The implementation of Basel II has helped Japanese financial institutions to better manage the risk associated with derivatives and other the complex financial products engineered by securitization. In recent remarks at an EU financial meeting, Commissioner Takafumi Sato of the Financial Services Agency said that there are embedded vulnerabilities in the securitization process, including inaccurate information about securitized products, such as mortgage-backed securities. In many cases, counterparties and investors did not fully understand the true nature of the risks they were bearing. As financial innovations led by securitization have scattered the risks of underlying assets over various parties around the world, he noted, it has become increasingly difficult to identify the location and the magnitude of risks in the financial system.
In his view, the Basel II Accord is a significant factor in achieving enhanced risk management and stronger market discipline. Pillar One of the accord requires financial institutions to calculate the minimum amount of capital in a more risk-sensitive manner than under the old Basel I framework. A typical example is the so-called look through approach with regard to banks' fund investments. The FSA has rigorously applied this approach within Japan’s Basel II framework, noted the commissioner, and banks are now required to keep larger amounts of capital for their fund investments if the components of the fund cannot be identified.
Therefore, banks are encouraged to look through the components of their fund investments. It has been reported that some banks have reduced their positions in funds for which detailed information cannot be obtained and also that some funds have improved their disclosure practices in response to the requests from Japanese banks. As these examples show, continued the official, Japanese banks have in general become more prudent and selective in choosing their portfolio.
As for the treatment of securitization exposures in Basel II, The FSA added some extra value to the original framework. In Basel II, banks are allowed to use external ratings in computing their capital charge for securitization exposures. Market discipline works less effectively for ratings of securitized products than those for conventional corporate bonds, he reasoned, since securitization ratings are difficult to validate given the very few actual default experiences for securitized products in Japan. In order for the securitization ratings to be eligible, the FSA requires that credit rating agencies publish, free of charge, not only general information such as rating criteria, but also detailed transaction-specific information such as the type of underlying assets. This has contributed to improved market transparency, he noted, as well as enhancing risk management.
The FSA has received positive responses on Pillar Three of Basel II, which requires banks to improve their disclosure of information on the risks they are taking. For example, banks must disclose information on their securitization exposures, including breakdowns by type of underlying asset and by risk weight. Market participants indicate that the Pillar Three disclosure requirements have helped a great deal in better understanding the magnitude of Japanese banks' involvement in the securitization business, leading to more transparency and contributing to calming down market concerns during a time of global market turbulence.
Turning to concerns over the rating of securitized products, the commissioner urged securitizers to be vigilant in regard to the quality of the credit they are bundling. Originators should keep a certain portion of the underlying assets, he said, and arrangers should keep a certain tranche of the structured products, as incentives for them to examine and monitor more carefully the quality of the credits and securitized products they are producing.
Commissioner Sato proposed a voluntary code of conduct requesting the disclosure of information on the portion kept by originators and arrangers so that credit rating agencies can take such information into account in their ratings. Securitized products with some portion kept by originators or arrangers might deserve higher ratings, he suggested, since the quality of credit for the underlying assets of these products is supposed to be more carefully examined and monitored by the originators and arrangers themselves.