Oct 11

Basel II: Securitization

by David Harper, CFA, FRM, CIPM

FRM |

basel2_securitizeIntro

Learning Outcome

  • LO 68.12: Discuss the Basel II Accord’s standardized and IRB treatments of asset securitization.

Basel II securitization starts with a principle-based preference for economic substance over legal form, supported by the Second and Third Pillars

The technical approach to securitizations falls under Basel II's First Pillar, as sibling to credit risk mitigation (CRM), where Basel II has significantly developed these areas to give enhanced recognition to the diverse substance of credit risk:

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But, as with the First Pillar generally, the technical guidance is supported ("reinforced") by the Second and Third Pillars. In regard to the Second Pillar, supervisors are specifically asked to monitor securitizations [Part 3.V] . BIS is aware, for example, that the First Pillar is unlikely to anticipate market innovations: "the minimum capital requirements [Pillar 1] may not be able to address all potential issues, supervisory authorities are expected to consider new features of securitization transactions as they arise."

Despite technical rules, the ultimate goal is principles-based: "the capital treatment of a securitization exposure must be determined on the basis of its economic substance rather than its legal form."

 

Traditional (asset sale) versus synthetic (risk transfer) securitization

Basel II distinguishes between a traditional and synthetic securitization. In a traditional securitization, assets are sold (divested) off the balance sheet. In a synthetic securitization (e.g., synthetic CDO), credit risk is transferred without an asset sale:

  • Traditional securitization: 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. Payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified/tranched structures that characterise securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation. 
  • Synthetic securitisation is a structure with at least two different stratified risk positions or tranches that reflect different degrees of credit risk where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio. Accordingly, the investors’ potential risk is dependent upon the performance of the underlying pool. [Source: Basel II]

In summary, the key characteristics of a securitization are:

  • In a traditional securitization (i.e., cash securitization), the asset is sold for cash, cash which is raised by the sale of securities that are structured into at least two tranches (the principal and interest income on the asset pool is the collateral).
  • The junior tranche (a.k.a., equity or toxic waste) absorbs losses before impairing senior tranches. Put another way, the difference between regular subordinated debt and a securitized junior tranche is that, the subordinated debt is subordinated in a liquidation but a junior tranche is subordinated in the ordinary course of the cash flow "waterfall."
  • In both cases, traditional and synthetic, note the credit risk transfer: investors depend on the underlying exposure, not the originating bank.

 

Traditional securitization: Standardized

As generally under credit risk, Basel II has a standardized and an internal ratings-based (IRB) approach to securitization. In order to qualify for the standardized approach for a traditional securitization, the assets must be removed from the balance sheet in a so-called true sale. The true sale has six requirements which, in total, insist that the really does give up control and ownership obligations.

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If the securitization is a true sale, the bank can apply "new" risk weights based on the rating of each tranche:

External credit assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ and below or unrated
Risk weight 20% 50% 100% 350% Deduction

 

In this way, the securitized exposure is recast from a single risk-weighted exposure into a set of "blended" risk weights that reflects the sub-divided risks that accompany its tranches.

Note the extreme treatment of the "deduction." To deduct the lowest-rated (or unrated) tranche from capital is, as Jorion notes, is tantamount to a 1250% risk weight! As 8% of 1250% = 100%, the deduction implies that the bank must hold capital equivalent to the notional value of a low-rated (un-rated) securitization tranche.

 

Internal ratings-based (IRB) Approach

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Under the IRB approach to securitization, there is a hierarchy:

  1. The external Ratings-Based Approach (RBA) must be applied to exposures that are rated or where a rating can be inferred.
  2. Where an external rating is not available (nor can be inferred), the bank may apply either the Supervisory Formula Approach (SFA), or
  3. The Internal Assessment Approach (IAA), permitted only for a limited scope of application.

Under the RBA, RWA are determined by multiplying the amount of the exposure by the appropriate risk weights. For example, a AAA tranche earns a 7% risk weight (0.56% capital); a BBB− tranche garners 100% (8% capital); and BB− garners 650% (52% capital).

Under the IAA, the bank applies its internal assessments of credit quality, which are then mapped to their equivalent external ratings. Using these ratings, the risk weights under the RBA are applied.

Under the SFA, the bank generates the capital charge using a closed-form solution to five parameters. As such, the SFA is a genuine bottom-up risk assessment.

 

Summary for FRM Candidates

Key takeaways for FRM candidates:

  • Both the traditional and the synthetic securitization achieve a credit risk transfer (from the bank to the investors in the securities issued by the SPE).
  • In a traditional securitization, assets are sold (divested) off the balance sheet; i.e., they shrink the balance sheet
  • In a synthetic securitization (e.g., synthetic CDO), credit risk is transferred without an asset sale. For example, the bank purchases credit protection with credit default swaps (CDS).
  • Securitization can be treated under the Standardized or IRB Approach. In regard to a traditional securitization, both require a true-sale (based on clean break criteria)
  • The Standardized approach used credit ratings to assign risk weights (20%, 50%, 100%, and 350%); low-rate and un-rated tranches actually deduct capital such that the bank must hold capital equal to their full notional.
  • The IRB approach includes three sub-approaches: Ratings-Based Approach (RBA), Supervisory Formula Approach (SFA), and Internal Assessment Approach (IAA)

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