On July 2, 2013, the Board of Governors of the Federal Reserve System (the Board) adopted new capital requirements1 implementing the so-called Basel III standards for domestic banks, federal savings associations and bank and savings and loan holding companies.2 On July 9, 2013, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency added their approval. These standards apply beginning on January 1, 2014, to banking organizations (other than savings and loan holding companies) that compute their capital using the advanced approaches; they apply beginning on January 1, 2015, to all other covered institutions except bank holding company subsidiaries of non-US banks that are currently relying on the Board’s Supervision and Regulation Letter 01-1, which are not required to comply until July 21, 2015.
In addition to provisions relating to capital generally, these requirements contain provisions relating specifically to the capital requirements associated with securitization exposures of covered banking organizations in their capacities as both securitizers and investors. The manner in which required capital is calculated depends upon, among other things, (i) whether the covered banking organization uses the standardized approach or the advanced approaches to compute its capital, and (ii) whether the securitization exposure is a traditional securitization, a synthetic securitization or a resecuritization. Although in general the requirements relate to exposures of all kinds, some of the provisions by their nature will only apply to an exposure retained by a securitizer.
Determining whether a securitization exposure exists and the category to which it should be assigned requires a covered banking organization to examine whether (i) the relevant pool consists of one or more financial assets, (ii) there is more than one layer of exposures, (iii) any exposure in any layer is tranched, and (iv) any special interpretations apply in reaching an analytical conclusion, and which risk weights apply to the various components of the exposures. Normally, the banking organization conducting such an evaluation will already have determined whether the standardized approach or the advanced approaches apply in calculating the resulting capital requirements.
The securitization provisions in the Basel III Release are divided into two principal parts. One part contains the so-called advanced (i.e., the individualized and mathematically more complicated) approaches3 used in determining capital requirements; the other contains the so-called standardized approach. Both of these parts are in the portion of the final rule referred to as the Common Rule, which contains the provisions that apply generally to all covered institutions. Each regulator also has adopted certain other provisions that apply only to the institutions for which it is responsible. Despite their differences in complexity, however, the advanced and standardized approaches both rely on many of the same fundamental definitions and principles. This alert will first describe what the two types of approaches have in common and then briefly summarize their differences, which largely relate to the manner in which the capital requirements are calculated for a given securitization exposure.
For an exposure to be subject to the special capital rules for securitizations, it must be a "securitization exposure," which is defined as:
- An on-balance sheet or off-balance sheet credit exposure (including credit-enhancing representations and warranties)4 that arises from a traditional securitization or synthetic securitization (including a resecuritization), or
- An exposure that directly or indirectly references a securitization exposure described in paragraph (1) of this definition.5
In other words, treatment as a securitization does not depend on whether an exposure is on- or off-balance sheet,6 on whether it is direct or indirect, or even on whether it is structural in nature, but rather on the substance of the arrangements. The term "exposure" itself is not defined in isolation in the Common Rule and must be understood in terms of the way it is treated in the various definitions, formulas and procedures; however, it roughly refers to the risk of loss associated with an asset.
A "traditional securitization" is:
… a transaction in which: (1) All or a portion of the credit risk of one or more underlying exposures is transferred to 7 one or more third parties other than through the use of credit derivatives or guarantees; (2) The credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority; (3) Performance of the securitization exposures depends upon the performance of the underlying exposures; (4) All or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities); …8
The effect of this definition is to treat as a traditional securitization a tranched, non-derivative exposure to financial assets that depends on the performance of those assets.
Although a credit derivative is not a traditional securitization, it can be a synthetic securitization, which is defined as:
… a transaction in which: (1) All or a portion of the credit risk of one or more underlying exposures is retained or transferred to one or more third parties through the use of one or more credit derivatives or guarantees (other than a guarantee that transfers only the credit risk of an individual retail exposure); (2) The credit risk associated with the underlying exposures has been separated into at least two tranches reflecting different levels of seniority; (3) Performance of the securitization exposures depends upon the performance of the underlying exposures; and (4) All or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities).9
Neither in the case of a traditional securitization nor in that of a synthetic securitization does securitization treatment depend on the transfer of all credit risk. In other words, each securitizer or any investor that is subject to the Basel III Release would be required to determine whether it has any exposure and, if so, how much. Nor is a pool of financial assets required. Instead, there must be a tranched exposure to at least one financial asset,10 which means that there must be at least two distinct exposures to the underlying financial asset or assets, each of which exposures must have a different seniority level.11
Exposures to resecuritizations receive capital treatment that differs from that accorded to other securitization exposures. The presence or absence of tranches at two levels determines whether a resecuritization exposure exists.
Resecuritization means a securitization which has more than one underlying exposure and in which one or more of the underlying exposures is a securitization exposure.
Resecuritization exposure means: (1) An on- or off-balance sheet exposure to a resecuritization; [or] (2) An exposure that directly or indirectly references a resecuritization exposure; …12
The effect of these definitions relating to resecuritization exposure is to require two levels of exposure, each of which must have some tranching. If there is only one level of exposure, or if one of the two levels of exposure is not tranched, then no resecuritization exists. It is also not a requirement for the existence of resecuritization that everything in the underlying exposure be tranched; rather, only some of that exposure must be tranched. The Preamble to the Basel III Release concludes from these definitions that neither the retranching of a single underlying exposure, such as a real estate mortgage investment conduit (a Re-REMIC), nor the creation of a tranched investment to hold pass-through securities that did not themselves tranche credit protection, constitutes a resecuritization.13
Similar considerations apply to a typical multi-seller asset-backed commercial paper conduit (ABCP Conduit). The provider of a liquidity facility to an individual seller’s pool of wholesale exposures creates a tranched exposure, according to the Basel III Release, but does not create a resecuritization in doing so, since the wholesale exposures are not themselves tranched; however, a program-wide credit enhancement that covers fewer than all losses (a Tranched Enhancement) does resecuritize if the partially covered program itself contains at least one securitization exposure, as it would, for example, if it contained a seller pool covered by the kind of liquidity facility described above.14 As a consequence, a single class of commercial paper issued by an ABCP Conduit would appear to constitute a resecuritization exposure in the hands of an investor subject to the Basel III Release if the ABCP Conduit both contained at least one securitization exposure and were covered by a Tranched Enhancement; however, it would not constitute a resecuritization exposure if the applicable credit enhancement fully covered the entire program.
The Preamble appears, however, to do more than just conclude that 100 percent credit-enhanced commercial paper does not constitute a resecuritization exposure. It appears, in fact, to treat commercial paper that is fully supported by the Conduit’s sponsor as not being a securitization exposure at all, even if the ABCP Conduit contains underlying securitization exposures.15 Although the Preamble seems potentially ambiguous on this point, and that potential ambiguity is exacerbated by the generality of the concept of securitization exposure used in the Basel III Release,16 the view that such commercial paper does not represent a securitization exposure at all is supported by the reference to the credit quality of the sponsor and to the fact that the risk to which the holders of commercial paper are exposed is described as the risk that the bank will default. This conclusion appears, however, to be implicitly contrary to the wording of Common Rule §__.42(c)(3), which treats such support as a securitization exposure.17 This apparent conflict is explained by noting several facts about the Common Rule. The definition of "resecuritization exposure" in §__.2 excludes commercial paper issued by an ABCP Conduit if it enjoys either of two types of credit support, program-wide credit enhancement that does not satisfy the definition of "resecuritization exposure" or liquidity support by the sponsor in a fashion that effectively exposes holders "to the default risk of the sponsor instead of the underlying exposures."18 The effect of this second exclusion is not only to eliminate resecuritization treatment but also to redirect the source of the commercial paper holder’s exposure from the ABCP Conduit to the sponsor.19 Section __.42(c)(3) of the Common Rule, on the other hand, treats the liquidity facility as a securitization exposure of the facility provider only.
Certain Entities Excluded
To alleviate some of the concerns about the breadth with which "securitization exposure" is defined, the definition of "traditional securitization" specifically excludes operating companies, even those with a large percentage of financial assets, and a number of pooled investment vehicles. The latter category includes small business investment companies as defined in the Small Business Investment Act, community development investments as defined in the National Bank Act, investment funds,20 collective investment funds permissible for depository institutions, US and non-US employee benefit plans regulated pursuant to applicable legislation, and SEC-registered US and similar non-US investment companies.21 The responsible bank regulatory agency may also make further exceptions.
Characterizations of the Parties
Characterization as an "originating banking organization" with respect to a securitization results in the application of certain provisions of the Common Rule to that bank, including the operational requirements described below, the definitions of "eligible clean-up call" and "investing bank,"22 and the provisions relating to the recognition of certain hedges. The "originating" bank with respect to a traditional securitization is the bank that "(1) [d]irectly or indirectly originated or securitized the underlying exposures included in the securitization; or (2) [s]erves as an ABCP program sponsor to the securitization."23 A bank is treated as an ABCP program sponsor if it satisfies any of the following criteria: It (i) establishes the program; (ii) approves the sellers who will be funded by the issuance of commercial paper; (iii) approves the exposures that the program will purchase; or (iv) administers the program.24
Operational and Diligence Requirements
In addition to the common definitional framework described above, the standardized and advanced approaches share operational and diligence requirements, which the Basel III Release describes (at least with respect to the diligence requirements) as "generally consistent with the goal of the agencies’ investment permissibility requirements."25
The applicable operational requirements vary somewhat, depending on whether the securitization is traditional or synthetic; in addition, it is something of a misnomer to refer to them as operational, since they are largely accounting and structural in nature. An originating banking organization that satisfies all of the operational requirements in connection with a securitization is permitted to use the approaches in the securitization provisions of the Common Rule to calculate its capital requirements for the securitization exposure that it retains. If it does not satisfy all of those requirements and the securitization is traditional, it must "hold risk-based capital against the transferred exposures as if they had not been securitized and must deduct from common equity tier 1 capital any after-tax gain-on-sale resulting from the transaction."26 If the securitization is synthetic, the bank suffers a different consequence: it may not recognize the hedging effect of collateral, a guarantee or a credit derivative (each of which is referred to as a "credit risk mitigant").27
For traditional securitizations, the following conditions must be satisfied for securitization treatment to be available to the bank that purported to transfer exposures:
- The exposures are not reported on the [BANK]’s consolidated balance sheet under GAAP;
- The [BANK] has transferred to one or more third parties credit risk associated with the underlying exposures;
- Any clean-up calls relating to the securitization are eligible clean-up calls;28 and
- The securitization does not: (i) Include one or more underlying exposures in which the borrower is permitted to vary the drawn amount within an agreed limit under a line of credit; and (ii) Contain an early amortization provision.29
For synthetic securitizations, a somewhat different set of standards must be met, in this case in order to be able to recognize in the calculation of exposures and capital requirements the hedging effect of any credit risk mitigant:
- The credit risk mitigant is: (i) Financial collateral; (ii) A guarantee that meets all criteria as set forth in the definition of "eligible guarantee" in §__.2, except for the criteria in paragraph (3) of that definition; or (iii) A credit derivative that meets all criteria as set forth in the definition of "eligible credit derivative" in §__.2, except for the criteria in paragraph (3) of the definition of "eligible guarantee" in §__.2.
- The [BANK] transfers credit risk associated with the underlying exposures to one or more third parties, and the terms and conditions in the credit risk mitigants employed do not include provisions that: (i) Allow for the termination of the credit protection due to deterioration in the credit quality of the underlying exposures; (ii) Require the [BANK] to alter or replace the underlying exposures to improve the credit quality of the underlying exposures; (iii) Increase the [BANK]’s cost of credit protection in response to deterioration in the credit quality of the underlying exposures; (iv) Increase the yield payable to parties other than the [BANK] in response to a deterioration in the credit quality of the underlying exposures; or (v) Provide for increases in a retained first loss position or credit enhancement provided by the [BANK] after the inception of the securitization;
- The [BANK] obtains a well-reasoned opinion from legal counsel that confirms the enforceability of the credit risk mitigant in all relevant jurisdictions; and
- Any clean-up calls relating to the securitization are eligible clean-up calls.30
In addition to the essentially structural component of the operational requirements described above, diligence requirements must be satisfied as well. The failure to satisfy the applicable diligence requirements leads to the imposition of a uniform 1250 percent risk weight to the relevant securitization exposure.
A securitizing or investing bank must perform diligence sufficient to demonstrate to its regulator that it has "a comprehensive understanding of the features of a securitization exposure that would materially affect the performance of the exposure."31 Such sufficiency can be attained by:
- Conducting an analysis of the risk characteristics of a securitization exposure prior to acquiring the exposure, and documenting such analysis within three business days after acquiring the exposure, considering: (A) Structural features of the securitization that would materially impact the performance of the exposure…;32 (B) Relevant information regarding the performance of the underlying credit exposure(s)…;33 (C) Relevant market data of the securitization…;34 and (D) For resecuritization exposures, performance information on the underlying securitization exposures…;35 and
- On an on-going basis (no less frequently than quarterly), evaluating, reviewing, and updating as appropriate the analysis required under paragraph (c)(1) of this section for each securitization exposure.36
The Mechanics of Calculating Capital – The Standardized Approach
A bank that uses the standardized approach must first sort its exposures into a number of categories and then choose one of the permissible means of calculating the risk weights applicable to those exposures. Those risk weights are then multiplied by the applicable exposure amounts to derive the risk-adjusted amounts with respect to which the required percentage of capital must be maintained.
After-tax gains-on-sale resulting from securitizations must be deducted directly from common equity tier 1 capital, and the portion of a credit-enhancing interest-only strip that does not constitute after-tax gain-on-sale must be assigned a risk weight of 1250 percent.
Other categories of exposure are distinguished from one another for the purpose of determining their amount. In general, other than as set forth above, the amount of an on-balance sheet securitization exposure is its carrying value, but special values are prescribed for available-for-sale or held-to-maturity securities for which an accumulated other comprehensive income opt-out has been made;37 repo-style transactions;38 eligible margin loans;39 OTC derivative contracts;40 and cleared transactions.41
The amount of an off-balance sheet securitization exposure "that is not a repo-style transaction, eligible margin loan, cleared transaction (other than a credit derivative), or an OTC derivative contract (other than a credit derivative) is the notional amount of the exposure."42 For eligible ABCP liquidity facilities, however, other rules apply. The exposure amount may equal (i) the maximum amount a bank could be required to fund, (ii) 50% of the notional amount if the simplified supervisory formula approach (SSFA) is not used to calculate required capital, or (iii) 100 percent of the notional amount if the SSFA applies.43 The provision of implicit support beyond what is required contractually leads to the requirement that capital be calculated as if no securitization had taken place.44 The effect of credit risk mitigants is determined by applying the general, non-securitization provisions in §§__.36 and __.37 of the Common Rule. The exposure amounts for repo-style transactions, eligible margin loans and derivatives are calculated pursuant to §§__.34 (OTC derivative contracts) or __.37 (collateralized transactions) of the Common Rule, as applicable. Section __.35 of the Common Rule provides the treatment for cleared transactions.
The SSFA is used to calculate risk weights unless the bank chooses to apply the gross-up approach, which it may do if it is not required to calculate its risk-weighted asset amounts under the market risk rule.45 Roughly speaking, the SSFA adjusts the weighted average total capital requirement of the exposures underlying a securitization exposure to reflect aspects of the creditworthiness of the underlying exposures.46 This adjusted value is then compared to the values of the attachment and detachment points for each securitization exposure to determine the risk weight for that securitization exposure. If the risk weight as so calculated is less than 20 percent, the minimum risk weight of 20 percent is used instead. If the capital requirement as adjusted for creditworthiness equals or exceeds the detachment point, the securitization exposure is assigned a risk weight of 1250 percent, since such a value implies a total loss at a required capital percentage of eight percent. If the attachment point of a securitization exposure equals or exceeds the creditworthiness-adjusted capital requirement, a special SSFA formula must be used to calculate the required risk weight. Otherwise (i.e., when the attachment point is less than the creditworthiness-adjusted amount and the detachment point exceeds it), the required risk weight is the sum of 1250 percent times a fraction47 plus 1250 percent times the value of the special SSFA formula times another fraction.48
By contrast, the gross-up approach, which if used must with some exceptions be applied to all securitization exposures, computes a credit equivalent amount of a securitization exposure by taking the sum of the exposure amount plus an amount equal to (i) the percentage of the par value of the applicable tranche represented by the bank’s exposure times (ii) the par value of the tranches that are senior to the applicable tranche. This credit equivalent amount is then multiplied by the weighted-average risk weight of the exposures underlying the securitization exposure. If the risk weight calculated in this fashion is less than 20 percent, a risk weight of 20 percent must be used instead.49
If there are exposures to which a bank applied neither the SSFA nor the gross-up approach, it must assign those exposures a risk weight of 1250 percent, with some exceptions. One of those exceptions permits a bank to compute the risk-weighted asset amount with respect to an eligible ABCP liquidity facility by multiplying the exposure amount times the risk weight of the riskiest exposure underlying the securitization exposure.
Just as with the SSFA, an advanced approaches bank must deduct after-tax gains-on-sale resulting from securitizations directly from common equity tier 1 capital, and assign a risk weight of 1250 percent to the portion of a credit-enhancing interest-only strip that does not constitute after-tax gain-on-sale. Once this requirement has been satisfied, a bank must then follow a hierarchy of approaches:
- The supervisory formula approach (SFA), which is set out in §__.143 of the Common Rule, must be applied by a bank that can compute all the parameters required for the application of §__.143 to each securitization exposure that does not require the deduction described immediately above;
- If the bank does not qualify to use the SFA but the other requirements of the preceding bullet point are met, the bank may apply the SSFA;50
- If the bank does not qualify to use the SFA and also does not apply the SSFA, it must apply a risk weight of 1250 percent to the exposure; and
- If the securitization exposure is a derivative contract (other than credit protection sold by the bank) that has a first priority claim on the cash flows from the underlying exposures, the bank may apply a special procedure instead of any of those referred to above.51
Despite these differences in approach and in parallel to the SSFA, special definitions apply in the advanced approaches to determine the amount of an exposure in general, as well as the specific amounts of the exposures represented by repo-style transactions, eligible margin loans, OTC derivative contracts and cleared transactions. As is the case for the SSFA, generally the carrying value is the exposure value for on-balance sheet securitization exposures, and the notional amount is the exposure value for off-balance sheet securitization exposures. In addition, limitations identical to those in the standardized approach apply to eligible ABCP liquidity facilities. For repo-style transactions, eligible margin loans, OTC derivative contracts (other than credit derivatives) and cleared transactions (again, other than credit derivatives), however, exposure at default is the measurement standard.52 Advanced approaches banks can recognize the effect of credit risk mitigants pursuant to §__.145 of the Common Rule.
Under the supervisory formula approach, which must be applied if a bank can calculate the various factors used in the associated procedure and formula, the risk-weighted asset amount for securitization exposures of advanced approaches banks is calculated by multiplying the result obtained by applying a procedure and a formula times 12.5. The procedure and the formula take into account more factors than does the SSFA, including, among other things, measures of the number of exposures, the exposure-weighted loss given default, the thickness of a tranche and the value of exposures subordinated to those of the bank.
In their general outline and effect, the definitions, rules and procedures described above resemble the analytical and compliance processes that banking organizations already understand. The complexity of these new requirements and the need for their precise and detailed implementation call, however, for a careful evaluation of their effect on all existing and future securitizations, as well as for a review to determine whether any securitization exposures exist that were not previously recognized as such.