary of The 2001 Basel Working Paper on Asset Securitisations

On October 12, the Basel Committee on Banking Supervision released a Working Paper on Asset Securitisations. The Working Paper supplements the Consultative Document on Asset Securitisation that the Committee published as part of its 500+ page consultative package on the proposed new Basel capital accord in January, 2001. You can download the papers at http://www.bis.org. The Committee has requested comments from interested parties by November 15, 2001. We have summarized the new Working Paper below.

The Committee and the Process

The Committee consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. In 1988, the Committee published an Accord entitled International Convergence of Capital Measurement and Capital Standards. That accord formed the basis for the risk-based capital standards adopted by bank regulators in the U.S. and other member countries.

In June 1999, the Committee announced that it had decided to introduce a new capital adequacy framework to replace the 1988 Accord and sought views on the proposed new approaches. The January consultative package then provided interested constituencies with the first detailed look at the proposed new framework.

Despite its length, the January consultative package did not fully flesh out some important aspects of the new framework. The new Working Paper addresses two such aspects:

the application of an internal ratings-based capital approach to banks' securitization activities; and

a risk-sensitive approach to synthetic securitizations.

The short timeframe for comments on the Working Paper reflects the Committee's desire to quickly publish a second draft of the overall framework, after receiving feedback on the Working Paper and other related publications. Though delayed a year from the schedule announced in January, the Committee's schedule is still ambitious: approval of a new Accord by the Committee by the end of 2002, and implementation in member nations by 2005.

Background Elements of the New Proposal

The Working Paper draws heavily on three elements of the framework proposed in the January package.

First, the proposal would replace the very broad risk categories used in the original Accord with a standardized approach that assigns particular corporate, bank or sovereign borrowers to varying risk weights based upon their credit ratings from well-recognized independent rating organizations (such as Fitch, Moody's and S&P). The standardized approach is meant to be more risk sensitive than the current Accord, but is also meant as a stepping stone to the even greater risk sensitivity that the Committee expects from the other approach described next.

Second, subject to overall regulatory approval of their methods, banks could determine appropriate capital levels based upon an internal ratings-based approach (or "IRB"). The January consultative paper described a proposed IRB approach to corporate, retail and some other exposure categories, but not securitization. The Working Paper now supplements the January package with a relatively detailed description of a securitization IRB. Both the January package and the Working Paper explicitly anticipate that the new framework will be designed to give banks incentives to move from the standardized approach to the IRB.

Third, along with the more refined differentiation among obligor credit risks (based on external or internal ratings), the proposal gives credit for a wider variety of credit risk mitigation techniques, including credit derivatives.

II. The Internal Ratings-Based Approach to Asset Securitizations

In general, required capital under the proposed securitization IRB will be calculated based on the following considerations:

whether a position has been externally rated (discussed further in Part A below),

whether an "inferred rating" can be assigned to a position (discussed further in Part B below),

whether a bank has sufficient information to calculate required capital for an unrated position in a non-revolving securitization using the proposed supervisory formula (discussed further in Part C below),

whether a bank is an originating bank in a revolving securitization (discussed further in Part D below), and

whether a bank is providing a liquidity commitment (discussed further in Part E below).

We have attached as Schedule 1 to this memorandum a copy of a flow chart decision tree included in the Working Paper to provide an overview of the application of the proposed IRB approach. We discuss the elements highlighted in that chart in more detail below.

A. Externally Rated Positions.

The general rule under the proposed IRB is that if a position is externally rated, the required capital will be assigned based on that external rating. This emphasis on external ratings may seem surprising in the context of an internal ratings-based approach. The explanation for this apparent paradox seems to be that the Committee (a) is attracted to the objectivity and standardization that external ratings provide, and (b) believes that in most cases even IRB banks will not be able to apply the true IRB capital calculation (the supervisory formula described below) to securitization positions relating to assets originated and packaged by third parties. So under the "internal ratings based" approach to securitization it seems likely that generally only originating banks will set capital for securitization positions based on their own internal rating systems. Banks that invest in third party asset-backed securities will mostly set capital based on a grid driven by external ratings which is similar to the grid used in the standardized approach but will probably yield lower capital requirements than the standardized approach.

The exceptions to the general rule that external ratings trump internal ones are residual interests and retained subordinated tranches of a securitization. Originating banks must deduct these positions from capital (regardless of whether an external rating has been assigned) unless the bank...