BIS Chief Outlines Plan to Reform Securitization Process

Recognizing that securitization remains essential to the global financial markets despite its role in the subprime crisis, Bank for International Settlement General Manager Malcolm Knight has set forth a reform plan focusing on better risk management, less reliance on rating agencies, and a fuller understanding of tranche exposures. In remarks at IOSCO’s annual conference, he also emphasized the need for better cross-border coordination among financial regulators.

While securitization beneficially increases the diversification of risk, noted the BIS official, it has also been a central element of the dynamics of the ongoing financial turmoil, largely caused by inadequate risk management practices and a lack of due diligence on the part of market participants.

In his view, a key element of reforming securitization is better risk management of securitized assets, including the risk of illiquidity. Since these risks are not well measured by simple tools such as value-at-risk, the BIS official urged risk managers to rely on a wide ranger of tools to capture the multidimensionality of risk. In addition, as noted by the Basel Committee, better stress testing is imperative, including on risk interactions between credit and liquidity risks in hedging existing exposures. One example would be prime brokers' exposures to hedge funds and how these, through collateral arrangements and margin calls, can interact with liquidity risks.

Another component of securitization reform is a full understanding of tranche exposures and the calibrating of the credit ratings of those instruments. Tranching allowed pools of various liabilities to be engineered in ways enabling a large proportion of the value of those instruments to obtain a AAA rating from the credit rating agencies. Investors in such tranches had few incentives to bear the costs of undertaking serious due diligence because they thought they could rely on these ratings for their investment decisions. And as lower-rated tranches were re-securitized, the burden of borrower scrutiny was passed along the chain to ever smaller groups of investors who faced an ever harder task of analyzing the credit quality of what they were buying.

The banking official emphasized that investors must realize that tranched instruments often have risk properties in terms of illiquidity that are different from those of cash products. Noting that ratings of tranched instruments should be less mechanistic, the BIS senior officer proposed a different rating system for structured finance instruments. Moreover, regulations encouraging undue reliance on credit ratings must be changed.

Finally, for banks that are both arrangers of and investors in securitized instruments, the Basel Committee has proposed higher capital requirements for certain products and a strengthened capital treatment of liquidity facilities for off-balance sheet vehicles. In cooperation with IOSCO, it has also proposed to adjust existing guidelines for the treatment of event risk in banks' trading books.

According to Mr. Knight, a key goal of these measures is to better align banks' risk taking with their capital and liquidity buffers, with specific attention to the evolution of these risks over the full business cycle. At the same time, they would sharpen existing incentives to limit the complexity and, ultimately improve, the liquidity of securitized markets.