Basel II Implications for Structured Finance

Basel II is the new regulatory framework that will apply to banks worldwide from 2007. The
Capital Requirements ire!ti"e is the legal te#t that will gi"e for!e to Basel II in the $% and on
whi!h dis!ussions should start "ery soon at the $uropean &arliament. Basel I was instrumental in
the de"elopment of se!uritisation and more generally of stru!tured finan!e. %nder Basel I'
se!uritisation had be!ome a !lassi! te!hnique that allowed banks to de!rease the amount of
regulatory !apital for some assets on their balan!e sheets' while not redu!ing the e!onomi!
!apital (designed to !apture the true e!onomi! risks asso!iated with those assets) to the same
e#tent. *s Basel II aims to better align regulatory !apital with e!onomi! !apital' one of the key
dri"ers of se!uritisation may disappear and one should legitimately question whether
se!uritisation and stru!tured finan!e still make sense in the !onte#t of Basel II.
Determining Regulatory Capital Charges
+ne ma,or !hange introdu!ed by Basel II !ompared with Basel I deals with the introdu!tion of
new approa!hes to determining regulatory !apital !harges. Capital !harges for market risk will not
!hange' whereas the !apital !harges for !redit risk and operational risk will. +perational risk is a
new type of risk that was not !onsidered under Basel I and refers to the risk of dire!t losses
resulting from fraud' te!hnology failures' legal risks or trade settlement errors' among other
things.
In !ontrast to the situation under Basel I' !redit risk !apital !harges will be!ome mu!h more risk-
sensiti"e as they will be linked to !redit ratings. Banks will either use publi! ratings published by
rating agen!ies under the simplest approa!h or the standardised approa!h or they will use their
own internal ratings under the more ad"an!ed internal ratings-based (IRB) approa!hes.
Credit !harges for se!uritisation e#posures are' howe"er' treated somewhat differently from
!orporate loans or bonds. rather more !onser"ati"ely' in fa!t. %nder the standardised approa!h'
risk weights are mu!h more !onser"ati"e for non-in"estment grade or unrated e#posures. /or
instan!e' a se!uritisation originator retaining a Ba2 tran!he should 0dedu!t0 the amount of the
tran!he from its regulatory !apital1 this is the 0one-for-one0 rule (one euro of !apital for one euro
of e#posure) whi!h !orresponds to a risk weight of 234 per !ent whi!h equals2250 per !ent. In
!omparison' a bank in"estor buying a Ba2 !orporate bond should apply a risk weight of 200 per
!ent' !orresponding to a !apital requirement of 4 per !ent of the amount of their in"estment.
IRB Approaches
The same differen!e in treatment for se!uritisation e#posures also applies to banks using the IRB
approa!hes. Indeed' Basel II does not re!ognise internal ratings determined by banks for
se!uritisation e#posures. Referring to the 0internal ratings-based0 approa!h in the !ase of
se!uritisation e#posures is therefore somewhat misleading. Instead of using internal ratings' IRB
banks may only use publi! ratings by rating agen!ies for rated tran!hes (ratings-based approa!h
- RB*)' or a regulatory formula (super"isory formula) for unrated tran!hes. 6owe"er' to be
perfe!tly fair' re!ognition of internal assessments does o!!ur in the "ery spe!ifi! !ase of liquidity
lines or !redit enhan!ements e#tended by sponsor banks to *BC& !onduits.
%nder the RB*' there are three different sets of risk weightings (linking risk weightings and publi!
ratings) that may be used depending on the granularity of the underlying pool of assets and the
seniority of the !onsidered tran!he. The lowest risk weights will be a!hie"ed for senior tran!hes
ba!ked by granular pools (residential mortgages or retail assets).
Implications of New Rules
7hat are the likely impli!ations of these new rules for se!uritisation issuers and in"estors8 Basel
II has in fa!t already had an impa!t on issuers' with banks ha"ing been a!ti"e in setting up
spe!ial task for!es to adapt their IT infrastru!tures and pro!esses. The implementation !osts of
Basel II ha"e been estimated at between 9200m and 9200m for ea!h large bank.
Beyond this transitional phase' the key benefi!iaries of Basel II will be those banks that hold a
ma,ority of high-grade or retail assets' while those banks that hold a ma,ority of low-grade assets
are likely to lose out as a result of the !hanges. *!!ording to the findings of the :uantitati"e
Impa!t ;tudy that the Basel Committee asked banks to !omplete in 200<' more !redit !apital will
be needed globally for banks= lending to so"ereigns' small banks and !orporates' or for
spe!ialised lending (pro,e!t finan!e) e#posures. >ess !redit !apital will be needed for portfolios of
;?$s' residential mortgages' retail assets and !redit !ards. Those banks that spe!ialise in
!onsumer lending are therefore more likely to benefit from Basel II than those with a different
fo!us.
To what use will the benefi!iaries of Basel II put their gain in regulatory !apital8 They may use the
e#tra !ushion to redu!e their !apital (through share buyba!ks' for instan!e)' boost loan
origination' de"elop new a!ti"ities' or e"en buy or merge with those entities that suffer from the
Basel II !hanges' depending on market !onditions. %ltimately' Basel II may well en!ourage
banking !onsolidation or e"en !ross-border mergers in $urope.
Coming ba!k to se!uritisation' it still seems to make sense for banks to se!uritise low-grade
assets to ensure that regulatory !apital remains at an a!!eptable le"el and to shift risks off their
balan!e sheets. @onetheless' banks may be less in!enti"ised to se!uritise high-grade or retail
assets as these assets will attra!t a lower le"el of regulatory !apital if they retain them on the
balan!e sheet. They may' howe"er' use them as !ollateral for on-balan!e-sheet finan!ings' su!h
as !o"ered bonds' stru!tured !o"ered bonds' or other types of !ollateralised issuan!es or
se!ured fundings.
Impact on Structured Finance Instruments
Basel II is likely to ha"e an impa!t on other stru!tured finan!e instruments' namely !redit
deri"ati"es and syntheti! se!uritisation' (stru!tured) !o"ered bonds or *BC& programmes. The
!urrent Basel II treatment for !redit deri"ati"es is somewhat !onser"ati"e. /or both single-name
and portfolio !redit deri"ati"es' Basel II !apital !harges are not determined by referen!e to a
double default of the underlying referen!e obligor or portfolio and the deri"ati"e !ounterparty' but
look solely to the !ounterparty.
In the !ase of syntheti! se!uritisation' spe!ial purpose "ehi!les (;&As) are generally not
re!ognised as eligible prote!tion pro"iders' e"en in a !ase where they are fully !ollateralised.
These !urrent !onser"ati"e rules for !redit deri"ati"es and syntheti! se!uritisation may for!e
issuers to restru!ture !urrent or future deals or e"en to stop issuan!e. @ote' howe"er' that the
Basel Committee and the International +rganisation of ;e!urities Commissions (I+;C+) are
,ointly working on refining these rules and other trading book issues. Current Basel II rules may
well !hange "ery soon.
Basel II may also impa!t !o"ered bonds' stru!tured or plain !o"ered bonds. ;tri!tly speaking'
their regulatory treatment is not dire!tly addressed within the Basel II a!!ord' but through the
Capital Requirements ire!ti"e in $urope. Basel II risk weights for (stru!tured) !o"ered bonds will
be determined by referen!e to the bank issuing the !o"ered bonds' rather than by referen!e to
the legal or stru!tural prote!tion of the !o"ered bonds themsel"es. These rules will on balan!e
benefit highly rated banks and may redu!e the in!enti"es to issue stru!tured !o"ered bonds with
dynami! stru!tural prote!tions.
Beyond that' some banks' espe!ially residential mortgage banks' will ha"e to de!ide whi!h way
to go for funding1 issue !o"ered bonds or se!uritise8 There seems to be no !lear ad"antage for
one solution or the other from a pure Basel II perspe!ti"e' although on a !ase-by-!ase basis one
may be preferred to another. The !hoi!e will !ertainly be dri"en by other !onsiderations1 spread
and !ost of funding of !o"ered bonds "ersus *aa ?B;. liquidity. and the need to maintain
different funding sour!es. Regulation may also influen!e the issuers= de!ision' for instan!e' the
/;* in the %B has adopted a soft rule asking %B banks to pro"ide ,ustifi!ation in the e"ent that
they issue !o"ered bonds for more than C per !ent of their assets.
ABCP Programmes
*BC& programmes are also likely to be impa!ted by Basel II' with potentially fewer bonds being
stored in *BC& !onduits. The margin deri"ed from this a!ti"ity will be squeeDed by the potentially
in!reasing !osts of liquidity lines e#tended by sponsor banks (more regulatory !apital will be
needed for those liquidity lines) and the potentially de!reasing spreads on the (in"estment-grade)
bonds stored in those !onduits (less regulatory !apital will be required for those bonds). In
addition' *BC& !onduits may pur!hase more trade re!ei"ables1 Basel II will somewhat in!rease
regulatory !apital for IRB banks lending to small and medium-siDed enterprises (;?$s)' whi!h
may translate into in!reased funding !osts for those ;?$s. ;e!uritising trade re!ei"ables through
*BC& programmes may therefore pro"e an attra!ti"e sour!e of funding for them.
Basel II will also lead to the restru!turing of liquidity lines pro"ided by *BC& sponsor banks. &ure
liquidity lines or alternati"e forms of liquidity lines relying on market me!hanism will be put in
pla!e to a!hie"e the lowest risk weights. In the e"ent that this pro"es impossible' liquidity lines
may !on"ersely be simplified to !o"er other risks than pure liquidity risk (typi!ally !redit risk of the
underlying assets). /inally' Basel II may well lead to more fully supported *BC& programmes.
Implications for Bank Inestors
Bank in"estors will also be impa!ted by Basel II and will ha"e to take a fresh look at their
in"estment strategies for se!uritisation. 7hi!h regulatory approa!h should they apply -
standardised or IRB8 *nd why8 7hi!h se!urities should they buy' hold and sell8 7hat will be the
!hanges in the in"estor base' the liquidity' the spreads8 ?any su!h questions need to be
addressed by bank in"estors.
+ne parti!ular issue' that of se!uritisation tran!hes rated Ba and below' is worth e#amining. ;u!h
tran!hes attra!t "ery high risk weightings for bank in"estors. *s a !onsequen!e' a bank in"estor
may well de!ide not to buy these tran!hes and they may end up being sold outside the Basel II
sphere. Con"ersely' a bank in"estor may well a!!umulate those tran!hes' repa!kage them as a
C+ of Ba-rated tran!hes' sell the senior C+ tran!he and keep the equity tran!he. This equity
tran!he will be dedu!ted from its !apital' but the e!onomi!s might turn to be highly profitable.
Regulatory arbitrages may well also de"elop for se!uritisation e#posures. Banks running the
standardised approa!h are in a stronger position than banks running the IRB approa!h when
holding Ba-rated tran!hes' while the !ontrary is the !ase when holding senior tran!hes. In this
!onte#t' why not !ontemplate 0regulatory swaps0 between an IRB bank and a standardised bank
whereby ea!h bank e#!hanges the total returns on the tran!hes they hold for the other bank8
6owe"er' it is not !rystal !lear how su!h swaps would be addressed by Basel II' if addressed at
all.
Conclusion
Basel II is a !omple# a!!ord that will undoubtedly reshape the stru!tured finan!e market in the
years to !ome. Elobally speaking' regulatory !apital arbitrage is unlikely to be a key dri"er of
stru!tured finan!e issuan!e' as may ha"e been the !ase under Basel I. +ther elements su!h as
the di"ersifi!ation of funding sour!es and' in!reasingly' the !ost of funding are more likely to
be!ome key stru!tured finan!e dri"ers. /inally' Basel II should be somewhat good news for
issuers' in"estors and other market parti!ipants. ;tru!tured finan!e and' abo"e all' those
stru!tured finan!e te!hniques whi!h allow issuers to a!hie"e *aa ratings appear to be here to
stay. Basel II should !reate new opportunities for all players' pro"ided they anti!ipate the !hanges
and adapt to them.