With our compliments. Tweaks to a sound system. By Mark Nicolaides of Latham & Watkins

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1 Article Reprint With our compliments Basel II Tweaks to a sound system By Mark Nicolaides of Latham & Watkins Reprinted from International Financial Law Review February 1, 2009 The Basel Committee s proposed adjustments are in stark contrast to the Commission s hurried additions On January the Basel Committee on Banking Supervision issued its consultation proposals for enhancing the June 2006 Accord published by the committee, the International Convergence of Capital Measurement and Capital Standards, a Revised Standard dealing with securitisation. Comments on the proposals are due no later than April The proposals principally focus on: (i) increasing capital requirements for socalled resecuritisations; and (ii) increasing capital requirements for, and public disclosure regarding, liquidity support provided by sponsors of assetbacked commercial paper (ABCP) conduits. The proposals are noteworthy for two reasons. First, the committee s incremental approach confirms its view that the Accord is fundamentally sound and effective in aligning regulatory capital with credit risks. Such an approach is in stark contrast to the European Commission s rush to modify the Capital Requirements Directive in material ways, in particular their muchcriticised and oft-modified skin-in-thegame proposals. Second, the committee harshly criticised banks handling of ABCP conduits, structured investment vehicles (Sivs) and other off-balance sheet vehicles sponsored by them during the recent credit crisis. Unsurprisingly, many of the proposals increase regulatory capital, as well as imposing additional internal risk management and public disclosure requirements in connection with such vehicles. Pillar 1: capital requirements Resecuritisation risk weights Banks will be required to apply risk weights to resecuritisation exposures approximately 200% higher than comparably rated non-resecuritisation exposures for banks under the standardised approach (SA) and approximately 300% higher for banks subject to the internal ratings-based (IRB) approach. The actual size of the increase will depend on the rating of the exposure. The proposed revised risk weights for exposures held by IRB banks with long-term ratings are as in the table. Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy and an affiliated partnership conducting the practice in Hong Kong. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2009 Latham & Watkins. All Rights Reserved. If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. This article is reprinted with permission from the February 1, 2009 issue of International Financial Law Review. Copyright 2009

2 A resecuritisation exposure will be defined an exposure where one or more of the underlying exposures is a securitisation exposure as defined in the Accord. A traditional securitisation exposure is one where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches reflecting different degrees of credit risk. Critically, an exposure will be classified as a resecuritisation exposure even if there is only one securitisation exposure in the underlying pool, irrespective of the number and quantity of other exposures. As noted in the table, banks will be subject to additional capital requirements if the resecuritisation exposure is not the most senior exposure. The definition of what is senior will prevent a bank from taking a mezzanine resecuritisation exposure, creating two tranches (for instance, a junior tranche of 0.1% and a senior tranche of 99.9%) and claiming that the senior tranche qualifies for the senior column of resecuritisation risk weights. Use of ratings subject to selfguarantee Banks will not be permitted to recognise internal ratings that are based on any unfunded guarantees or similar support provided by the bank itself. In addition, a bank s capital for such exposures held in the trading book must be at least the amount required under the banking book treatment. Therefore, if a bank sponsor supports its ABCP conduit with liquidity or credit enhancement, but buys ABCP instead of funding the liquidity or CE facility, it must treat the ABCP as if it were unrated. If the bank is authorised by its supervisor to use the internal assessments approach (IAA), it can prepare an implied rating to determine the risk weight of the ABCP that it holds. Alternatively, it might be able to use the supervisory formula approach (SFA) to determine a risk weight, although the IAA was originally developed because the SFA does not work well with ABCP conduits for several technical reasons. If a bank is unable to determine a risk weight 2

3 using either the IAA or the SFA, it will be required to deduct the ABCP from capital. enhancements, market value triggers and deal-specific definitions of default. Operational criteria for credit analysis Banks will be required to hold and use minimum information regarding securitisation exposures in order to be entitled to use the securitisation rules to determine risk weights of such exposures. The new requirements will apply to both standardised and IRB banks, and will be applicable equally to exposures in the banking book and in the trading book. If a bank does not meet these additional requirements with respect to any exposure, that exposure must be deducted from capital. In general, the information required will permit a bank to achieve a comprehensive understanding of the risk characteristics of its individual securitisation exposures, whether on-or off-balance sheet, as well as the risk characteristics of the pools underlying those exposures. The information required includes the following. Continuing and timely performance information relating to the underlying pool, including appropriate: (i) exposure type; (ii) percentage of loans 30, 60 and 90 days past due; (iii) default rates; (iv) prepayment rates; (v) loans in foreclosure; (vi) property type; (vii) occupancy; (viii) average credit score or other measures of creditworthiness; (ix) average loanto-value ratio; and (x) industry and geographic diversificationn. For resecuritisations, information regarding not only the underlying securitisation tranches (such as the issuer name and credit quality) but also the characteristics and performance of the pools underlying such securitisation tranches. A thorough understanding of all structural features of a securitisation transaction that would materially affect the performance of the bank s exposures to that transaction, such as the contractual waterfall and waterfallrelated triggers, credit enhancements, liquidity Liquidity facilities The committee is proposing three changes to liquidity facilities. First, for standardised banks, the committee is abolishing the distinction between commitments in respect of eligible liquidity facilities with an original maturity of one year or less (a credit conversion factor or CCF of 20% at present) and those of more than one year (a CCF of 50% at present). Instead, the CCF for all eligible liquidity facilities provided by standardised banks will be 50%. Second, for IRB banks, the committee is clarifying the circumstances under which a liquidity facility will be recognized as senior for purposes of determining the risk weight of that facility (either directly where the facility is externally rated or by mapping to a rating where the IAA is used). The proposal is meant as a clarification of, and not as a change to, existing treatment. A liquidity facility may be viewed as being the most senior if it is sized to cover all of the outstanding ABCP of a conduit (and other senior debt supported by the underlying pool), so that no cash flows from the pool can be transferred to other creditors until all liquidity draws are repaid in full. Finally, the committee is eliminating the preferential CCFs that were available to both standardised and IRB banks for eligible liquidity facilities that may only be drawn in the event of a general market disruption. A general market disruption exists if more than one vehicle across different transactions is unable to roll over maturing ABCP (but is not the result of an impairment in the one vehicle s own credit quality or in the credit quality of its underlying exposures). Pillar 2: supervision The committee criticised in unambiguous and harsh terms banks recent internal credit risk management 3

4 activities, particularly in connection with ABCP conduits, Sivs and other offbalance sheet vehicles sponsored by them: [Many] financial institutions did not fully understand the risks associated with the businesses and structured credit products in which they were involved. Moreover, these banks did not adhere to the fundamental tenets of sound financial judgment and prudent risk management. Strong demand for structured products created incentives for banks using the originate-to-distribute model to originate loans, such as subprime mortgages, using unsound and unsafe underwriting standards. At the same time, many investors relied solely on the ratings of the credit rating agencies (CRAs) when determining whether to invest in structured credit products. Many investors conducted little or no independent due diligence on the structured products they purchased. [Many] banks had insufficient risk management processes in place to address the risks associated with exposures held on their balance sheet, as well as those associated with offbalance sheet entities, such as assetbacked commercial paper (ABCP) conduits and structured investment vehicles (Sivs). The proposals require banks to bolster their internal risk management processes to address these notable weaknesses. The committee identified in particular several areas in which banks reputational risks influenced them to provide financial support that exceeded their contractual obligations to do so (so-called implicit support), including in connection with banks sponsorship of ABCP conduits and Sivs, banks sale of assets to investment trusts and banks sponsorship of collective investment activities such as money market funds, in-house hedge funds and real estate investment trusts (Reits). The committee also identified circumstances in which banks reputational risks influenced them to deal with liabilities in excess of their contractual obligations to do so, such as in connection with the redemption of hybrid or subordinated debt forming a component of regulatory capital. However, recognising that implicit support is a more subtle form of exposure than direct commitments, the committee stated that risks arising from the provision of implicit support would never be fully covered by the Accord s capital requirements in Pillar 1. It remains unclear whether the committee will be satisfied that reputational risks and implicit support can be handled solely through supervisory mechanisms in Pillar 2, or whether an incremental capital charge to address reputational risks and implicit support is required. An adjustment to the capital charge for operating risks is one possibility. Pillar 3: public disclosure The committee has described weaknesses in public disclosure during the recent credit crisis and is proposing to supplement the disclosure requirements of the Accord in certain important respects. First, the committee will require each bank, in addition to the specific disclosure required by the Accord, to disclose its actual risk profile to market participants and ensure that the disclosed information will be adequate to fulfil this objective. Such an objective is laudable, and may well already be generally consistent with the public reporting obligations to which banks are subject in connection with listings of their debt and/or equity securities. In addition, the committee is proposing that banks disclose to the public additional information relating to securitization exposures in the trading book, resecuritisation exposures, sponsorship of off-balance sheet vehicles, use of the internal assessment approach, ABCP liquidity facilities, valuation with regard to securitisation exposures and pipeline and warehousing risks with regard to securitisation exposures. The proposed additional disclosures include the following. 4

5 All securitisation exposures to special purpose vehicles in which the bank is involved as a sponsor, regardless of whether the exposure is in the banking or trading book, on- or off-balance sheet, and whether or not the exposure is subject to the securitisation framework. Related entities managed by the bank that invest in securitisation exposures that the bank has securitised or in vehicles that the bank sponsors. Quantitative information on banking book exposures for each regulatory capital approach, such as IAA and SFA, and on trading book exposures for each regulatory capital approach under the securitisation framework, as well as for the market risk approach. Processes in place to monitor changes in the credit and market risk of securitisation exposures, the bank s policy governing the use of hedging and financial guarantee insurance to mitigate the risks retained through securitisation and resecuritisation exposures and the type of risks assumed and retained with resecuritisation activities. Qualitative disclosure regarding valuation of securitisation positions, including key assumptions for valuing positions. Aggregate amount of pipeline and warehousing assets awaiting securitisation broken down by exposure type. 5