Proposed Revisions To Risk-Based Capital Requirements

The United States federal bank regulators, including the Office of the Comptroller of the Currency (the "OCC"), the Board of Governors of the Federal Reserve System (the "Board"), the Federal Deposit Insurance Corporation (the "FDIC"), and the Office of Thrift Supervision (the "OTS") (collectively, the "Agencies") are proposing to revise their risk-based capital standards. The proposal would significantly change the risk-based capital treatment of most securitization transactions. This memorandum provides some background to the proposal and summarizes the most significant provisions of the proposal.

Direct credit substitutes are treated differently from recourse under the current risk-based capital standards. Under the current standards applied by the OCC, the Board and the FDIC, off-balance sheet direct credit substitutes, such as financial standby letters of credit provided for third-party assets, carry a 100% credit conversion factor. However, only the dollar amount of the direct credit substitute is converted into an on-balance sheet credit equivalent amount, so capital is held only against the face amount of the direct credit substitute. The capital requirement for a recourse arrangement, in contrast, generally is based on the full amount of the assets enhanced.¹

If a direct credit substitute covers less than 100% of the potential losses on the assets enhanced, the current capital treatment results in a lower capital charge for a direct credit substitute than for a comparable recourse arrangement. For example, if a direct credit substitute covers losses up to the first 20% of the assets enhanced, then the on-balance sheet credit equivalent amount equals that 20% amount, and risk-based capital is held against only the 20% amount. In contrast, required capital for a first-loss 20% recourse arrangement is higher because capital is held against the full outstanding amount of the assets enhanced, subject to the low-level recourse rule.

Currently, under the guidelines applied by the OCC, the Board and the FDIC, purchased subordinated interests receive the same capital treatment as off-balance sheet direct credit substitutes. In contrast, a banking organization that retains a subordinated interest in connection with the transfer of its own assets is considered to have transferred the assets with recourse. As a result, the banking organization must hold capital against the carrying amount of the retained subordinated interest as well as the outstanding amount of all senior interests that it supports, subject to the low-level recourse rule.

On November 5, 1997, the Agencies published a notice of proposed rulemaking, 62 FR 59943 ("1997 Proposal"). In the 1997 Proposal, the Agencies proposed to amend the risk-based capital standards applied to U.S. banking institutions to treat recourse transactions the same as direct credit substitutes for purposes of risk based capital and to use credit ratings from nationally recognized statistical rating organizations to determine the capital requirement for recourse obligations, direct credit substitutes, and senior asset-backed securities. The 1997 Proposal requested comment on a series of options and alternatives to supplement or replace the ratings-based approach. A number of comments regarding the 1997 Proposal were submitted to the Agencies, but until now the Agencies had not responded to these comments or moved the 1997 Proposal forward.

The comments to the 1997 Proposal included objections to the proposed treatment of direct credit substitutes as recourse. Commenters asserted that the risks associated with enhancing non-bank assets are different than those associated with financing bank assets, the business of providing third-party credit enhancements has historically been safe and profitable for banks and the proposed capital treatment would impair the competitive position of U.S. banks and thrifts.

In June 1999, the Basel Committee on Banking Supervision issued a consultative paper, "A New Capital Adequacy Framework," that sets forth possible revisions to the 1988 Basel Accord. The Basel consultative paper discusses potential modifications to the current capital standards applied by banks worldwide, including the capital treatment of securitizations. The suggested changes in the Basel consultative paper would also look to external credit ratings issued by qualifying external credit rating agencies as a basis for determining the credit quality and the resulting capital treatment of securitizations. Comments with respect to the Basel consultative paper are due by March 31, 2000.

The most significant provisions of the current proposal:

• define "recourse" as the risk of credit loss that a banking organization retains in connection with the transfer of its assets.
• define "direct credit substitutes" as all forms of third-party enhancements, i.e., all arrangements in which a banking organization assumes risk of credit loss from third-party assets or other claims that it has not transferred.
• assess equivalent risk-based capital charges to recourse obligations and direct credit substitutes.
• vary the risk-based capital assessed to banking organizations in securitization transactions on the basis of ratings assigned by third party rating agencies to the positions of such organizations in such transactions.
• would permit the limited use of a banking organization’s qualifying internal risk rating system, a rating agency’s or other appropriate third party’s review of the credit risk of positions in structured programs, and qualifying software to determine the capital requirement for certain unrated direct credit substitutes.
• would require the sponsor of a revolving credit securitization that involves an early amortization feature to hold capital against all of the assets under management, i.e., the off-balance sheet securitized receivables, to the extent described below.

The Agencies are again proposing to extend the current risk-based capital treatment of asset transfers with recourse, including the low-level recourse rule, to direct credit substitutes. The proposal indicates that the Agencies have attempted to address the competitive disadvantage that U.S. banks and thrifts would suffer at the international level if this approach were adopted solely by the Agencies by encouraging the bank supervisory authorities from the other countries represented on the Basel Committee on Banking Supervision to also adopt this approach. The Basel Committee’s 1999 consultative paper has not adopted this approach, but it does acknowledge that the current Basel Capital Accord treats recourse transactions and direct credit substitutes differently.

Under the ratings-based approach contained in the proposal, the capital requirement for a recourse obligation, direct credit substitute, or traded asset-backed security would be determined as follows:

Under the proposal, the ratings-based approach is available for traded asset-backed securities² and for traded and non-traded recourse obligations and direct credit substitutes. A position is considered "traded" if, at the time it is rated by an external rating agency, there is a reasonable expectation that in the near future: (1) the position may be sold to investors relying on the rating; or (2) a third party may enter into a transaction (e.g., a loan or repurchase agreement) involving the position in which the third party relies on the rating of the position. If external rating agencies rate a traded position differently, the single highest rating applies.

An unrated position that is senior (in all respects, including access to collateral) to a rated position that is traded is treated under the proposal as if it had the rating given the rated position, subject to the banking organization satisfying its supervisory agency that such treatment is appropriate.

Recourse obligations and direct credit substitutes not qualifying for a reduced capital charge and positions rated more than one category below investment grade would receive "gross-up" treatment, that is, the banking organization holding the position would hold capital against the amount of the position plus all more senior positions, subject to the low-level recourse rule. This grossed-up amount would then be risk-weighted according to the obligor and collateral.

The ratings-based approach is based on current ratings, so that a rating downgrade or withdrawal of a rating could change the treatment of a position under the proposal. However, a downgrade of a position by a single rating agency would not affect the capital treatment of a position if the position still qualified for the previous capital treatment under one or more ratings from a different rating agency.

The 1997 Proposal included criteria to reduce the possibility of inflated ratings and inappropriate risk weights if ratings are used for a position that is not traded. Under the terms of the 1997 Proposal a non-traded position could qualify for the ratings-based approach only if: (1) it qualified under ratings obtained from two different rating agencies; (2) the ratings were publicly available; (3) the ratings were based on the same criteria used to rate securities sold to the public; and (4) at least one position in the securitization was traded. In comments responding to the 1997 Proposal, banking organizations expressed concern about the cost and delay associated with obtaining ratings, particularly for direct credit substitutes, that they would not otherwise need.

In the proposal, the Agencies have retained the first three of the 1997 Proposal’s four criteria for rated non-traded positions, but have eliminated the fourth criterion, i.e., the requirement that one position in the securitization be traded. To address concerns expressed by commenters on the 1997 Proposal, however, the Agencies have now proposed several alternative approaches for determining the capital requirements for unrated direct credit substitutes. Under each of these approaches, the banking organization must satisfy its supervisory agency that use of the approach is appropriate for the particular banking organization. Each of these approaches could be used to qualify a direct credit substitute (but not a retained recourse provision) for a risk weight of 100% or 200% of the face value of the position under the ratings-based approach, but not for a risk weight of less than 100%.

One such approach would permit a banking organization with a qualifying internal risk rating system to use that system to apply the ratings-based approach to the banking organization’s unrated direct credit substitutes in asset-backed commercial paper programs. This relatively limited proposed permitted use of internal risk ratings for risk-based capital purposes is consistent with the goal of providing for broader use of internal risk ratings as discussed in the Basel Committee’s June, 1999 Consultative Paper.

A second approach referenced in the proposal would be to authorize a banking organization to use a rating obtained from a rating agency or other appropriate third party of unrated direct credit substitutes in securitizations that satisfy specifications set by the rating agency.

A third approach referenced in the proposal would allow banking organizations, particularly those with limited involvement in securitization activities, to rely on qualifying credit assessment computer programs that the rating agencies or other appropriate third parties have developed for rating otherwise unrated direct credit substitutes in asset securitizations. Banking organizations would be permitted to use these programs for purposes of applying the ratings-based approach under the proposal only if the banking organization satisfies its primary regulator that the programs result in credit assessments that credibly and reliably correspond with the rating of publicly issued securities by the rating agencies.

The proposal would apply a managed assets approach that would require a banking organization to hold additional capital against the potential credit and liquidity risks stemming from the early amortization provisions of revolving credit securitization structures. The approach would require a sponsoring banking organization’s securitized (off-balance sheet) receivables in transactions of this type to be included in risk-weighted assets when determining its risk-based capital requirements. The securitized, off-balance sheet assets would be assigned to the 20 percent risk category, thereby effectively applying a 1.6% risk-based capital charge to those assets.

The 1.6% capital charge against securitized assets could be limited in certain cases. If the sponsoring banking organization in a revolving credit securitization provides credit protection to investors, either in the form of retained recourse or a direct credit substitute, the sum of the regulatory capital requirements for the credit protection and the 1.6% charge on the off-balance sheet securitized assets would not, under the terms of the proposal, exceed 8% of securitized assets for that particular securitization transaction.

The Agencies have requested comment on the proposed managed assets approach, and on any potential effects that the approach will have on current industry practices involving revolving credit securitizations. The Agencies have also requested comment on possible alternative measures that would address more effectively the risks arising from early amortization provisions in revolving securitizations.

The proposed definitions of "recourse" and "direct credit substitute" cover credit derivatives to the extent that a banking organization’s credit risk exposure exceeds its pro rata interest in the underlying obligation. The ratings-based approach therefore applies to rated instruments such as credit-linked notes issued as part of a synthetic securitization.³ The Agencies have requested comment on the inclusion of credit derivatives in the definitions of "recourse" and "direct credit substitute," as well as on the definition of "credit derivative" contained in the proposal.

A capital charge would be assessed only against arrangements that create exposure to credit or credit-related risks. This continues the Agencies’ current practice and is consistent with the risk-based capital standards’ traditional focus on credit risk. The proposal states that Agencies have undertaken other initiatives to ensure that the risk-based capital standards take interest rate risk and other non-credit related market risks into account.

The existence of implicit recourse is usually demonstrated by a banking organization’s actions to support a securitization beyond any contractual obligation. Actions that may constitute implicit recourse include: providing voluntary support for a securitization by selling assets to a trust at a discount from book value; exchanging performing for non-performing assets; or other actions that result in a significant transfer of value in response to deterioration in the credit quality of a securitized asset pool.

To date, the Agencies have taken the position that when a banking organization provides implicit recourse, it generally should hold capital in the same amount as for assets sold with recourse. However, the proposal states that the complexity of many implicit recourse arrangements and the variety of circumstances under which implicit recourse may be provided raise issues about whether recourse treatment is always the most appropriate way to address the level of risk that a banking organization has effectively retained or whether a different capital requirement would be warranted in some circumstances.

The proposal states that the Agencies intend to address implicit recourse on a case-by-case basis, but may issue additional guidance if needed to clarify further the circumstances in which a banking organization will be considered to have provided implicit recourse.

The definitions of recourse and direct credit substitutes contained in the proposal explicitly cover a banking organization’s ownership of subordinated interest in loans or pools of loans. The proposal would treat both retained subordinated interests and purchased subordinated interests as recourse obligations.⁴

The proposal addresses those particular representations and warranties that function as credit enhancement, i.e., where a banking organization, by making such representations and warranties, agrees to protect purchasers or some other party from losses due to the default or non-performance of the obligor or insufficiency in the value of collateral. To the extent a banking organization’s representations and warranties function as credit enhancement in this manner, the proposal treats them as recourse or direct credit substitutes.

The proposed definitions of "recourse" and "direct credit substitute" cover loan servicing arrangements if the servicer is responsible for credit losses associated with the loans being serviced. However, cash advances made by residential mortgage servicers to ensure an uninterrupted flow of payments to investors or the timely collection of the mortgage loans are specifically excluded from the definitions of recourse and direct credit substitute, provided that the residential mortgage servicer is entitled to reimbursement for any significant advances. This type of advance is assessed risk-based capital only against the amount of the cash advance, and is assigned to the risk-weight category appropriate to the party obligated to reimburse the servicer.

If a residential mortgage servicer is not entitled to full reimbursement, then the maximum possible amount of any nonreimbursed advances on any one loan must be contractually limited to an insignificant amount of the outstanding principal on that loan in order for the servicer’s obligation to make cash advances to be excluded from the definitions of recourse and direct credit substitute.

The proposal provides that nonreimbursed advances on any one loan that are generally contractually limited to no more than one percent of the amount of the outstanding principal on that loan would be considered insignificant. Reimbursement includes reimbursement payable from subsequent collections and reimbursement in the form of a general claim on the party obligated to reimburse the servicer, provided that the claim is not subordinated to other claims on the cash flows from the underlying asset pool.

The proposal states that because overcollateralization does not ordinarily impose a risk of loss on a banking organization, it normally would not fall within the proposed definition of recourse. However, a retained interest in a spread account that is reflected as an asset on a selling banking organization’s balance sheet (directly as an asset or indirectly as a receivable) is a form of recourse and is treated accordingly for risk-based capital purposes.

Under the market risk rule,⁵ a position properly located in the trading account is excluded from risk-weighted assets. The OCC, the Board and the FDIC are not proposing to modify this treatment, so a position that is properly held in the trading account would not be included in risk-weighted assets, even if the position otherwise met the criteria for a recourse obligation or a direct credit substitute.

If a direct credit substitute is originated by a banking organization which then sells a participation in that direct credit substitute to another entity, the originating banking organization must apply a 100% conversion factor to the full amount of the assets supported by the direct credit substitute. The originating banking organization would then risk weight the credit equivalent amount of the participant’s pro rata share of the direct credit substitute at the lower of the risk category appropriate to the obligor in the underlying transaction, after considering any relevant guaranties or collateral, or the risk category appropriate to the participant entity. The remaining pro rata share of the credit equivalent amount is assigned to the risk-weight category appropriate to the obligor in the underlying transaction, or, if relevant, the collateral on the guaranty.

A banking organization that acquires a risk participation in a direct credit substitute must apply a 100% conversion factor to its percentage share of the direct credit substitute multiplied by the full amount of the assets supported by the credit enhancement. The credit equivalent amount is then assigned to the risk category appropriate to the obligor or, if relevant, the collateral or guaranty.

The Agencies are proposing to add language to the risk-based capital standards to clarify their authority, on a case-by-case basis, to determine the appropriate risk-weight for assets and credit equivalent amounts and the appropriate credit conversion factor for off-balance sheet items if (i) the related instrument is "novel" and "imposes risks on the banking organization at levels that are not commensurate with the nominal risk-weight or credit conversion factor for the asset, exposure or instrument" or (ii) the credit rating of the risk position is deemed by the relevant Agency to be inappropriate. This type of open-ended provision will make it more difficult for banking organizations to structure securitization transactions with certainty as to the amount of risk-based capital such transactions will ultimately attract.

Currently, the agencies assign privately issued mortgage-backed securities to the 20% risk-weight category if the underlying pool is composed entirely of mortgage-related securities issued by the Federal National Mortgage Association ("Fannie Mae"), Federal Loan Mortgage Corporation ("Freddie Mac"), or Government National Mortgage Association ("Ginnie Mae"). Privately issued mortgage-backed securities backed by whole residential mortgages are now assigned to the 50% risk-weight category. The Agencies propose to eliminate these treatments in favor of a ratings-based approach.

Any final rules adopted as a result of the proposal that result in increased risk-based capital requirements for banking organizations will apply only to securitization activities (as defined in the proposal) entered into or acquired after the effective date of those final rules. Conversely, any final rules that result in reduced risk-based capital requirements for banking organizations may be applied to all transactions outstanding as of the effective date of those final rules and to all subsequent transactions. Because some ongoing securitization conduits may need additional time to adopt any new capital treatments, the proposal states that the Agencies intend to permit banking organizations to apply the existing capital rules to asset securitizations with no fixed term, e.g., asset-backed commercial paper conduits, for up to two years after the effective date of any final rule.

The Agencies have requested comment on all aspects of the proposal, which comments must be received within 90 days after the publication of the proposal in the Federal Register.

1 The OTS risk-based capital regulation treats some forms of direct credit substitutes (e.g., financial standby letters of credit) in the same manner as the other banking agencies. However, the OTS treats purchased subordinated interests (except for certain high quality subordinated mortgage-related securities) under its general recourse provisions. The risk-based capital requirement is based on the carrying amount of the subordinated interest plus all senior interests, as though the thrift owned the full outstanding amount of the assets enhanced.

2 Similar to the current approach under which "stripped" mortgage-backed securities are not eligible for risk weighting at 50% on a "pass-through" basis, stripped mortgage-backed securities are ineligible for the 20% or 50% risk categories under the ratings based approach.

3 "Synthetic securitization" refers to the bundling of credit risk associated with on-balance sheet assets and off-balance sheet items for subsequent sale into the market. Credit derivatives, and in particular credit-linked notes, are used to structure a synthetic securitization.

4 As noted above, the OTS currently treats both retained and purchased subordinated securities as recourse obligations.

5 The OTS does not have a market risk rule.