THE IMPLICATION OF BASEL II ON SECURITISATION TRANSACTIONS OF BANKS

Transcription

1 THE IMPLICATION OF BASEL II ON SECURITISATION TRANSACTIONS OF BANKS Wilhelm Pieter Campe Smith Dissertation submitted in fulfillment of the requirements for the degree Magister Commercii in Economics in the Faculty of Economic Science at the University Of Johannesburg JOHANNESBURG September 2007 Supervisor: Dr. R. Hattingh Co-supervisor: Dr. C. Schoeman 1

2 ACKNOWLEDGEMENTS The author wishes to express his gratitude to Dr. Hattingh and Dr. Schoeman for their advice and guidance. 2

3 SYNOPSIS The securitisation industry started in the early 1970s in the United States when securities, backed by pools of home loans, were issued for the first time. During the 1980s, securities supported by other types of financial assets such as auto loans and credit card receivables were issued. Since then, securitisation has expanded rapidly into many countries, including South Africa. The first securitisation transaction in South Africa was a securitisation of home loans in 1989, but very few securitisations came to the market after that. In December 2001 the South African Reserve Bank amended the securitisation regulations, which had been in existence since This created greater certainty for arrangers and investors, and from 2002, the South African securitisation market has grown quickly, driven by frequent securitisation issues by banks. Securitisation is attractive for banks, because it is an additional funding source and allows for the matching of the maturity of a bank s assets and liabilities. Another reason for the attractiveness of securitisation for banks is that it is a mechanism for managing the regulatory capital that a bank is required to hold. In a securitisation transaction, a loan originator such as a bank sells loans on its balance sheet to an independent company, which issues asset-backed securities to fund the acquisition of loans. Provided the transaction complies with the securitisation regulations, the transaction will result in the bank having to hold less regulatory capital compared to a situation where it had not securitised the loans. This regulatory capital arbitrage has been a major factor in banks securitising loans. Regulatory capital arbitrage is possible because of the relatively simplistic manner in which the Basel I capital adequacy guidelines calculate the regulatory capital a bank is required to hold. Given the worldwide growth of the securitisation industry, regulators have become increasingly concerned that banks may not be holding adequate capital as a buffer for the economic risks to which banks are exposed. The Bank for International Settlements, through its Basel Committee on Banking Supervision, has therefore devised a new set of capital adequacy guidelines to replace the Basel I guidelines. The aim of the new Basel II framework is to achieve a greater alignment of regulatory capital with economic risks and to improve risk management practices in banks. Although the Basel Committee cannot enforce its recommendations, it is expected that most regulators throughout the world will adopt the Basel II framework. It is generally expected that the implementation of Basel II will have a substantial impact on banks securitisation activities, especially to the extent that securitisation has been used for regulatory capital arbitrage purposes. 3

4 LIST OF DIAGRAMS Diagram 2.1: Generic securitisation structure Diagram 2.2: Commercial mortgage-backed securitisation structure Diagram 2.3: Credit-tenant lease structure Diagram 2.4: Covered bond structure Diagram 2.5: Registering SPV structure Diagram 2.6: SUBI structure Diagram 2.7: Future flow securitisation structure Diagram 2.8: Inventory pledge structure Diagram 2.9: Inventory sale structure Diagram 2.10: Whole business securitisation structure Diagram 2.11: Intellectual property secured loan structure Diagram 2.12: Intellectual property true sale structure Diagram 2.13: Single-seller ABCP conduit structure Diagram 2.14: Multi-seller ABCP conduit structure Diagram 3.1: Total return swap Diagram 3.2: Credit default swap Diagram 3.3: Credit spread option Diagram 3.4: Credit-linked note Diagram 3.5: CLN issued by an SPV Diagram 3.6: Different generations of synthetic CDOs Diagram 3.7: Unfunded synthetic portfolio CDO Diagram 3.8: Unfunded synthetic CDO with an SPV Diagram 3.9: Funded synthetic portfolio CDO Diagram 3.10: Partially funded synthetic portfolio CDO Diagram 3.11: Synthetic portfolio CDO with protection buyer as super-senior counterparty Diagram 3.12: Synthetic CSO (collateralised swap obligation) transactions Diagram 3.13: Hybrid synthetic transaction Diagram 3.14: Single-tranche synthetic structure Diagram 3.15: Synthetic CDOs of CDOs Diagram 3.16: Standard tranches of credit default swap indices Diagram 3.17: Arbitrage synthetic CDO Diagram 4.1: The securitisation rating process Diagram 5.1: Structure of the Basel II Accord 4

5 Diagram A1.1: South African security structure Diagram A1.2: Mortgage guarantee trust structure Diagram A1.3: Assignment of mortgage guarantees Diagram A4.1: Reference entity successor test Diagram A4.2: Replicating credit default swap exposure 5

6 LIST OF TABLES Table 2.1: Thekwini floating rate notes Table 2.2: Rating multipliers Table 2.3: Characteristics of various CDO types Table 5.1: Causes of banking problems Table 5.2: Capital management options Table 5.3: Comparing default rates with confidence intervals Table 5.4: Comparing measures of capital Table 5.5: Risk weights per asset category Table 5.6: Credit conversion factors per asset category Table 5.7: Add-on amounts for derivative transactions Table 5.8: Reasons for Basel II Table 5.9: Risk weights in the Standardised approach for banking book risk Table 5.10: Asset classes in the IRB approach Table 5.11: Retail correlation factors Table 5.12: Eligible collateral under the Standardised and IRB approaches Table 5.13: Comparing the Standardised and IRB approaches Table 5.14: Standardised risk weights for securitisation exposures Table 5.15: Different risk weights for investing and originating banks Table 5.16: RBA risk weights for long-term rated securitisation exposures Table 5.17: RBA risk weights for short-term rated securitisation exposures Table 5.18: Comparing risk weights under the Standardised approach and the RBA Table 5.19: Comparing the Standardised and IRB approaches Table 6.1: Comparing return on regulatory capital Table A4.1: Using credit spreads to price a credit default swap Table A4.2: Default probability table for pricing credit default swaps Table A5.1: Comparing rating symbols Table A5.2: Comparing rating definitions Table A5.3: Comparing annual cumulative default rates Table A6.1: Basel II adjustment factors Table A6.2: Claims on sovereigns Table A6.3: Risk weighting of banks under option 1 Table A6.4: Risk weighting of banks under option 2 Table A6.5: Claims on corporates Table A6.6: Short-term risk weights 6

7 Table A6.7: Standard supervisory haircuts Table A6.8: Minimum holding periods Table A6.9: Risk weight categories for specialised lending Table A6.10: Mapping supervisory categories to external ratings Table A6.11: Supervisory categories for high-volatility commercial real estate Table A6.12: Determining effective LGD Table A6.13: Supervisory risk weights for specialised lending Table A6.14: Supervisory risk weights for high-volatility commercial real estate Table A6.15: Supervisory risk weights for long-term securitisation exposures Table A6.16: Supervisory risk weights for short-term securitisation exposures Table A6.17: Credit conversion factors for credit lines with controlled early amortisation Table A6.18: Credit conversion factors for credit lines with non-controlled early amortisation Table A6.19: Long-term risk weights under the RBA Table A6.20: Short-term risk weights under the RBA 7

8 LIST OF CHARTS Chart 4.1: Vintages of loans Chart 4.2: Static default data for one vintage Chart 4.3: Static default data for different vintages Chart 4.4: Loss probability distribution Chart 4.5: Variations in probability distributions Chart 5.1: Value at risk for different rating categories Chart 5.2: Distribution of losses Chart 5.3: Confidence level for potential losses Chart 6.1: Multiple of the SF capital requirements to RBA capital requirements Chart 6.2: Difference between SF and RBA varies across securitisation tranches Chart 6.3: Disparity between SF and RBA evident across all asset classes Chart 6.4: Multiple of unsecuritised to securitised capital requirements Chart 6.5: Comparing unsecuritised and securitised assets under Basel II Chart 6.6: Comparing risk weights for Standardised and RBA rating categories Chart 6.7: The impact of Basel II on the securitisation of different asset classes 8

9 LIST OF ABBREVIATIONS ABCP: Asset-Backed Commercial Paper ABS: Asset-Backed Security AMA: Advanced Measurement Approach BATS: Bond Automated Trading System CBO: Collateralised Bond Obligation CCF: Credit Conversion Factor CDO: Collateralised Debt Obligation CDS: Credit Default Swap CLN: Credit Linked Note CLO: Collateralised Loan Obligation CMBS: Commercial Mortgage-Backed Security CMO: Collateralised Mortgage Obligation CP: Commercial Paper CPR: Conditional Prepayment Rate CRM: Credit Risk Mitigation CSO: Collateralised Swap Obligation CTL: Credit Tenant Lease DSCR: Debt Service Coverage Ratio EAD: Exposure at Default ECAI: External Credit Assessment Institution ECN: Extendible Commercial Note EL: Expected Loss FHLMC: Federal Home Loan Mortgage Corporation FNMA: Federal National Mortgage Association FRN: Floating Rate Note GIC: Guaranteed Investment Contract GNMA: Government National Mortgage Association HVCRE: High-Volatility Commercial Real Estate IAA: Internal Assessment Approach IMF: International Monetary Fund IO: Interest Only IPRE: Income Producing Real Estate IRB: Internal Ratings-Based ISDA: International Swaps and Derivatives Association 9

10 JIBAR: Johannesburg Interbank Agreed Rate LIBOR: London Interbank Offered Rate LGD: Loss-Given-Default LTV: Loan-to-Value MBS: Mortgage-Backed Security MDB: Multilateral Development Bank MTM: Mark-to-Market MTN: Medium-Term Note NIF: Note Issuance Facility NPL: Non-Performing Loan OTC: Over the Counter PAC: Planned Amortisation Class PC: Participation Certificate PD: Probability of Default PO: Principal Only PSA: Public Securities Association PSE: Public Sector Entity RBA: Ratings-Based Approach RMBS: Residential Mortgage-Backed Security RUF: Revolving Underwriting Facility RWA: Risk-Weighted Asset SDA: Standard Default Assumption SF: Supervisory Formula SLN: Secured Liquid Note SMM: Single-Monthly Mortality SIV: Structured Investment Vehicle SPV: Special Purpose Vehicle STRIP: Separately Traded Registered Interest and Principal SUBI: Special Unit of Beneficial Interest TAC: Targeted Amortisation Class UL: Unexpected Loss VADM: Very Accurately Determined Maturity VaR: Value at Risk WAC: Weighted-Average Coupon WAM: Weighted-Average Maturity 10

11 TABLE OF CONTENTS PAGE 1. INTRODUCTION AND FRAMEWORK 1. INTRODUCTION FRAMEWORK OF THE STUDY AN OVERVIEW OF CASH FLOW SECURITISATION 1. INTRODUCTION HISTORY AND DEVELOPMENT OF SECURITISATION MOTIVATION FOR SECURITISATION GENERIC SECURITISATION STRUCTURE AND MECHANICS KEY SECURITISATION PARTIES AND THEIR ROLES KEY FEATURES OF SECURITISATION SECURITISATION ASSET CLASSES CONCLUSION AN OVERVIEW OF CREDIT DERIVATIVES AND SYNTHETIC SECURITISATION 1. INTRODUCTION THE DEVELOPMENT OF CREDIT DERIVATIVES THE DEVELOPMENT OF SYNTHETIC COLLATERALISED DEBT OBLIGATIONS CONCLUSION THE ROLE OF RATING AGENCIES IN SECURITISATION 1. INTRODUCTION THE SECURITISATION RATING PROCESS RISK ANALYSIS IN RATING SECURITISATION TRANSACTIONS DATA EVALUATION IN SECURITISATION TRANSACTIONS COMBINING QUANTITATIVE AND QUALITATIVE MODELS CONCLUSION AN OVERVIEW OF CAPITAL ADEQUACY REGULATIONS 1. INTRODUCTION BANKING RISKS AND THE CAUSES OF BANKING CRISES BANK CAPITAL MANAGEMENT THE DEVELOPMENT OF BANKING REGULATIONS AND THE BASEL I ACCORD

12 5. THE DEVELOPMENT AND USE OF REGULATORY ARBITRAGE BY BANKS BACKGROUND AND MOTIVATION FOR THE BASEL II ACCORD THE OVERALL STRUCTURE OF THE BASEL II ACCORD CONCLUSION THE IMPACT OF BASEL II ON BANKS SECURITISATION ACTIVITIES 1. INTRODUCTION THE IMPACT OF BASEL II ON SECURITISATION MARKETS CONCLUSION CONCLUSION AND RECOMMENDATIONS 1. INTRODUCTION MAJOR FINDINGS RECOMMENDATIONS 295 APPENDIX 1 - LEGAL CONSIDERATIONS IN SECURITISATION 296 APPENDIX 2 - ACCOUNTING CONSIDERATIONS IN SECURITISATION 305 APPENDIX 3 - TAX CONSIDERATIONS IN SECURITISATION 310 APPENDIX 4 - FEATURES OF CREDIT DEFAULT SWAPS 317 APPENDIX 5 - CREDIT RATING SYMBOLS AND DEFINITIONS 345 APPENDIX 6 - SUMMARY OF THE MINIMUM CAPITAL REQUIREMENTS IN TERMS OF THE BASEL II FRAMEWORK 360 APPENDIX 7 - BASEL II CAPITAL REQUIREMENTS ON SAMPLE PORFOLIOS 428 REFERENCES

13 CHAPTER ONE INTRODUCTION AND FRAMEWORK 1. INTRODUCTION The object of this dissertation is to examine critically the implications of the new Basel II capital adequacy framework 1 on the regulatory capital arbitrage deriving from banks participation in securitisation transactions. In primitive societies people made use of barter to satisfy their needs. Given the difficulty of finding a double coincidence of wants between two people, societies have, over the ages, adopted common measures of value such as gold or silver. Later on paper notes backed by these precious metals, or specie, started replacing gold and silver coins as stores of value and mediums of exchange. Later cheques, i.e. orders by depositors to the goldsmiths and bankers to make payments on their behalf to someone else, became widely accepted as a means of payment. In this way claims on deposits and orders to make transfers between deposits came to dominate specie itself as a means of payment. Yet another important development was when bankers realised that they need not hold specie fully equal to their liabilities in the form of banknotes and deposits in order to be able to meet their promise to pay on demand. This was because few depositors wanted to be repaid their deposits at one and the same time. Banks began to lend out money in greater amounts than the specie kept in their custody, and earned interest on these loans. This process constituted the origin of the fractional reserve banking system, for whenever a banker granted a loan without receiving full specie in exchange, money was created. In this way the rigid link that existed between specie and the money supply was broken and banks as institutions that accept deposits and extend loans came into being. Legal definitions of what constitutes a bank vary from country to country, but it has become widely accepted that the activity that makes banks special is the taking in of deposits, since deposits, specifically demand deposits, constitute funds on call that can be used as a means of payment and settling debts with third parties. Consequently, banks find themselves at the centre of the payments system, the efficiency of which is very important for a country s economy, and the whole financial system. 1 Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards, Bank for International Settlements, June An updated version was published in

14 A country s financial system comprises the arrangements embracing the lending out of funds by savers to borrowers, either between savers and borrowers contracting directly with each other, or through the intervention of financial intermediaries. The financial system s primary function is to mobilise savings and allocate those funds among competing borrowers on the basis of expected riskreturn. This process can be carried out in two competing ways: either through financial intermediation or through financial disintermediation. Financial intermediation refers to the process whereby financial intermediaries such as commercial banks take in deposits from savers with the aim of on-lending to borrowers. Depositors and borrowers risk appetite, term preferences, savings availability and borrowing requirements, however, are seldom matched. Depositors tend to save smaller amounts for shorter periods than the amounts and periods required by borrowers. Depositors are also risk averse and do not have the resources available to assess the risks that borrowers might not repay their loans. Banks bridge this divide by means of maturity transformation and by risk diversification. Maturity transformation refers to the process whereby banks take in generally short-term deposits from savers, and lend the funds so procured out to borrowers for generally longer periods. In doing so the banks expose themselves to liquidity risk, credit risk and price or market risk. Liquidity risk refers to the inability of a bank to meet its commitments on time, specifically the commitment to repay depositors their deposits when they require these, which is an inherent risk of maturity transformation. Credit risk refers to the potential inability of a borrower to repay its loan in full. Market risk refers to the risk of unexpected movements in, for example, interest rates and the impact thereof on the bank. For taking on these risks they charge an interest rate spread, which is the margin between the interest rate paid on deposits and the interest rate charged on loans to borrowers. Banks attempt to ameliorate these risks by diversification of their loans across different borrowers, and across different market sectors, something that would be very difficult for an individual saver to do. Despite the difficulties of savers and borrowers matching their different requirements, and therefore using financial intermediaries such as banks to do this, the process of financial disintermediation has grown rapidly. Disintermediation is the process whereby financial intermediaries are bypassed and savers contract directly with borrowers. The markets that bring savers or investors directly together are the money markets and the capital markets. The money market deals in short-term financial instruments usually with a maturity of less than one year, whereas the capital market deals in longerterm instruments. Investors in the money and capital markets are institutional investors such as insurance companies, pension funds and asset managers, while borrowers tend to be large corporates. The credit risk is borne by the investors, who are assisted in the risk assessment and risk monitoring 14

15 by credit rating agencies such as Standard & Poor s, Moody s Investors Service and Fitch Ratings. Liquidity, e.g. the ability for an investor to liquidate its investment is provided by the secondary market, which is the market for trading financial instruments after they have been issued originally in what is termed the primary or new issue market. Both the money market and the capital market have a primary and secondary market. Typically, the financial instruments issued and traded in the money market are negotiable certificates of deposit, promissory notes and commercial paper, which are all certificates of indebtedness with maturities ranging from a few days to 364 days. Instruments with maturities in excess of 364 days that are issued and traded in the capital market are fixed coupon bonds, zero coupon bonds and floating rate notes. The different money market instruments are technically very much the same, whereas the various capital market instruments are distinguished by their different interest rate profiles. On a fixed rate bond the investor receives a fixed interest payment, called the coupon. A zero coupon bond does not pay a coupon over its lifetime, but is issued at a discount and redeemed at its nominal or face value. The difference between the issue price the investor pays for the zero coupon bond, and the redemption amount reflects the investor s return on the instrument. Floating rate notes are bonds that pay a variable rate coupon, which is linked to a specified reference interest rate. Traditional financial intermediation is an inherently costly process because the intermediary requires, and is required by, the regulators to hold sufficient capital to protect itself against default risk, which adds a layer of cost to the process. It comes as no surprise that financial intermediaries such as banks have been steadily losing market share to the process of disintermediation. Disintermediation as such is not a new phenomenon, as financial markets have been trading equities and bonds for over a century. The greater acceptance by investors of credit ratings provided by rating agencies, as well as more liquid secondary markets, has greatly encouraged the growth of disintermediation during recent times. Disintermediation has gained additional impetus from the development of the securitisation market over the last 25 years. Until the development of securitisation, disintermediation only really applied to the issue by large creditworthy corporates of relatively large amounts of debt into the money and capital markets. Securitisation however allows much smaller amounts of consumer and business debt to be funded through the money and capital markets. Through securitisation, which is a more elaborate process of disintermediation than the issuance of corporate bonds or commercial paper, illiquid consumer loans such as residential mortgages, vehicle finance and credit card receivables can be repackaged into liquid financial instruments. A typical securitisation transaction is structured around a number of basic building blocks: 15

16 Origination, which is the process carried out by the financial institution that extended the loans and comprises the acquisition and credit appraisal of loans. Structuring, which entails the creation of a special legal entity known as a special purpose vehicle (SPV) for the sole purpose of purchasing loans from the originating institution, using the assets so purchased as collateral for asset-backed securities issued into the capital market to fund the purchase. True sale, the principle whereby assets are legally sold to the SPV and the SPV has no recourse to the originator if some of the assets default, nor do the originator s creditors have any claim against the assets if the originator becomes insolvent. Bankruptcy remoteness, whereby the SPV is limited by its constitutive documents to engage only in the purchase of specified assets and the issue of asset-backed securities to finance the purchase. Credit enhancement, which is the technique whereby the credit quality of the asset pool is improved to such an extent that the asset-backed securities that are issued on the strength of the collateral plus the credit enhancement are of a sufficiently high credit rating assigned by a rating agency to make them attractive to investors. Often the originator provides credit enhancement through a subordinated loan to the SPV. Otherwise, external credit enhancement can be procured from an insurer that provides a guarantee, or internal credit enhancement can be used by way of creating an internal reserve. Underwriting and placing, whereby the asset-backed securities are placed with investors. Hedging, the process whereby all interest rate and currency risk is hedged out through financial derivatives in order to protect investors. Servicing, being the process of collecting interest and principal debt from the borrowers and paying it over to the SPV for disbursement to investors. Servicing is usually performed by the originator. The securitisation market had its beginnings in the early 1970s with the sale of pooled mortgage loans guaranteed by United States government agencies, namely the Government National Mortgage 16

17 Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). In the United States a lender can extend a conventional mortgage loan based on the credit of the borrower and on the mortgage collateral. The lender may also take out mortgage insurance from these government agencies to provide a guarantee for the fulfilment of the borrower s obligations. Because the United States government guarantees the loans, these guaranteed mortgage loans are of a high quality and became obvious candidates for securitisation. In 1985 the first securitisation transaction backed by assets other than mortgage loans, in this instance computer leases, was launched in the United States. Later in that same year the first auto loan-backed securities were issued, followed by the first credit card-backed securities in Since then the securitisation market has expanded, as has the range of assets that have been repackaged into securities. While the United States market still accounts for the largest share of the global securitisation market, securitisation has become increasingly popular in Europe and Asia as well as emerging markets. The flexibility and applicability of the securitisation concept itself means that virtually any asset is a candidate for transformation into securities. Generally speaking, the securitisation market is composed of mortgage-backed securities (MBS), where the underlying assets that are being securitised are mortgages, and the asset-backed securities (ABS) market, which includes all other asset classes except mortgages. Each type can be further subdivided, for example, the MBS market can be subdivided into residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). As a rule of thumb, the nature of the underlying assets determines what the securities are called. The original mortgage securitisations were structured as pass-through transactions, in which case the regular repayments by borrowers (being payment of interest and capital) and pre-payments, are directly passed through to investors. The investor s return is equal to the underlying cash flow from the asset, minus a servicing fee paid to the originator, and other transaction fees. Subsequently, paythrough structures were developed whereby the cash flows emanating from the underlying assets are not passed through to investors as the cash flows are received, but captured in the SPV and allocated to investors according to certain rules. These pay-through structures allow for different classes, called tranches, of MBS and ABS to be issued, each tranche having a different cash flow and risk profile. A securitisation SPV could for instance issue three tranches rated AAA, AA and BBB by a credit rating agency. The repayment method can be sequential, which means that all the cash flows are first used to retire the AAA debt, then the AA debt, and only finally the BBB rated securities. Because the AAA securities are retired first, they are the least exposed to any losses on the underlying assets, which is why they carry the highest rating reflecting the lowest risk. On the other hand, the BBB securities have the highest risk exposure, since they stand last in line for payment and are liable to 17

18 sustain most of any losses. If, for instance, 5% of the total securities issued by the SPV is rated BBB and eventual losses on the underlying assets amount to 5%, then BBB investors will lose all of their investment, whereas AAA and AA investors will be repaid in full. If losses exceed 5% then the AA investors will be the next in line to suffer losses. This tranching of securities and the so-called waterfall of payments, where the higher rated securities are paid first from the available cash flow is a common feature of pay-through securitisation structures. Investors in securitisation transactions rely considerably on the credit ratings provided by a credit rating agency. The rating agency conducts a due diligence on the pool of assets, and rates the securitisation structure, including the adequacy of the cash flows, credit enhancement and administrative competence of the originator as service provider. Based on these factors, it gives a rating to the asset-backed securities. During the life of the securitisation transaction the rating agency monitors the transaction every month and provides a quarterly surveillance report. Securitisation transactions, where the assets are physically sold by the originator to the SPV, are called cash transactions. Another form of securitisation that has become popular is what is called synthetic securitisation. In a synthetic transaction the originator does not sell the assets to the SPV, but only the credit risk of the assets is transferred to the SPV. This is done through the use of credit derivative instruments. Financial derivatives, of which credit derivatives represent but one type, have grown exponentially since their inception 30 years ago, around the same time as when the concept of securitisation started. The origin of the derivatives industry can be traced back to 1975 when Fischer Black and Myron Scholes published their now famous Black-Scholes option pricing methodology in the Journal of Political Economy. This led to the birth of today s huge financial derivatives industry and the concept of financial engineering, whereby mathematical techniques are used to manipulate financial flows. In the June 2004 Quarterly Review of the Bank for International Settlements the aggregate turnover of exchange traded financial derivatives contracts amounted to US $272 trillion during the first quarter of The amount of outstanding over-the-counter (OTC meaning that counterparties deal with each other directly outside of a derivatives exchange) derivatives stood at US $197 trillion at the end of A derivative contract assumes its value from the price of an underlying item such as a commodity, financial asset or an index. The underlying item could be a physical good such as wheat, copper or frozen pork bellies or a financial instrument such as equities, bonds or currencies, where a derivative s 18

19 price is affected by expectations about future supply and demand factors. Generally a financial derivative contract derives a future price for a specific asset on the basis of that asset s current price (the spot price) and interest rates (the time value of money). In the case of financial derivatives the underlying assets are typically based on interest rates or currency exchange rates. A relatively recent derivative instrument is the credit derivative of which the credit-default swap is the preferred instrument of use in synthetic securitisation transactions. A credit default swap (CDS) is a credit derivative in which a bank that owns a portfolio of assets purchases credit protection on the portfolio from a protection seller, usually another financial institution. To the extent that any defaults occur on the portfolio, the protection seller will make good the losses to the protection buyer. In return for taking on the risk of the asset portfolio the protection seller receives a regular payment, the premium, from the protection buyer. Synthetic securitisation is a combination of securitisation and credit derivative techniques. In a synthetic securitisation there is no true sale of bank assets (reference assets); however, asset risk is transferred through a credit derivative, usually a credit default swap from the bank to the securitisation SPV. Because the reference assets are not removed from the bank s balance sheet, synthetic securitisations are easier to execute than cash-funded structures. This is particularly so in the case of bank loans, which may require borrower notification and consent, or have other restrictions on loan sales. Synthetic securitisation transactions are typically used by banks to achieve a reduction in the regulatory capital they are required to hold against the loans on their balance sheets. Securitisation is particularly attractive to banks because of the regulatory arbitrage opportunities it offers. Regulatory arbitrage is the process whereby banks restructure their asset categories so as to attract a lower regulatory capital adequacy charge. It must be borne in mind that governments heavily regulate banks and the rules on capital adequacy are the most prominent of these regulations. This prominence results from the central role banks play in financial intermediation and the payments system in an economy; the systemic risks posed to the economy if a bank fails; the importance of sufficient bank capital for bank soundness; and the efforts of the international community to adopt common capital adequacy standards. Capital, of course, carries a cost. Bank shareholders would prefer the minimum amount of capital consistent with the risks the bank takes, so as to have the highest possible return-on-equity. Regulators, on the other hand, are mostly concerned with the safety and soundness of banks and would therefore prefer more rather than less capital. Countries such as the United States had first 19

20 begun to lay down minimum capital standards for banks in the early 1980s. Many other countries had prudential approaches, but without specified minimum capital adequacy standards. Capital as a percentage of assets had seen a long-term decline throughout banking systems across the world and there was a concern that there would be a further erosion of bank capital thus making the banking system more risky. Capital adequacy regulations also differed across countries thereby giving banks in some countries a competitive advantage, forcing banks operating in a more restrictive environment to lower their pricing in order to compete, thus potentially weakening their capital base. When banking systems in a number of industrial countries weakened in the late 1980s, pressure developed for a harmonisation of bank regulations among these industrial countries. The harmonisation was driven by the need to prevent banking failures in one country from spreading to another, and also levelling the playing fields, so that banks in different countries would not gain a competitive advantage through different regulatory requirements. In order to address the situation, the central banks and bank regulators of the so-called Group of Ten (G10) countries, in effect the major industrial countries of the world, agreed on a common approach to bank capital regulations. The design of the new international regulatory regime was delegated to the Basel Committee on Banking Supervision (Basel Committee) based at the Bank for International Settlements in Basel, Switzerland. The Basel Committee completed the accord on capital adequacy regulations, called the Basel Accord or Basel I, in 1988 for implementation by member G10 countries by the beginning of Over time the benefits of standardised capital adequacy regulations were realised by other countries, including emerging economies, and by 1999 Basel I had been adopted by around 100 countries worldwide. The major contribution of Basel I was to lay down minimum capital guidelines for banks and a standard methodology for the assessment of a bank s capital adequacy. Since the beginning of 1993 banks incorporated in G10 countries have been obliged to comply with a minimum capital to riskweighted assets ratio of 8% 2, also known as the Cooke ratio. The ratio is defined as capital as a percentage of the total of risk-weighted on-balance sheet assets plus the risk-weighted credit equivalent for off-balance sheet exposures. Basel I divided assets into four risk buckets, namely: for a bank s exposure to sovereign governments (0%); exposures to other banks (20%); exposures to residential mortgages (50%); and lastly all claims on the non-bank sector, irrespective of the credit quality of the exposure (100%). It is especially this last one size fits all calculation that opened the door for regulatory arbitrage. For example, a bank loan to a corporate with a good credit rating carries, under Basel I, exactly the same risk weight (and therefore capital allocated) as a loan to a risky 2 In South Africa, the South African Reserve Bank increased the minimum capital requirement to 10%. 20

21 start-up company. Because of the higher risk, the bank would charge a higher interest rate on the start-up loan, thus achieving a higher return on the capital that the bank is required to hold. Basel I therefore provided the incentive for banks to shift towards more risky asset portfolios for which they could command higher interest rates, while having to hold the same amount of capital, as the bank would have to hold against low-risk assets. These activities that allow the bank to assume greater risk without any increase in its regulatory capital requirements are the oldest form of regulatory capital arbitrage. Securitisation is a newer form of arbitrage that achieves the same result. When a bank sells assets to a securitisation SPV, it normally retains most of the risk of the assets sold because of the credit enhancement the bank provides to the transaction. In terms of Basel I, a bank must hold regulatory capital against the full amount of credit enhancement provided to the transaction, if the bank previously owned the assets. It follows that, if the credit enhancement amounts to less than 8% of the asset portfolio that has been securitised, the bank has reduced its regulatory capital requirement despite being exposed to essentially the same risk it faced before the securitisation. Initially, Basel I was a significant success and global average levels of bank capital increased. However, over time the shortcomings of specifying the same risk-weight for corporate loans irrespective of the risk thereof became apparent. The consequences of this were that banks migrated to higher-margin higher-risk lending; pricing in corporate lending continued to be undifferentiated by risk; activities that carried no explicit risk-weight such as asset management and custodial services were seen to be risk-free; and regulatory arbitrage became widespread, primarily through the use of securitisation, whereby high-quality low-margin lending is removed from a bank s regulatory balance sheet without a commensurate reduction in economic risk. The end result is that the current Basel I Accord has encouraged a reduction in overall bank solvency standards, rather than the increase that was originally envisaged. The shortcomings of Basel I led the Basel Committee to devise improved international capital adequacy regulations starting in 1999 with the development of what was to become the Basel II framework. The overall objective of Basel II is to increase the soundness of the international banking system by establishing regulatory capital requirements that more accurately reflect the true economic risks that banks face. This means more capital will be required for more risky activities and less where there is less risk, thus departing from the one size fits all approach of the Basel I Accord. The final Basel II document was published in June 2004 (followed by an updated version in 2005), with implementation to commence as of year-end 2006 in countries that plan to fully implement Basel II. Banks in these countries will have three years, from 2007 to 2009, to make the transition to compliance. In South Africa, full implementation of Basel II is planned for January The new 21

22 framework proposes a system based on three mutually reinforcing pillars, which are briefly discussed below. Pillar 1 specifies minimum capital requirements for banks exposures to credit risk (substantially revised and enhanced from Basel I), market risk (unchanged from the 1997 Amendment to Basel I), and operational risk (new in Basel II). The rules contained in Pillar 1 set out the minimum ratio of capital to risk-weighted assets. The current definition of capital and the 8% minimum capital requirement remained unchanged; however, risk weights will become more risk sensitive. In terms of credit risk, Pillar 1 of Basel II draws a distinction between non-securitised assets on the bank s balance sheet, and the treatment of a bank s exposure to securitisation transactions as originator and investor. For the credit risk of bank assets Basel II advances three approaches, namely the Standardised approach, and the Internal Ratings-Based Foundation and Advanced approaches. The Standardised approach is a relatively simple method conceptually in line with the existing approach under Basel I, but with more risk weight categories. Instead of only one risk weight category for corporate lending (100%), there will be four categories (20%, 50%, 100%, and 150%). Banks will slot assets into weighting categories to be referenced to a credit rating provided by an approved rating agency. The Internal Ratings-Based (IRB) Foundation approach allows banks to categorise exposures based on the banks internal risk assessments. If a bank has had in place a system, recognised by its supervisor, for internally rating borrowers for at least three years, it will be able to use its own ratings to slot loans into probability-of-default (PD) bands. The bank will be able to choose as many bands as it wishes, with the capital requirement for each band set according to a formula. A set loss-givendefault (LGD) factor is applied to produce the actual capital charge, reflecting the likelihood of recoveries, given the type of collateral. The IRB Advanced approach will allow banks to recognise any form of collateral and will allow banks to set their own LGD factors. For the credit risk of a bank s securitisation exposures Basel II advances two approaches, being the Standardised approach and the IRB approach. Banks that apply the Standardised approach to credit risk for the type of underlying assets that will be securitised must use the Standardised approach under the securitisation framework. The capital treatment of positions retained by originators, liquidity facilities, credit risk mitigants, and 22

23 securitisation of revolving exposures are identified separately. The risk-weighted asset amount of a securitisation exposure is computed by multiplying the amount of the position by the appropriate risk weight determined in accordance with specified tables. Banks that have received regulatory approval to use the IRB approach for the type of underlying exposures securitised must use the IRB approach for securitisation. Conversely, banks may not use the IRB approach to securitisation unless they have received approval from their national supervisor to use the IRB approach for the underlying assets. Under the IRB approach for securitisation, a hierarchy of approaches is proposed, depending on whether assets are rated or not. The Ratings- Based Approach (RBA) must be applied to securitisation exposures that are rated, or where a rating can be inferred. Under the RBA, the risk-weighted assets are determined by multiplying the exposure by a specified risk weight that depends on the external rating grade, the diversification (granularity) of the underlying asset pool, and the seniority of the exposure. Where an external or inferred rating is not available, either the Supervisory Formula (SF) or the Internal Assessment Approach (IAA) must be used. The IAA is only available to exposures that banks extend to asset-backed commercial paper (ABCP) programmes. Under the SF, the capital charge for a securitisation tranche depends on five bank-supplied inputs: the IRB capital charge had the underlying assets not been securitised; the tranche s credit enhancement level and thickness; the asset pool s number of exposures, and the pool s exposure-weighted average loss-given-default. A bank may use its internal assessments of the credit quality of the securitisation exposures the bank extends to ABCP programmes, only if the bank s internal assessment process meets the approval of the bank s national supervisor. The internal assessment of exposures must be mapped to equivalent external ratings of a rating agency. In terms of Pillar 1, there is no change in the calculation of market risk from the current Accord. For operational risk there are three possible approaches: the Basic approach, Standardised approach, and the Advanced Measurement approach. It is not foreseen that this risk element will influence banks involvement in securitisation, since securitisation is mainly used as a regulatory capital management tool and as a source of funding. The second Pillar provides for the supervisory review of banks capital adequacy and their internal assessment processes. National supervisors will be responsible for evaluating and ensuring that banks have sound internal processes in place to assess the adequacy of their capital, and may intervene to prevent a bank s capital from falling below the level required by the bank s specific risk requirements. 23

24 Pillar 3 will promote market discipline through enhanced disclosure requirements for banks. This increased transparency should give market participants a better idea of a bank s risk profile and its capital buffer. Basel II is expected to have an even more profound impact on the banking industry than its predecessor. It will have an equally important impact on the securitisation industry. The objective of Basel II is, inter alia, to achieve a much greater congruence between regulatory and economic capital and reduce the regulatory arbitrage that is currently achievable through securitisation transactions. The new regulatory capital treatment of bank assets and banks securitised exposures will therefore have a major impact on banks participation in securitisation transactions, and it is expected that Basel II will lead to significant shifts in the securitisation market. It will be the aim of this study to investigate to what extent and in what manner the new Basel II regulations will impact on securitisation. More specifically, the aim will be to investigate to what extent the economically more realistic treatment of securitisation under Basel II will influence the use of securitisation by banks to manage their regulatory capital. 2. FRAMEWORK OF THE STUDY The investigation will attempt to trace the development of securitisation with reference to banks in particular and the importance of banking regulations with respect to securitisation, and to analyse the new Basel II framework and its potential impact on securitisation, to the extent that banks use securitisation as a regulatory arbitrage tool. The research methodology proposed is a literature study. This method is proposed since a field study will not be helpful, as Basel II will only be implemented from 2008 onwards in South Africa. A literature study is feasible and would fit the chosen objective. It is proposed that only the potential impact of Basel II on banks participation in securitisation, in so far as it is used as a regulatory arbitrage technique, be covered in the research. The use of securitisation by banks for purposes other than regulatory arbitrage, e.g. for funding, will therefore not form part of this study. The aspects of Basel II that would influence the use of securitisation by banks the most profoundly are the new regulations regarding credit risk. The effects of other parts of Pillar I, e.g. market risk and operational risk, will not be investigated. Likewise, Pillars II and III are 24

25 not regarded as having a major impact on banks decisions whether, or not, to participate in securitisation transactions. These restrictions should not influence the validity of the research. The study will be divided into the chapters set out below. Chapter 2 will provide an overview of cash flow securitisation. Chapter 3 will present an overview of synthetic securitisation. Chapter 4 will investigate the role of the credit rating agencies. Chapter 5 will offer an overview of capital adequacy and the Basel regulations. Chapter 6 will investigate the implications of Basel II in regard to the use of securitisation by banks for purposes of regulatory arbitrage. Chapter 7 will conclude the study. 25

26 CHAPTER TWO AN OVERVIEW OF CASH FLOW SECURITISATION 1. INTRODUCTION The purpose of this chapter is to examine the history and development of securitisation and its use in the financial markets. The parties to a securitisation, the reasons for securitisation, the key features of a securitisation transaction, the various securitisation structures and different asset classes are described. Securitisation is a financing tool for selling assets in the form of receivables. Assets in this context can be defined as rights or access to future economic benefits controlled by an entity as a result of transactions concluded in the past. Through the process of securitisation, assets from corporates or banks are pooled, repackaged and sold as asset-backed securities. These asset-backed securities are collateralised or backed by the pooled assets, and are therefore not considered as obligations of the sellers. Investors only consider the cash flows from these assets as repayment of their investments in the securities. Securitisation has become established as an important method of finance, whereby an investor effectively agrees to evaluate only the credit risk of the relevant pool of assets, thus divorcing the credit risk from the original owner of the assets. Asset securitisation differs from collateralised debt or traditional asset-based lending, in the sense that the assets, such as loans or other financial claims, are assigned or sold to a third party, typically a special purpose vehicle (SPV) constituted as a company or trust. This third party, in turn, issues asset-backed securities to fund the purchase of the assets. Securitisation can thus be seen to have evolved from the process of factoring, where a corporate sells short-term assets, such as trade receivables at a discounted price to a third party such as a collection agency. In the factoring process, the seller retains no interest in the receivables (which are usually sold at a significant discount), and no longer controls the collection of the cash flows. In a securitisation transaction however, the seller (also referred to as the originator) of the assets continues to administer and collect the cash flows from the assets. The originator also retains a substantial part of the profit generated by the underlying assets by extracting this profit from the SPV. The SPV is established with the strictly limited purpose of only purchasing specified assets and funding them only in the capital markets. This structure effectively isolates the underlying assets from 26