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Punishment or reward? That is, will a more risk-sensitive approach to asset securitization prove better for banks than the minimum capital requirements currently in place? Two stylized portfolios--one of investment-grade loans and one of non-investment-grade loans--are examined to find the answer.
By creating a more risk-sensitive approach to capital requirements, goes the theory banks will be encouraged to use advanced approaches in their determination of regulatory capital. In June 2001, the Basel Committee indicated that "capital incentives between the standardized and IRB [internal risk-based] approaches should exist to encourage banks to adopt these more advanced approaches to credit risk." (1)
Likewise, with respect to securitization, the Basel Committee's objective is "to develop a comprehensive framework for securitization that is risk sensitive and provides banks with the proper incentives to move from the standardized to the IRB approach." The Basel Committee went on to state: "In recognition of asset securitization as an important source of funding and mechanism for credit risk transference, the IRB approach should be neutral with regard to the capital requirements it produces in order not to create incentives or disincentives for banks to engage in securitizations." (2)
To what degree are these objectives satisfied? How will the minimum regulatory capital requirement compare with economic capital? Answering these questions requires the ability to compare the minimum regulatory capital that would be required for portfolios of credit assets calculated using the different approaches proposed in Basel II, both before and after the portfolios are securitized.
To this end, let's consider two stylized portfolios made up of commercial loans--term loans or funded commitments--to externally rated obligors. The primary difference between the two portfolios is the credit quality of the assets assigned to each portfolio: One has predominantly investment-grade obligors, while the other has predominantly non-investment-grade obligors. Part A of Table 1 summarizes the characteristics of the two portfolios.
To examine the regulatory capital that would be required if these portfolios were securitized, let's assume the stylized portfolios were securitized in separate transactions. Hypothetical Moody's and Standard and Poor's ratings were assigned to the tranches of these transactions, using models that approximate the ratings methodologies of these external credit assessment institutions (ECAI). Part B of Table 1 summarizes the tranching of these portfolios for the securitization transactions.
Minimum Regulatory Capital for Portfolios on a Bank's Balance Sheet
The regulatory capital associated with each of the portfolios was calculated using the Standardized Approach, the Foundation IRB Approach, and the Advanced IRB Approach. Using identical parameters for exposure at default (EAD) and loss given default (LGD) to those used in the Foundation IRB Approach offered the greatest comparability in the calculation of the minimum capital requirement for the Advanced IRB Approach. The minimum regulatory capital requirements under each of these approaches are shown in Part A of Table 2.
Consistent with the stated objective of the Basel Committee, for both the investment-grade and non-investment-grade portfolios, the minimum regulatory capital requirement calculated using the Standardized Approach is larger than the capital requirements calculated using either of the IRB Approaches.
However, for both portfolios, the minimum regulatory capital requirement calculated using the advanced IRB Approach is larger than the minimum regulatory capital requirement calculated using the Foundation IRB Approach. The difference is small for the investment-grade portfolio; however, it is substantial for the non-investment-grade portfolio. This result does not appear to be consistent with the Basel Committee's objectives.
Since the EAD and LGD parameters were identical in the Foundation and Advanced IRB calculations, the larger minimum regulatory capital requirement calculated using the Advanced IRB Approach can be attributed to the maturity adjustment (M). This conclusion is troubling, because the maturities used in the stylized portfolios are representative of those for the assets in commercial lending portfolios. These results suggest that the maturiry adjustment used in the Advanced IRB Approach is punitive--especially for the non-investment-grade portfolio.
Minimum Regulatory Capital for Securitized Portfolios
To permit a valid comparison of the minimum regulatory capital before and after securitization, the calculation of minimum regulatory capital assumed that the risks inherent in these transactions remained within the banking industry. To calculate the capital requirements for originating banks after securitization, it was assumed that the originating bank held all the positions after the securitization. Capital requirements for investing banks were calculated assuming that all of the positions in these transactions were sold to other commercial banks.
The minimum regulatory capital requirements for the portfolios …