basics_of_risk_based_capital.pdf

Basics of Risk-Based Capital for Securitization Exposures

Bill Falcon, PNC

Tim Mohan, Chapman and Cutler LLP

Speakers:

Executive Summary

Risk-based capital is equity, qualifying reserves, and qualifying capital that must be maintained by a bank to cover risks associated with conducting day-to-day business

Risk-based capital is determined in compliance with the jurisdictional implementation of Basel I, Basel II, and any corresponding revisions thereto – Basel I established two fundamental objectives

• Strengthen the soundness and stability of the international banking system • Create a framework that is fair and consistent among banks in different countries to diminish an existing source of competitive

inequality among international banks

– Basel II, “A Revised Framework on International Convergence of Capital Measurement and Capital Standards” • Proposed in 1999 in response to the banking crisis in the 1990’s and the criticisms of Basel I

Recent changes and developments impacting the current risk-based capital framework – Basel II.5 released July 2009 – Dodd-Frank Act – enacted in July 2010

• Intended to promote financial stability in the U.S. by improving accountability and transparency in the financial system

– Basel III released in December 2010 to reform Basel II • Intended to improve the banking sector’s ability to absorb shocks arising from financial and economic stress

Future of risk-based capital framework – Intersection of Dodd-Frank and Basel III

• Common objective– To promote prudential capital standards for the banking sector • Challenges

– Are such standards applicable to all banks? – How will the reliance on credit ratings be addressed? – How do supervisors ensure a level international playing field?

Brief History of Capital Regulation

Regulatory monitoring of U.S. bank capital levels has existed since the early 20th century

Three events triggered movement toward an international regime re: capital adequacy in the 1970s/1980s – Decline in worldwide capital ratios – poor economic conditions – Upheaval in the financial services industry – increased competition from capital markets – In the U.S., an abandonment of many traditional devices for assuring bank safety and soundness – limits on

activities of banks relaxed and caps on interest rates removed

U.S. bank regulators published capital ratios for banks in 1982 and indicated that large banks with primary capital to asset ratios of less than 5% would be considered “undercapitalized”

Fed and OCC applied capital ratios (7%) to U.S. multinational banks in 1983 and moved quickly with the other bank regulators to impose capital requirements on all U.S. banks

By 1985 nearly all Basel Committee countries placed substantial regulatory reliance on capital ratios

Basel Committee published its first consultative paper on international capital standards in December of 1987

Basel I

Basel I Overview: “International Convergence of Capital Measurements and Capital Standards”

Effective since 1988 and implemented by all Basel Committee members by the end of 1992, Basel I established two fundamental objectives:

Strengthen the soundness and stability of the international banking system

The proposed framework should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks

Defined the Constituents of Capital – Tier 1 Capital – core capital including equity capital and disclosed reserves – Tier 2 Capital - all other qualifying capital

Basel I

Basel I Overview: “International Convergence of Capital Measurements and Capital Standards”

Established a risk weighting system – Riskless – 0% – Low risk – 20% – Moderate risk – 50% – High risk – no less than 100%

In general, corporate and consumer exposures are assigned to the 100% risk-weight category

Established the minimum capital requirements of financial institutions with the goal of minimizing credit risk – Calculated using the Target Standard Ratio

• Set a universal standard whereby 8% of a bank’s risk-weighted assets must be covered by Tier 1 and Tier 2 capital reserves • Tier 1 capital must cover 4% of a bank’s risk-weighted assets; this ratio was seen as “minimally adequate” to protect against credit

risk in deposit insurance-backed international banks in all Basel Committee member states

X 8% = Capital

Requirement

Credit Conversion

Factor for off-balance sheet

exposures

Risk Weight X Exposure

Amount X

Basel I

Basel I Risk Weights and Credit Conversion Factors

Under Basel I, risk-based capital for securitization exposures is determined based on risk weights mapped to measures of creditworthiness, and credit conversion factors for off-balance sheet items

Original measures of credit worthiness were broad categories such as “riskless” – In 2001, references to credit ratings were introduced to the U.S. framework, and specific rules for residual interests and direct

credit substitutes were adopted

Unrated exposures are generally assigned a 100% risk weight unless they are retained interests, direct credit substitutes or other recourse positions

1 Source: Electronic Code of Federal Regulations website (http://www.ecfr.gpoaccess.gov)

Basel I Risk-Weight Tables1

Basel I Credit Conversion Table

Long-term rating category Example

Risk weight

(In percent)

Highest or second highest investment grade AAA, AA 20

Third highest investment grade A 50

Lowest investment grade BBB 100

One category below investment grade BB 200

Short-term rating category Examples

Risk weight

(In percent)

Highest investment grade A-1, P-1 20

Second highest investment grade A-2, P-2 50

Lowest investment grade A-3, P-3 100

Instruments

Credit

Conversion

Factors

1. Direct credit substitutes, e.g. general guarantees of indebtedness (including standby letters of

credit serving as financial guarantees for loans and securities) and acceptances (including

endorsements with the character of acceptances)

100%

2. Certain transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and

standby letters of credit related to particular transactions)50%

3. Short-term self-liquidating trade-related contingencies (such as documentary credits

collateralised by the underlying shipments)20%

4. Sale and repurchase agreements and asset sales with recourse,1 where the credit risk remains

with the bank100%

5. Forward asset purchases, forward forward deposits and partly-paid shares and securities,1 which

represent commitments with certain drawdown100%

6. Note issuance facilities and revolving underwriting facilities 50%

7. Other commitments (e.g. formal standby facilities and credit lines) with an original maturity of

over one year50%

8. Similar commitments with an original maturity of up to one year, or which can be unconditionally

cancelled at any time0%

Basel I

Special Rules for unrated retained interests, direct credit substitutes and recourse positions

Recourse positions – Arrangements in which a bank retains, in form or in substance, of any credit risk directly or indirectly

associated with an asset it has sold (in accordance with generally accepted accounting principles (“GAAP”)) that exceeds a pro rata share of the bank’s claim on the asset • If a bank has no claim on an asset it has sold, then the retention of any credit risk is recourse

Retained interests – On-balance sheet assets that represent an interest (including a beneficial interest) created by a transfer of

the bank’s assets that qualifies as a sale (in accordance with GAAP) of financial assets, whether through a securitization or otherwise, and that exposes a bank to credit risk directly or indirectly associated with the transferred assets that exceeds a pro rata share of the bank’s claim on the assets, whether through subordination provisions or other credit enhancement techniques

– Retained interests are a special category of recourse positions

Direct credit substitutes – Arrangements (e.g. letters of credit) in which a bank assumes, in form or in substance, credit risk associated

with an on- or off-balance sheet credit exposure that was not previously owned by the bank (third-party asset) and the risk assumed by the bank exceeds the pro rata share of the bank’s interest in the third party asset

Basel I

Special Rules for unrated retained interests, direct credit substitutes and recourse positions

In general, the credit-equivalent amount for an unrated recourse obligation or direct credit substitute is the full amount of the credit-enhanced assets for which the bank directly or indirectly retains or assumes credit risk multiplied by a 100% conversion factor – A bank that absorbs the first 10% of loss on a transaction, must maintain capital against the full amount of

the assets being supported

A bank must maintain risk-based capital for a residual interest (excluding a credit-enhancing interest-only strip) equal to the face amount of the residual interest (net of any existing associated deferred tax liability recorded on the balance sheet), even if the amount of risk-based capital required to be maintained exceeds the full risk-based capital requirement for the assets transferred

Basel I: ABCP Exclusion

U.S. implementation of the Basel I ABCP exclusion

With the release of FASB Fin 46(R), the U.S. banking agencies amended the risk-based capital standards by providing a capital treatment for assets in ABCP programs that are consolidated onto the balance sheets of sponsoring banks

Interim rule was implemented as of October 2003 and made permanent as of July 2004

Allowed sponsoring banking organizations to remove the consolidated ABCP program assets from their risk-weighted asset bases for the purpose of calculating their risk-based capital ratios

Under the exclusion, sponsoring banking organizations would continue to hold risk-based capital against all other risk exposure arising in connection with ABCP programs, including direct credit substitutes, recourse obligations, residual interests, long-term liquidity facilities, and loans, in accordance with each agency’s existing risk-based capital standards

Basel I: ABCP Exclusion

Permanent Capital Relief Rule: ABCP eligible liquidity rules

Effective for periods after September 30, 2004

Provided for a 10% credit conversion factor for eligible liquidity facilities (50% for commitments over one year)

After September 30, 2005, liquidity facilities were required to meet certain eligibility criteria in order to qualify for the 10% or 50% Credit Conversion Factor (otherwise they were treated as direct credit substitutes and risk-weighted not less than 100%) – Liquidity could not fund against assets that were more than 90 days past due or in default

• A liquidity facility could qualify as eligible liquidity if the ineligible assets were covered by eligible credit enhancement – Funded credit enhancements such as overcollateralization, cash reserves, subordinated securities, and funded spread

accounts – Surety bonds and letters of credit issued by third parties with credit ratings of at least “A” – One month’s worth of excess spread if the excess spread is required to be captured when it falls below 4.5% and there is no

material adverse change in the bank’s ABCP underwriting standards

– If the assets funded against were externally rated, the liquidity could not fund against the assets if the assets were rated below investment grade at the time of the proposed liquidity funding

U.S. Rules Refining Basel I Guidelines

2001 U.S. Recourse Rules and March 30, 2005, Guidance for Calculating Capital on Program Wide Credit Enhancement (“PWCE”), for ABCP Conduits

Both rules modified the risk weights for securitization exposures held by U.S. banks based on external credit ratings

With primary regulatory approval, banks were permitted to use their own internal credit ratings systems to determine the appropriate amount of capital for PWCE (a special category of direct credit substitute). Use of these systems could not result in a risk weight of less than 100%

U.S. regulators issued guidance on the use of internal credit ratings systems for calculating capital on PWCE provided by banks; a “weakest link” approach was used to determine the capital charge – If all of the exposures in the ABCP conduit were internally rated investment grade or better, the capital charge was 8% of the amount of

the PWCE – If not, then a formula-driven approach was used to calculate capital as follows

Basel II

Basel II Overview: “A Revised Framework on International Convergence of Capital Measurement and Capital Standards”

Proposed in 1999 in response to the banking crisis in the 1990’s and the criticisms of Basel I

The fundamental objective of the Basel Committee's work to revise the 1988 Accord was to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation would not be a significant source of competitive inequality among internationally active banks

Expands on objectives of Basel I – more comprehensive capital adequacy accord – Covers new approaches to credit risk – Adapts to the securitization of bank assets – Covers market, operational, and interest rate risk – Incorporates market-based surveillance and regulation

Basel Committee issued the final revised framework in 2004

Basel II Three Pillars of Basel II2

2 Source: GAO

Pillar 1 Pillar 3Pillar 2

Minimum capital requirements

Market Risk

Standardized

approach

Foundation

internal

ratings-based

approach

Advanced

internal

ratings-based

approach

(“A-IRB”)

Basic indicator

approach

Standardized

approach

Advanced

measurement

approaches

(“AMA”)

Risk Measurement Approaches

Currently proposed in the U.S. Standardized approach as an option for non-core banks

Other approaches available in the international accord

Required in the U.S. final rule for core banks, opt-in available to non-core banks

Supervisory review

Market discipline (via disclosure)

Supervisory roles:

• Evaluate banks’ internal

capital adequacy

assessments and

compliance with minimum

capital requirements

• Expect and be able to

require banks to hold

capital in excess of

minimum , to address risks

not fully captured under

Pillar 1

• Intervene early to

prevent capital from falling

below minimum levels

Requires banks to publicly

disclose qualitative and

quantitative information

on:

• Capital ratios

• Capital components

• Risk assessment process

• Aggregate information

underlying risk estimates

Credit Risk

Operational Risk

Basel II

Hierarchy of approaches for securitization exposures

According to Basel II, banks must apply the following hierarchy of approaches to determine the risk-based capital requirement for a securitization exposure

Gains-on-Sale and Credit Enhancement Interest Only Strips (“CEIOs”)

Ratings-Based Approach (“RBA”)

Ratings-Based Approach and Use of Inferred Ratings

Internal Assessment Approach (“IAA”)

Supervisory Formula Approach (“SFA”)

Deduction from capital

Basel II


Gains-on-Sale and Credit Enhancement Interest Only Strips (“CEIOs”) – After-tax gain-on-sale resulting from a securitization is deducted from Tier 1 capital – Any portion of a CEIO that does not constitute a gain-on-sale is deducted from total capital (split evenly

between Tier 1 and Tier 2 capital)

Ratings-Based Approach (“RBA”) – Used if a securitization exposure is not a gain-on-sale or a CEIO – An exposure qualifies for the RBA if the exposure has an external credit rating from a Nationally Recognized

Statistical Ratings Organization (“NRSRO”) or has an inferred credit rating (the exposure is senior to another securitization exposure in the transaction that has an external credit rating from an NRSRO)

– An originating bank is eligible to use the RBA for a securitization exposure if • The exposure has two or more external credit ratings, or • The exposure has two or more inferred credit ratings

– An investing bank is eligible to use the RBA for a securitization exposure if the exposure has one or more external or inferred credit ratings

Basel II


Ratings-Based Approach (“RBA”) (cont’d) – An unrated securitization exposure has an inferred credit rating if another securitization exposure issued by

the same issuer and secured by the same underlying exposures has an external credit rating and this rated reference exposure • Is subordinate in all respects to the unrated securitization exposure • Does not benefit from any credit enhancement that is not available to the unrated securitization exposure • Has an effective remaining maturity that is equal to or longer than the unrated securitization exposure

– Securitization exposures with an inferred credit rating are treated the same as securitization exposures with an identical external credit rating

– If a securitization exposure has multiple external credit ratings or multiple inferred credit ratings, a bank is required to use the lowest credit rating (the credit rating that would produce the highest risk-based capital requirement)

– The risk-based capital requirement per dollar of securitization exposure depends on four factors • The applicable credit rating of the exposure • Whether the credit rating reflects a long-term or short-term assessment of the exposure’s credit risk • Whether the exposure is a ‘‘senior’’ exposure • The granularity of the exposure

Basel II


Ratings-Based Approach and Use of Inferred Ratings – To use the charts these items must be

known • Explicit or inferred credit rating of the

position • Granularity of the “pool” (effective

number of exposures, “N”) • Seniority of the position

– Column 2 (most favorable) of the charts is used if N is 6 or more and the position has the most senior claim on the assets in the securitization pool

– Column 4 (least favorable) is used if N is less than 6

– Column 3 (standard) is used in all other cases

– Note that the resecuritization exposures in columns 5 and 6 have not been adopted in the U.S.

3 Source: Basel Committee on Banking Supervision Enhancements to the Basel II Framework, dated July 2009

Long-term

Rating

Senior,

Granular

Non-senior,

Granular

Non-granular Senior Non-senior

AAA 7 12 20 20 30

AA 8 15 25 25 40

A+ 10 18 35 35 50

A 12 20 35 40 65

A- 20 35 35 60 100

BBB+ 35 50 50 100 150

BBB 60 75 75 150 225

BBB- 100 100 100 200 350

BB+ 250 250 250 300 500

BB 425 425 425 500 650

BB- 650 650 650 750 850

Below

Securitization Exposures Resecuritization Exposures

Deduction

ABS Risk Weights for Long-Term Credit Rating and/or Inferred Rating Derived from a Long-Term Investment3

Short-term

Rating

Senior,

Granular

Non-senior,

Granular


A1 7 12 20 20 30

A2 12 20 35 40 65

A3 60 75 75 150 225

Below


Deduction

ABS Risk Weights for Short-Term Credit Rating and/or Inferred Rating Derived from a Short-Term Investment3

Basel II

Hierarchy of Minimal Capital Requirements Approaches

Internal Assessment Approach (“IAA”) – A bank must receive written approval from its primary Federal regulator to use the IAA – A bank must satisfy the following requirements to qualify for the IAA

• The bank’s internal credit assessments of securitization exposures must be based on publicly available credit rating criteria used by an NRSRO

• The bank’s internal credit assessments of securitization exposures used for risk-based capital purposes must be consistent with those used in the bank’s internal risk management process, management information reporting systems, and capital adequacy assessment process

• The bank's internal credit assessment process must have sufficient granularity to identify gradations of risk – Each of the bank's internal credit assessment categories must correspond to an external credit rating of an NRSRO

• The bank's internal credit assessment process, particularly the stress test factors for determining credit enhancement requirements, must be at least as conservative as the most conservative of the publicly available credit rating criteria of the NRSROs that have provided external credit ratings to the commercial paper issued by the ABCP program

• The bank must have an effective system of controls and oversight that ensures compliance with these operational requirements and maintains the integrity and accuracy of the internal credit assessments

– The bank must have an internal audit function independent from the ABCP program business line and internal credit assessment process that assesses at least annually whether the controls over the internal credit assessment process function as intended

• The bank must review and update each internal credit assessment whenever new material information is available, but no less frequently than annually

• A bank that elects to use the IAA for any securitization exposure to an ABCP program must use the IAA to compute risk-based capital requirements for all securitization exposures that qualify for the IAA

Basel II

Hierarchy of Minimal Capital Requirements Approaches

Internal Assessment Approach (“IAA”) (cont’d)

– A bank’s exposure must satisfy the following requirements to qualify for the IAA • The bank initially rated the exposure at least the equivalent of investment grade • The ABCP program has robust credit and investment guidelines for the exposures underlying the securitization exposure • The ABCP program performs a detailed credit analysis of the sellers of the exposures underlying the securitization exposure • The ABCP program’s underwriting policy for the exposures underlying the securitization exposure establishes minimum asset

eligibility criteria that include the prohibition of the purchase of assets that are significantly past due or of assets that are defaulted, as well as limitations on concentration to individual obligors or geographic areas and the tenor of the assets to be purchased

• The aggregate estimate of loss on the exposures underlying the securitization exposure considers all sources of potential risk, such as credit and dilution risk

• Where relevant, the ABCP program incorporates structural features into each purchase of exposures underlying the securitization exposure to mitigate potential credit deterioration of the underlying exposures

Basel II

Hierarchy of Minimal Capital Requirements Approaches (cont’d)

Supervisory Formula Approach (“SFA”) – SFA can be applied to a securitization exposure if the securitization exposure is not a gain-on-sale or a CEIO, does not qualify for

the RBA, and is not an exposure to an ABCP program for which the bank is applying the IAA – A bank qualifies to use the SFA if the bank is able to calculate a set of risk factors relating to the securitization, including the

risk-based capital requirement for the underlying exposures as if they were held directly by the bank

– The SFA capital requirement for a securitization exposure depends on the following inputs: • The amount of the underlying exposures • The securitization exposure’s proportion of the tranche that contains the securitization exposure • The sum of the risk-based capital requirement and expected credit loss (“ECL”) for the underlying exposures (as determined under the final

rule as if the underlying exposures were held directly on the bank’s balance sheet) divided by the amount of the underlying exposures (Kirb) • The tranche’s credit enhancement level • The tranche’s thickness • The securitization’s effective number of underlying exposures • The securitization’s exposure weighted average loss given default

– A bank must deduct from total capital any part of a securitization exposure that incurs a 1,250% risk weight under the SFA. Any part of a securitization exposure that incurs less than a 1,250% risk weight must be risk weighted rather than deducted

– Under SFA, capital for retained interests and other residual interests is equal to the amount of such exposures if the amount of such exposure is less than Kirb

Deduction from capital – If a bank is not able to use the above approaches, the bank must deduct the exposure from total capital

Basel II

Exceptions to the General Hierarchy of Approaches

Maximum risk-based capital requirement – Unless one or more of the underlying exposures does not meet the definition of a wholesale, retail, securitization, or equity

exposure, the total risk-based capital requirement for all securitization exposures held by a single bank associated with a single securitization (including any regulatory capital requirement that relates to an early amortization provision, but excluding any capital requirements that relate to the bank’s gain-on-sale or CEIOs associated with the securitization) cannot exceed the sum of (i) the bank’s total risk-based capital requirement for the underlying exposures as if the bank directly held the underlying exposures; and (ii) the bank’s total ECL for the underlying exposures

General risk-based capital rules – Banks are required to hold a dollar in capital for every dollar in residual interest, regardless of the effective risk-based capital

requirement on the underlying exposures

Double-counting of risks in overlapping of securitization exposures – For banks that have multiple securitization exposures providing duplicative coverage of the underlying exposures of a

securitization (such as when a bank provides a program-wide credit enhancement and multiple pool-specific liquidity facilities to an ABCP program)

– The applicable risk-based capital treatment under the securitization framework that results in the highest capital requirement is applied to overlapping positions

Other exceptions under original U.S. guidelines – Interest-only mortgage-backed securities must be assigned a risk weight that is no less than 100% – A sponsoring bank that qualifies as a primary beneficiary and must consolidate an ABCP program as a variable interest entity

under GAAP generally may exclude the consolidated ABCP program assets from risk-weighted assets4 • The bank must hold risk-based capital against any securitization exposures of the bank to the ABCP program

– A special set of rules applies to transfers of small business loans and leases with recourse by well-capitalized depository

institutions

4 Source: The January 2010 Risk Based Guidelines; Capital Adequacy Guidelines; Capital Maintenance; Regulatory Capital; Impact of Modifications to Generally Accepted Accounting Principles; Consolidation of Asset-Backed Commercial Paper Programs; and Other Related Issues; Final Rule removed the ABCP exclusion

Dodd-Frank Act

“Dodd-Frank Wall Street Reform and Consumer Protection Act”

Enacted July 21, 2010, the intention of this act is to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘‘too big to fail’’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes

Applicable sections that impact risk-based capital for securitizations

Section 939A – Removal of Reliance on Credit Ratings – No later than 1 year after the enactment of this section, each Federal agency shall, to the extent applicable,

review • Any regulation issued that requires the use of an assessment of the credit-worthiness of a security or money market instrument • Any references to or requirements in such regulations regarding credit ratings

– Each agency shall modify any such regulations identified by the review to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations

– Such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each agency, taking into account the entities regulated by each agency and the purposes for which such entities would rely on such standards of credit-worthiness

– Notice of Proposed Rulemaking on Section 939A still pending. Expected 1Q12 – Market Risk Rules NPR released in December of 2011

Dodd-Frank Act

“Dodd-Frank Wall Street Reform and Consumer Protection Act”

Applicable sections that impact risk-based capital for securitizations

Section 171 (potentially impacts securitization exposures) – Collins Amendment – establishes – Collins Amendment final rule was adopted on June 14, 2011. Compliance with capital floor calculated on an

enterprise-wide basis, and floor possibly subject to change with future changes to Basel I rules – Minimum Leverage and Risk-Based Capital Requirements – Investments in Financial Subsidiaries

Section 941 – Requires that a securitizer retain an economic interest in a material portion of the credit risk for any asset

that it transfers, sells, or conveys to a third party

Basel II.5

Resecuritizations

Global Resecuritization Definition – Securitization exposure in which the risk to the underlying exposures is tranched and at least

one or more of the underlying exposures is a securitization exposure

ABCP Programs – Assumption: ABCP Conduit does not hold securitization exposures that are resecuritization

exposures: • Deal-specific liquidity facility generally not a resecuritization exposure. • Program-wide credit enhancement (PWCE) that provides protection across pools above seller protection generally would

be a resecuritization exposure. • CP would not be a resecuritization exposures if either:

– PWCE was not a resecuritization exposure, or – CP is fully supported by the sponsoring bank.

Basel II.5

Modification of RBA Tables under IRB Approach

Senior Resecuritization Exposures – Senior position – None of the underlying exposures are

themselves resecuritization exposures.


Long-term

Rating

Senior,

Granular

Non-senior,

Granular


AAA 7 12 20 20 30

AA 8 15 25 25 40

A+ 10 18 35 35 50

A 12 20 35 40 65

A- 20 35 35 60 100

BBB+ 35 50 50 100 150

BBB 60 75 75 150 225

BBB- 100 100 100 200 350

BB+ 250 250 250 300 500

BB 425 425 425 500 650

BB- 650 650 650 750 850

Below Deduction


Short-term

Rating

Senior,

Granular

Non-senior,

Granular


A1 7 12 20 20 30

A2 8 15 25 25 40

A3 10 18 35 35 50

Below Deduction

Basel II.5

Changes to securitization risk weights under Standardized Approach

Long-term Rating Securitization Exposures Resecuritization Exposures

AAA to AA- 20 40

A+ to A- 50 100

BBB+ to BBB- 100 225

BB+ to BB- 350 650

B+ and below or unrated Deduction

Short-term Rating Securitization Exposures Resecuritization Exposures

A-1 / P-1 20 40

A-2 / P-2 50 100

A-3 / P-3 100 225

All other ratings or unrated Deduction

Basel II.5

Treatment of ABCP liquidity facilities

Standardized Approach – Credit conversion factor (CCF) for short-term securitization liquidity facilities increased from 20% to 50%.

This means 50% CCF applies to all undrawn ABCP liquidity facilities regardless of the length of commitment

IRB Approach – Clarification of When a Liquidity Facility is a Senior Exposure – Senior Liquidity Facility must cover all of the ABCP and other senior debt supported by the pool such that no

cash flows from the underlying pool could be transferred to other creditors until liquidity draws are paid in full

Market Disruption – Favorable treatment eliminated. The favorable CCFs for market disruption liquidity facilities (0% -

Standardized Approach / 20% - IRB Approach) have been eliminated

Changes to Market Risk Rules

– Basic Principle – Capital requirement in respect of a securitization exposure to be calculated by reference to the risk-weighted exposure amount that would apply if the exposure were held in the banking book

Basel III

Basel III Overview: “A Global Regulatory Framework for More Resilient Banks and Banking Systems”

Released in December 2010 with the following objectives: – Improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus

reducing the risk of spillover from the financial sector to the real economy – Improve risk management and governance – Strengthen banks’ transparency and disclosures

6 Source: Basel III: A global regulatory framework for more resilient banks and banking systems

2011 2012 2013 2014 2015 2016 2017 2018

As of

1 January

2019

Migration

to Pillar I

3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

0.625% 1.25% 1.875% 2.50%

20% 40% 60% 80% 100% 100%

4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%

8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%

Observation

period

begins

Introduce

minimum

standard

Observation

period

begins

Introduce

minimum

standard

Supervisory

monitoring

Parallel run

1 Jan 2013 - 1 Jan 2017

Disclosure starts 1 Jan 2015

Phased out over 10 year horizon beginning 2013

Capital Consevation Buffer

Leverage Ratio

Phase-in of deductions from

CET1 (including amounts

exceeding the limit for DTAs,

MSR and financials)

Minimum Tier 1 Capital

Minimum Total Capital

Liquidity coverage ratio

Capital intstruments that no

longer qualify as non-core Tier 1

capital or Tier 2 capital

Minimum Total Capital plus

conservation buffer

Minimum common equity plus

capital conservation buffer

Net stable funding ratio

Basel III Implementation Schedule (as currently drafted)6

Basel III

Changes to capital rules affecting securitizations

Tightens definitions qualifying capital – Mortgage servicing rights and other similar assets in excess of 15% of common equity must be deducted

from common equity capital. Remainder of these assets risk-weighted at 250%

Derecognizes increases in equity capital resulting from a securitization transaction – Expected future margin income from a securitization transaction resulting in gain on sale does not count in

the calculation of common equity

1250% risk-weight for certain securitization exposures – Securitizations formerly deducted from capital now receive a 1250% risk-weight, which results in increased

capital requirements

Collateral haircut for counterparty exposures – Exposure haircuts twice as large as haircuts for corporate bonds – resecuritizations not eligible collateral

Market Risk – New specific risk haircuts for securitizations and resecuritizations that are higher than similarly rated

government and corporate securities

Basel III Leverage Ratio

Similar to leverage ratio applicable to U.S. banks – Basel III imposes a leverage ratio (essentially a requirement to maintain a specified amount of equity (“Tier 1”) capital) that is

similar in many respects to the leverage ratio already imposed upon U.S. banks

Equity capital must be maintained against unused commitments – One major difference, however, is that the current U.S. leverage ratio is a measurement of Tier 1 capital as a percentage of on-

balance sheet assets. The Basel III leverage ratio is a measurement of Tier 1 capital to on-balance sheet assets plus off-balance sheet credit and liquidity commitments

– If adopted in its current form, this could greatly increase the cost to banks of providing letters of credit and unfunded commitments

– Unconditionally cancellable commitments are included in the leverage ratio at 10% of their face amount. All other unfunded commitments are included at 100% of their face amount

No risk adjustment of assets – Assets are not risk-adjusted for purposes of the leverage calculation

TIER 1 CAPITAL ASSETS PLUS OFF-BALANCE SHEET EXPOSURES

Common Equity On-balance sheet assets

Perpetual Preferred Equity ≥ 3% of Repo and securities lending exposure (no netting)

Stock surplus on Tier 1 eligible shares Derivatives (no netting)

Credit derivatives sold (no netting of purchased protection)

Securitization exposures (per accounting rules)

Off-balance sheet exposures

• 10% CCF for unconditionally

cancellable commitments• 100% CCF for all other commitments

Market Risk Risk-Based Capital NPR – December 2011

Basic Approach

Introduces a simplified version of the Basel II supervisory formula approach (SSFA)

If a bank cannot, or chooses not to, use the SSFA, securitization position is assigned a risk weighting factor of 100%, which translates to a 1250% risk weight

Required Inputs to Calculate SSFA

Weighted average capital requirement that would be assigned to the underlying exposures under the general risk-based capital rules (Basel I)

Position’s level of subordination

Position’s relative size within the securitization

Level of losses actually experienced on the underlying exposures

SSFA Designed to Apply Higher Capital to “Risky Junior Positions” and Lower Capital to Most Senior Positions

1250% risk weight assigned to positions that absorb losses up to the amount of capital that would be required for the underlying exposures under the general risk-based capital rules.

For remaining positions, capital decreases as seniority increases, subject to the supervisory floor.


SSFA Risk Weighting Depends Upon the Following Inputs:

Kg = Weighted average capital requirement of the underlying exposures calculated using the general risk-based capital rules.

Parameter A (Attachment Point of Position) = Threshold at which credit losses would first be assigned to the position.

Parameter D (Detachment Point of Position) = Threshold at which credit losses would result in a total loss to the investor in the position.

Supervisory calibration parameter, p = 1.5 for resecuritization positions; 0.5 for other securitization positions.

Cumulative losses on the underlying asset pool.

Dollar Amount of Subordinated Positions

Dollar Amount of Asset Pool

Dollar Amount of Position Plus all Pari Passu Positions

Dollar Amount of Asset Pool

Value of Parameter A +


SSFA Formula

KSSFA =

Capital Under SSFA Equals the Greater of:

KSSFA x 100 expressed as a percentage, and

Minimum risk weighting factor that increases over time as cumulative losses increase on the underlying asset pool

Supervisory Minimum Risk-Weighting Factor Floor

ea-u – ea-1

______________

a(u-l)

1 P - Kg

Where a = u = D - Kg l = A - Kg e = 2.71828 (base of natural logarithms)

Cumulative losses of principal on originally issued securities as a percent of Kg at origination

Specific risk weighting factor (in percent)

Greater than: Less than or equal to: 1.6

0 50 1.6

50 100 8.0

100 150 52.0

150 n/a 100.0

Appendix B: Basel II Timeline Basel II Timeline: Europe and U.S. transitions to Basel II10

10 Source: GAO for portions of the timeline.

International Transition to Basel II U.S transition to Basel II

June: Basel Committee issues final revised framework for Basel II (New Basel Accord). It

reiterates objectives of broadly maintaining the level of aggregate required capital while also

providing incentives to adopt the more advanced approaches. The framework includes

changes such as a 1.06 scaling factor by which capital requirements for credit risk would be

multiplied in order to maintain capital neutrality with previously estimated results.

Bank regulators - OCC, OTS, Federal Reserve, and FDIC (hereafter "regulators") - implement

Basel I with a transition period to 1992.

January: Basel Committee amends Basel I to incorporate market risks. The M arket Risk

Amendment introduces the use of institutions' internal models of risk to determine

regulatory capital requirements.

July: Basel Committee issues Basel Capital Accord (Basel I), international risk-based

capital requirements for banks in G10 countries, to be fully implemented by 1992.

A pril-M ay: Basel Committee releases results of a global quantitative impact study (QIS-3)

and issues third consecutive paper for comment.

January: Basel Committee releases revised proposal based on consultation with industry

and supervisors. The Committee aims to encourage improved risk management practices in

part through capital incentives for banks to move to the more risk-sensitive IRB approach.

June: Basel Committee proposes for comment incremental revisions to Basel I for credit

risk (standardized approach), plans to develop an alternative internal ratins-based (IRB)

approach, and the proposed capital charges for other major risks, including operational risk.

Regulators fully phase in Basel I as part o f broader changes to capital regulation. The prompt

corrective action provisions of FDICIA require adequately capitalized and well-capitalized

institutions to meet or exceed Basel I risk-based capital requirements as well as a leverage

requirement.

September: OCC, Federal Reserve, and FDIC issue final rule implementing the M arket

Risk Amendment, requiring institutions with significant trading activity to use internal models

to measure and hold capital in support of market risk exposure.

A ugust: Regulators release advance NPR on Basel II for comment. The proposed rule

requires the advanced approaches for credit and operational risk to be applied by only the

large and/or internationally active banks and holding companies. Existing capital rules would

be retained for all o ther banks.

September: Regulators announce 1-year delay in implementation and additional

safeguards to prevent unacceptable declines in required capital as estimated in QIS-4. The

agencies retain the leverage requirement, add a transition year, and establish stricter

transition period limits on capital reductions for individual institutions.

Octo ber: Regulators issue Basel IA advance NPR. It revises Basel I to address

competitive inequities between large and small institutions by providing a more risk-sensitive

framework similar to the standardized approach under the Basel II international accord.

June: SEC releases alternative net capital rule the permits certain broker-dealers to use

internal mathematical models to calculate market and derivatives-related credit risk. To apply

the rule, a broker-dealer's ultimate holding company must consent to group-wide supervision

and report capital adequacy measures consistent with Basel standards.

January: Regulators issue interagency statement on qualification process for advanced

approaches based on New Basel Accord.

A pril: Regulators announce delay in Basel II rulemaking process, after results of a

quantitative impact study (QIS-4) estimated material reductions in aggregate capital

requirements and significant variations in results across institutions and portfo lios.

Regulators later state that such results would be unacceptable in an actual capital regime.

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Appendix B: Basel II Timeline (cont’d) Basel II Timeline: Europe and U.S. transitions to Basel II10

10 Source: GAO for portions of the timeline.

International Transition to Basel II U.S transition to Basel II

January: The agencies release "Risk-Based Capital Guidelines; Capital M aintenance:

Regulatory Capital; Impact of M odifications to Generally Accepted Accounting Principles;

Consolidation of Asset Backed Commercial Paper Programs; and Other Related Issues"

July : Dodd-Frank Act

A ugust : Section 939a ANPR

D ecember: US M arket Risk NPR

M arch: Comment periods for Basel II and Basel IA NPRs close.

D ecember: Basel II July: Regulators agree to issue advanced approaches rule more consistent with New Basel

Accord and to issue an NPR for an optional standardized approach.

D ecember: Regulators issue advanced approaches rule.

July: Regulators issue NPR for optional standardized approach containing question on

whether core banks should be able to choose this approach. Regulators issue updated

guidance for supervisory review.

Octo ber: Last date for core banks to adopt implementation plan signed by board of

directors.

M arch: Federal Reserve releases draft Basel II NPR to allow industry time to comment and

prepare. In addition to previously announced safeguards, it states that agencies would view a

10% or greater decline in aggregate risk-based capital requirements (compared to Basel I) as

a material drop warranting changes to the Basel II framework.

June: Basel Committee releases results of a global quantitative impact study (QIS-5) of

estimated changes in minimum required capital under Basel II.

June: EU issues final rule implementing Basel II (EU Capital Directive.) September: Regulators release for comment official NPRs for Basel II and for market risk.

The Basel II NPR approach should be provided to banks as an option in addition to the

advanced approach for credit risk.

D ecember: Regulators release NPR for Basel IA.

July : Basel II enhancements F ebruary: Regulators issue proposed guidance for advanced approaches and supervisory

review.

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2009

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2011

Speakers

Bill Falcon, Vice President, PNC, Pennsylvania

Tim Mohan, Chief Executive Partner, Chapman and Cutler LLP, Illinois

basics_of_risk_based_capital.pdf

Documents