Key Points:

The changes to the Basel II Framework are a response to the global financial crisis, and will be implemented by APRA in Australia by late 2010.

In July 2009 the Basel Committee on Banking Supervision (the Basel Committee) finalised enhancements to the "Basel II: International Convergence of Capital Measurement and Capital Standard: A Revised Framework - Comprehensive Version (June 2006)" (the Basel II Framework) which it had foreshadowed earlier in the year. This followed an extensive consultation process.

The enhancements are a response to the lessons learned from the global financial crisis. They predominantly relate to the area of securitisation and are aimed at strengthening the regulation and supervision of internationally active banks in light of weaknesses revealed by the financial markets crisis. They introduce enhancements to each of the three pillars of Basel II - minimum capital requirements; risk management and the supervisory review process; and market discipline through disclosure.

Shortly after the release of the enhancements, the Australian Prudential Regulation Authority (APRA), which is responsible for the prudential supervision of Australia's authorised deposit-taking institutions (ADI) and the implementation of Basel II through its prudential standards, issued a letter confirming its support of the Basel Committee initiatives, indicating that changes to the Prudential Standard APS 120 Securitisation (APS 120) are "likely to result". The timetable set by APRA targets the release of a discussion paper and draft prudential standard in late 2009 and its implementation by late 2010.

Below, we focus on the Pillar 1 changes resulting from the Basel II enhancements. These changes directly impact the regulatory capital required to be held by banks on certain securitisation exposures. We also briefly describe the enhancements in relation to Pillars 2 and 3 of Basel II.

Pillar 1 initiatives

Pillar 1 of Basel II establishes the rules for calculating the minimum capital that a bank must hold against its key risks. The Basel II enhancements have the following regulatory capital consequences for banks:

  • Increased capital requirement for resecuritisation exposures.

"Resecuritisation" is a securitisation exposure where the underlying pool of assets consists of one or more securitisation exposures. Resecuritisation exposures include collateralised debt obligations of residential mortgage-backed securities or other asset backed securities but may also include asset-backed commercial paper.

Under the Basel II enhancements, considerably higher risk weights have been introduced at every notch of the credit rating spectrum for both senior and non-senior resecuritisation exposures than apply for plain securitisation exposures. As an example of the magnitude of the increase, the risk weights for senior and non-senior resecuritisation exposures are now, respectively, 20 percent and 30 percent for instruments that have a long-term rating of AAA, whereas the risk weight for senior granular securitisation exposures with the same long-term rating of AAA is 7 percent.

These changes penalise exposures to these more complex financial products and would clearly act as a deterrent for banks to acquire such products.

  • Increased capital requirement for rated securitisation exposures where the rating on that exposure is based on support provided by the bank itself. Such exposure must be treated as if it were unrated.

In assessing the risk weight of a particular exposure, a bank may no longer recognise the rating of that exposure where the rating is based on guarantees or similar support provided by the bank itself.

This initiative addresses bank practices that developed during the GFC. For example, the Basel Committee observed that banks that provided liquidity facilities to asset-backed commercial paper programmes bought commercial paper (CP) issued under those programmes rather than allowing a drawdown under their facility. The bank then used the rating given to the CP to determine the risk-weight that applied to that exposure, which in turn was based on the bank's support to the programme in the form of the liquidity facility. The new rules require the exposure arising from holding the CP to be treated as if it were unrated.

  • Deduction of a securitisation exposure from capital unless the bank has complied with specific due diligence requirements.

Under the enhancements, banks must conduct a credit analysis of its securitisation exposures and undertake other specific operational requirements. These enhancements are designed to ensure that the bank properly and fully understands the underlying risk of its exposures rather than simply relying on rating agency credit ratings.

The new provisions will require a bank to:

  • have a comprehensive understanding of the risk characteristics of its individual securitisation exposures, as well as the risk characteristics of the pools underlying those exposures;
  • be able to access performance information on the pools underlying its securitisation exposures on an ongoing basis and in a timely manner;
  • thoroughly understand all of the structural features of a securitisation transaction that would materially impact the performance of the bank's exposures to the transaction, such as contractual waterfall triggers, credit enhancements, liquidity enhancements, market value triggers and deal-specific definitions of default.

If a bank does not meet the specified due diligence requirements, it must deduct the securitisation exposure from its capital.

  • For standardised approach banks, increased capital requirement for undrawn eligible liquidity facilities with maturities of less than one year. The credit conversion factor (CCF) in respect of these facilities has increased from 20 percent to 50 percent.

Currently under the standardised approach, the Basel II framework (and, similarly, APS 120) applies a 20 percent CCF to undrawn eligible liquidity facilities with maturities of less than one year, and a CCF of 50 percent for those with maturities of longer than one year. The new Basel II requirements no longer distinguish between undrawn liquidity facilities on the basis of their maturities.

  • Removal of the favourable capital treatment given to liquidity facilities which can only be drawn when there is a general market disruption. These facilities are rarely used in Australia and, in any case, do not enjoy such favourable treatment under APS 120.

Pillar 2 and Pillar 3 Initiatives

The Basel Committee enhancements also impact Pillar 2 and Pillar 3 of Basel II. In general, these enhancements require a bank to identify and understand its risks on a bank-wide and specific basis so as to, in respect of Pillar 2, adopt appropriate risk management and governance processes and, in respect of Pillar 3, adequately disclose those risks to other market participants.

The Supplemental Pillar 2 Guidance issued by the Basel Committee as part of its July enhancements supplements Basel II's second pillar with respect to banks' risk management and capital planning processes. It makes it clear that the capital requirements under Pillar 1 are only minimum requirements and that an appropriate level of capital under Pillar 2 should exceed that minimum.

Through this supplement, the Basel Committee seeks to address "notable weaknesses" that have been revealed in banks' risk management processes during the global financial crisis and to introduce bank-wide risk oversight such that senior management is able to identify and react to emerging and growing risks in a timely and effective manner. It also pinpoints specific risk management concerns which, in brief, relate to risks concerning concentration, a bank's off-balance sheet exposures (particularly securitisations), reputation and implicit support, the valuation of complex structured products held by banks and liquidity. It also emphasises the need to embed risk management into the culture of a bank by adopting sound stress-testing practices and sound compensation practices.

The third pillar of the Basel II Framework is intended to complement the other two Pillars by allowing market participants to assess a bank's capital adequacy through key pieces of information. In response to observed weaknesses in public disclosure and after a careful assessment of leading disclosure practices, the Basel Committee revised the current Pillar 3 requirements.

Importantly, the revisions require not only enhanced disclosure in relation to certain securitisation-related exposures of banks but also impose an overall requirement on banks to assess and make disclosures that reflect their real risk profile as markets evolve over time. The objective is to improve comparability amongst banks and to allow market participants to better understand the overall risk profile of an institution, avoiding a recurrence of pervasive market uncertainty about the strength of banks' balance sheets, as was seen with respect to banks' securitisation activities in recent times.

Future developments

The July enhancements to the three pillars of Basel II are just the beginning. They form part of the Basel Committee's broader programme to strengthen the regulatory capital framework. Other initiatives that the Basel Committee has advised will be released for consultation in the first quarter of 2010 include new standards to:

  • promote the build-up of capital buffers that can be drawn down in periods of stress;
  • strengthen the quality of bank capital; and
  • introduce a leverage ratio applicable to banks.

There is little doubt that APRA will introduce some form of the July Basel II enhancements in the not too distant future. As a recently admitted member of the Basel Committee in March 2009, we expect that APRA will also be keen to support any future enhancements to Basel II by bringing them home and introducing them in Australian prudential standards.