By James Hamilton, J.D., LL.M.
As financial institutions move towards an originate and distribute model of securitizing loans into asset-backed securities, the Basel II Accord just adopted by the Federal Reserve Board provides a new securitization framework with concomitant disclosure mandates. A central principle of Basel II is that external ratings for securitization exposures retained by an originating bank, which typically are not traded, are subject to less market discipline than rating for exposures sold to third parties,. In the Fed’s view, this disparity in market discipline warrants more stringent conditions. Thus, Basel II requires that two external ratings be obtained
Basel II also requires that banks disclose the amount of credit risk transferred and retained by the organization through securitization transactions and the types of products securitized. These disclosures are designed to provide users a better understanding of how securitization transactions impact the credit risk of the bank.
Generally, the Fed believes that banks will be able to fulfill some of their disclosure requirements by relying on disclosures made in accordance with accounting standards, SEC mandates, or regulatory reports. In these situations, banks must explain any material differences between the accounting or other disclosure and the disclosures required under Basel II.
As recently noted by Jean-Pierre Landau, Deputy Governor of the Bank of France, the current model of securitization has two distinctive features. One is the increasing complexity of customized derivatives, which has made valuation and risk assessment more difficult. The second is the fragility of off-balance sheet structures and vehicles which underpin securitization. Structured investment vehicles are not built to absorb shocks.
Their relationships with sponsor banks are sometimes very ambiguous, he noted, and there may be a gap between the legal commitments taken by the banks through liquidity support and credit enhancements and the true level of responsibility they felt obliged to take to protect their reputation. But the central banker predicted that the implementation of Basel II will bring significant improvements in risk management of securitization exposures. Had it been in place some years ago, he speculated, current problems may have been avoided.
Echoing these remarks, Fed Governor Randall Kroszner said that the enhanced public disclosures under Basel II should allow market participants to better understand a bank’s risk profile, adding that recent market events have underscored the importance of such transparency.
In his view, Basel II requires banks to assess the creditworthiness of borrowers and individual loans and investments, such as highly structured asset-backed securities, and to hold capital commensurate with that risk. This enhanced risk-sensitivity requires banks to hold a larger capital cushion for higher-risk exposures and thereby creates positive incentives for banks to lend to more creditworthy counterparties.