An Impact Assessment of the EU Capital Requirements Directive (CRD) Retention Rule

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1 Teleconference 18 January 2010 An Impact Assessment of the EU Capital Requirements Directive (CRD) Retention Rule Ian Linnell Ramadurai Krishnan Lars Jebjerg

2 Agenda Why the Retention Rule? What Is the Retention Rule? When Will It Be Implemented? Timeline How Will the Rule Play Out? Interplay with Incentives, Capital & Accounting Takeaways

3 Agenda Why the Retention Rule? What Is the Retention Rule? When Will It Be Implemented? Timeline How Will the Rule Play Out? Interplay with Incentives, Capital & Accounting Takeaways

4 Why the Retention Rule? To address the perceived misalignment between Originators and investors > The retention rule is intended to put securitisation markets on a sounder footing by: Promoting responsible underwriting Improved disclosure and information > Implicit in these measures is the attempt to revive securitisation markets Measures adopted should make securitisation markets more robust and transparent In the process promote the use of securitisation as an effective tool of funding and risk transfer 3

5 Agenda Why the Retention Rule? What Is the Retention Rule? When Will It Be Implemented? Timeline How Will the Rule Play Out? Interplay with Incentives, Capital & Accounting Takeaways

6 The Retention Rule: Four Options 5

7 Retention Rule: Exceptions > Transactions based on a transparent index > Syndicated loans, purchased receivables, CDS instruments where they are not used to hedge a securitisation covered by the rule > Securitised exposures to central governments, central banks, regional governments, local authorities, public sector entities, 50% risk-weighted institutions and multilateral development banks > Investors will be required to demonstrate to their local regulators that a formal due diligence process is in place 6

8 Agenda Why the Retention Rule? What Is the Retention Rule? When Will It Be Implemented? Timeline How Will the Rule Play Out? Interplay with Incentives, Capital & Accounting Takeaways

9 Timeline for Implementation > The directive will be applicable to new securitisation transactions from 1 January 2011 > After 31 December 2014, for existing securitisation transactions Where new underlying exposures are added or substituted 8

10 Agenda Why the Retention Rule? What Is the Retention Rule? When Will It Be Implemented? Timeline How Will the Rule Play Out? Interplay with Incentives, Capital & Accounting Takeaways

11 Incentives The Retention Rule DOES > Take a small step to putting the SF market on a sounder footing > Reduce the attractiveness of originate-to-distribute > Improve incentive alignment between investors and originators Equity retention exposes the originator 1:1 to losses as long as losses are below 5%. For low-loss portfolios, this incentivises good origination and servicing Vertical Slice and Seller s Share both give incentive for loss mitigation regardless of the level of losses. However, 5% may be too little skin in the game Random Selection looks and feels similar to Vertical Slice and Seller s Share and SS but may incentivise the originator to focus servicing efforts on the on-balance loans 10

12 Incentives The Rule DOES NOT > Overcome the asymmetry of information between originators and investors which is at the heart of the problem > Work equally well in all situations it is highly dependent on the specifics of each securitisation and the environment over the life of the transaction > in reality change current market practice in many cases Equity Retention, Random Selection and Seller s Shares are all widely used already > Incentivise originators to de risk securitisation transactions > Provide clarity of application many open questions remain 11

13 Illustrative Results Prime RMBS Unsecuritised Capital Charges IRB Unsecuritised PD LGD (EL + UL) = K IRR IRB Unsecuritised (UL Only) Standardised Unsecuritised (35% risk-weight) Total (including reserve account) Securitised Capital Charges Tranche Rating Enhancement Exposure Amount (USD) Standardised (Std) RBA Standard Capital Charge (USD) RBA Capital Charge (USD) AAA AA A BBB BB Reserve Fund Total

14 Illustrative Results Prime RMBS Summary of the Impact of Retention Rules (5%) and Basel II Capital Charges on a Sample RMBS Transaction Capital Charge RBA Cap. VS Std Cap. VS RBA Cap. Charge exc. RF Std Cap. Charge exc. RF RBA Cap. RS Std Cap. RS 5.00 Capital ET VS: Vertical Slice RF: Reserve Fund RS: Random Selection ET: Equity Tranche 13

15 Illustrative Results Prime RMBS 10% Summary of the Impact of Retention Rules (10%) and Basel II Capital Charges on a Sample RMBS Transaction Capital Charge RBA Cap. VS Std Cap. VS RBA Cap. Charge exc. RF Std Cap. Charge exc. RF RBA Cap. RS Std Cap. RS Capital ET VS: Vertical Slice RF: Reserve Fund RS: Random Selection ET: Equity Tranche 14

16 Illustrative Results CMBS Unsecuritised Capital Charges IRB Unsecuritised PD LGD (EL + UL) = K IRR IRB Unsecuritised (UL Only) Standardised Unsecuritised (35% risk-weight) Securitised Capital Charges Tranche Rating Enhancement Exposure Amount (USD) Standardised (Std) RBA Standard Capital Charge (USD) RBA Capital Charge (USD) AAA AAA AAA AAA AAA BBB BB Total

17 Illustrative Results CMBS Summary of the Impact of Retention Rules (5%) and Basel II Capital Charges on a Sample CMBS Transaction Capital Charge RBA Cap. VS Std Cap. VS Capital ET VS: Vertical Slice ET: Equity Tranche 16

18 Illustrative Results ABS Unsecuritised Capital Charges IRB Unsecuritised PD LGD (EL + UL) = K IRR IRB Unsecuritised (UL Only) Standardised Unsecuritised (35% risk-weight) Securitised Capital Charges Tranche Rating Enhancement Exposure Amount (USD) Standardised (Std) RBA Standard Capital Charge (USD) RBA Capital Charge (USD) AAA A BBB Seller's interest n.a Early amortisation Charge Total Note: The amount of exposure sold to investors is 93.7 in this example 17

19 Illustrative Results ABS Summary of the Impact of Retention Rules (10%) and Basel II Capital Charges on a Credit Card Transaction Capital Charge RBA Cap. VS Std Cap. VS RBA Cap. SS 1.20 Std Cap. SS RBA Cap. RS 6.00 Std Cap. RS VS: Vertical Slice SS: Seller s Share RS: Random Selection 18

20 Illustrative Results Corporate (Arbitrage) CDO Unsecuritised Capital Charges IRB Unsecuritised PD LGD (EL + UL) = K IRR IRB Unsecuritised (UL Only) Standardised Unsecuritised (35% risk-weight) Securitised Capital Charges Tranche Rating Enhancement Exposure Amount (USD) Standardised (Std) RBA Standard Capital Charge (USD) RBA Capital Charge (USD) AAA AAA AA A BBB BB Equity Total

21 Illustrative Results Corporate (Arbitrage) CDO Summary of the Impact of Retention Rules (5%) and Basel II Capital Charges on a Sample CDO Transaction Capital Charge RBA Cap. VS Std Cap. VS Capital ET VS: Vertical Slice ET: Equity Tranche 20

22 Illustrative Results Corporate CDO Unsecuritised Capital Charges IRB Unsecuritised PD LGD (EL + UL) = K IRR IRB Unsecuritised (UL Only) Standardised Unsecuritised (35% risk-weight) Securitised Capital Charges Tranche Rating Enhancement Exposure Amount (USD) Standardised (Std) RBA Standard Capital Charge (USD) RBA Capital Charge (USD) AAA Equity Total

23 Illustrative Results Corporate CDO Summary of the Impact of Retention Rules (5%) and Basel II Capital Charges on a Sample Corporate CDO Capital Charge RBA Cap. VS Std Cap. VS Capital ET 5.0 VS: Vertical Slice ET: Equity Tranche 22

24 Illustrative Results CDO of Small & Medium Sized Borrowers Unsecuritised Capital Charges IRB Unsecuritised PD LGD (EL + UL) = K IRR IRB Unsecuritised (UL Only) Standardised Unsecuritised (35% risk-weight) Total (including reserve account) Securitised Capital Charges Tranche Rating Enhancement Exposure Amount (USD) Standardised (Std) RBA Standard Capital Charge (USD) RBA Capital Charge (USD) AAA A BBB BB B Reserve Fund Total

25 Illustrative Results CDO of Small & Medium Sized Borrowers Summary of the Impact of Retention Rules (5%) and Basel II Capital Charges on a Sample CDO of Small-and-Medium-Sized Borrowers Capital Charge RBA Cap. VS Std Cap. VS RBA Cap. Charge exc. RF Std Cap. Charge exc. RF RBA Cap. RS Std Cap. RS 5.00 Capital ET VS: Vertical Slice RF: Reserve Fund RS: Random Selection ET: Equity Tranche 24

26 Interplay with Accounting > The retention rule in combination with the requirement of banks to recognise their continuing involvement will make it difficult for banks to derecognise assets > In Europe as regulatory capital relief is not closely aligned to the accounting framework, the impact of the retention rule is likely to be muted > The retention rule may impinge on significant risk transfer rules banks may struggle to obtain capital relief 25

27 Interplay with Accounting > In the US proposed changes to the accounting framework are likely to bring assets back on to bank balance sheets > As regulatory capital relief is tied closely to the accounting framework in the US, banks will struggle to obtain regulatory capital relief > Retention rule may have an impact on the proposed leverage ratio 26

28 Unanswered Questions of the Retention Rule 1. Are liquidity providers and swap counterparties caught up within these provisions? 2. Standards for due diligence, how will it be monitored, differences in requirements for originators and investors. 3. Will sellers share option be available to RMBS master trusts? 4. How will granularity be defined under random selection? 5. What is an appropriate hedge? 6. The duration of the retention requirement and the treatment of interruptions that are not the fault of the originator. 7. How will the penalty clause be applied when there is a breach? 8. Will retention of first loss in the underlying assets (eg CMBS B loans) count towards the 5%? 27

29 Takeaways > A one-size fits all retention rule is unlikely to effectively and consistently align interests of originators and investors in all cases > The rule may reduce the attractiveness of the originate-to-distribute model > The retention rule that best achieves a closer alignment of originator and investor interests may remove the incentive to securitise assets > The rule is likely to come into conflict with the accounting rules > Uncertainty regarding the rules may result in inconsistent application > Issues of asymmetric information will persist > Disclosure and transparency are equally important considerations 28

30 Fitch Ratings New York One State Street Plaza New York, NY FITCH London 101 Finsbury Pavement London EC2A 1RS Fitch Group Fitch Ratings Fitch Solutions Algorithmics

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