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Basel committee on banking supervision - asset securitisation

Asset Securitisation
Supporting Documentto the New Basel Capital Accord Table of Contents

The treatment for originating banks.2(a) Minimum operational requirements for achieving a clean break.3 Minimum capital requirements for credit enhancements .3 Minimum operational requirements for revolving securitisations with early The treatment for investing banks .6(a) Minimum capital requirements for investments in ABS.6 The treatment for sponsoring banks in conduit programs .8 SECURITISATION UNDER IRB: A HYBRID APPROACH .131. The treatment for issuing banks .13 The treatment for investing banks .13 THE TREATMENT OF EXPLICIT RISKS ASSOCIATED WITH SYNTHETIC

Retained/repurchased senior/mezzanine risk .17 Retention of both first-loss and senior risk .17 IMPLICIT AND RESIDUAL RISKS.19
In view of the vast developments that have occurred in financial markets since the introduction of the 1988 Basel Accord, the Committee recognises the importance indeveloping a comprehensive capital framework for asset securitisation, including traditionalforms as well as synthetic forms of securitisation. Within the meaning of the proposed rules,traditional securitisation involves the legal or economic transfer of assets or obligations to athird party that issues asset-backed securities (ABS) that are claims against specific assetpools. Synthetic securitisation refers to structured transactions in which banks use creditderivatives to transfer the credit risk of a specified pool of assets to third parties. However,while pursuing broadly similar economic objectives, these types of securitisations differ inmany respects, such that the treatment of the explicit risks associated with them requiresthat they be discussed separately in Sections I and II, respectively. The Committee has alsoconsidered and continues to study implicit and residual risks as outlined in Section III.
Finally, the Committee has set out disclosure requirements in order for banks to gain capitalrelief from securitisation, which are described in Section IV.
The treatment of explicit risks associated with traditional

The securitisation process is complex and involves banks playing a wide range of roles. Banks may act as the originator of the assets to be transferred, as the servicing agentto the securitised assets, or as sponsors or managers to securitisation programs thatsecuritise third party assets. In addition, banks may act as a trustee for third-partysecuritisations, provide credit enhancement or liquidity facilities, act as a swap counterparty,underwrite or place the ABS, or invest in the securities.
Banks that securitise assets are able to accomplish several objectives. First, in selling or otherwise transferring, rather than holding, the originated assets, banks are able to1) reduce their regulatory capital requirements; 2) obtain an additional source of funding,generally at a lower cost; 3) enhance financial ratios; and 4) manage their portfolio risk, e.g.
reduce large exposures or sectoral concentrations. As investors, banks are able to diversifytheir portfolios by acquiring different asset types from different geographic areas.
While benefits accrue to banks that engage in securitisation activities, these activities have the potential of increasing the overall risk profile of the bank if they are notcarried out in a prudent manner. Generally, the risk exposures that banks encounter insecuritisation are identical to those that they face in traditional lending. These involve creditrisk, concentration risk, operational risk, liquidity risk, interest rate risk (including prepaymentrisk), and reputational risk. However, since securitisation unbundles the traditional lendingfunction into several limited roles, such as originator, servicer, sponsor, credit enhancer,liquidity provider, swap counterparty, underwriter, trustee, and investor, these types of risksmay be less obvious and more complex than when encountered in the traditional lendingprocess. Accordingly, supervisors should assess whether banks fully understand andadequately manage the full range of the risks involved in securitisation activities.
In the June 1999 consultative paper, A New Capital Adequacy Framework,1 the Committee put forth several proposals to base the regulatory capital requirement for ABS ontheir relative riskiness by using credit ratings from external credit assessment firms (seeAnnex 2, paragraphs 33-36 of the First Consultative Paper). In addition, the FirstConsultative Paper proposed that in the case of securitisations involving revolving credits,e.g. credit card receivables that pose special problems in the opinion of the nationalsupervisor, the off-balance sheet securitised receivables could be converted, at thediscretion of the national supervisory authorities, to a credit equivalent amount at 20% andrisk weighted based on the obligor’s weighting (Annex 2, paragraph 36).
The Committee, working under the assumption that capital requirements are not the only way to address risks that arise from securitisation activities, initiated further work toexplore the possibility of harmonising operational requirements for originating banks. Inaddition, the Committee explored the need for a special treatment of “unratedsecuritisations” and reviewed the treatment of revolving securitisation structures.
The following proposals for the treatment of securitisation are discussed first in the context of the standardised approach, then in the context of an internal ratings-basedapproach.
The standardised approach
The discussion of the framework under the standardised approach focuses first on originating banks, then on investing banks and finally on sponsoring banks in conduitprograms.
The treatment for originating banks
In developing the securitisation proposals for the First Consultative Paper, the Committee, on the basis of a survey it had conducted, identified the regulatory operationalconstraints or limitations that certain countries impose on their banks’ securitisationactivities. The intention of these restrictions is to ensure a “clean break” between the bankoriginating assets and the securitisation transaction itself. The clean break approachestablishes regulatory requirements regarding the transfer of assets from the originatingbank and limits the roles that originating banks are permitted to perform in an attempt toseparate the seller legally and economically from the securitised assets. Such requirementsalso are intended to minimise the reputational risk of the bank sponsoring or otherwiseestablishing a securitisation structure. For instance, originators of assets in certain countriesmay not provide liquidity facilities (also known as “servicer cash advances”) to theirsecuritisations or use the name of the bank in identifying the securitisation.
In some countries, such explicit regulatory constraints are minimal because the private sector (e.g. the accounting industry and the credit rating agencies) has, in effect,established requirements that are similar to many of the regulatory “clean break” constraintsimposed by some supervisors.
From the comprehensive array of operational constraints, the Committee sought to determine if it could create a set of minimum standards to be incorporated into the FirstPillar. After studying the issue, the Committee believes that common application of certain Hereinafter referred to as the “First Consultative Paper”.
basic criteria with respect to the transfer of assets from an originating bank to thesecuritisation transaction is achievable.
Minimum operational requirements for achieving a clean break The Committee is proposing that certain minimum criteria be met before a bank can remove securitised assets from the calculation of its risk-based capital ratio.
In order for an originating bank to remove a pool of securitised assets from its balance sheet for purposes of calculating risk-based capital, the bank must transfer theassets legally or economically via a true sale, e.g. novation, assignment, declaration of trust,or subparticipation. More specifically, a clean break has occurred only if: The transferred assets have been legally isolated from the transferor; that is, theassets are put beyond the reach of the transferor and its creditors, even inbankruptcy or receivership. This must be supported by a legal opinion; The transferee is a qualifying2 special-purpose vehicle (SPV) and the holders of thebeneficial interests in that entity have the right to pledge or exchange thoseinterests; and The transferor does not maintain effective or indirect control over the transferredassets.3 Clean-up calls4 should represent a relatively small percentage of the overall issuance ofsecurities backed by the securitised assets. If such call arrangements are not a relativelysmall percentage of the total security issuance or if the sponsoring bank wishes to exercisethe clean-up call at a level greater than the pre-established level, then the bank shouldconsult with its national supervisor prior to exercising the call.
If the minimum requirements described above are not met, then the securitised assets must remain in the originating bank’s risk-weighted assets for purposes of calculatingits risk-based capital ratios – even if the transaction otherwise would be treated as a “truesale” under the home country’s accounting or legal systems.
Minimum capital requirements for credit enhancements Banks acting as originators may continue to be involved in a securitisation transaction as loan servicers (or servicing agents) and providers of credit enhancement. Inorder for the risk of association to be limited, the enhancement must only be provided at theoutset of the scheme. Originators and loan servicers that provide credit enhancement to asecuritisation transaction must deduct the full amount of the enhancement from capital,taking into account the risk-based capital charge that would have been assessed if theassets were held on the balance sheet (see also paragraph 27). Subject to national As defined by national accounting standards or legal frameworks.
3 A transferor has maintained effective control over the transferred assets if the transferor is able to repurchase from the transferee the assets to realise their benefits and is obligated to retain the risk of the assets. For purposes of determining
whether a clean break has been made, the transferor’s retention of servicing rights to the asset does not necessarily
constitute indirect control of the asset.
4 A clean-up call is an option held by the servicer, which may also be the transferor, to purchase previously transferred assets when the amount of outstanding assets falls to a level at which the cost of servicing those assets becomes discretion, there may be additional requirements that a credit enhancement must meet to beaccorded this treatment. Otherwise, the bank providing the enhancement may not haveachieved a clean break and, as such, would not be permitted to remove the assets from thecalculation of its risk-based capital ratios. Credit enhancement can take the form of servicingfees. In jurisdictions where servicing fees are capitalised and reported as an on balancesheet asset, any portion of these servicing assets functioning as credit enhancementsshould be deducted as well for capital purposes.5 Subject to national discretion, a second loss credit enhancement may be treated as a direct credit substitute if there is significant first-loss protection. Such prior loss protectionmust be provided by a third party and may elevate the credit quality of the second-lossenhancement to an investment grade level. In this case, capital would be assessed againstthe face amount of the second loss enhancement. Alternatively, a second-loss creditenhancement may require a deduction from capital.
Generally, apart from contractual provisions for providing short-term liquidity, originators or loan servicers may not provide “cash advances” or liquidity facilities to asecuritisation transaction to cover short-term deficiencies in cash flow since this would beconsidered the equivalent of providing funding or credit enhancement. As a result, the cleanbreak criteria will not have been met and the securitised assets must remain on the balancesheet. However, subject to national discretion and if contractually provided for, loan servicersmay advance cash to ensure an uninterrupted flow of payments to investors so long as theservicer is entitled to reimbursement for any advances. Reimbursement includes repaymentfrom subsequent collections, as well as repayment from the available credit enhancements.
The payment to any investors from the cash flows stemming from the underlying asset pooland the credit enhancement must be subordinated to the reimbursement of the cashadvance. Cash advances that, based on these conditions, involve very low credit risk aredetermined to be primarily liquidity enhancements and may be treated as commitments forcapital purposes that are converted to an on-balance-sheet equivalent at 20% and generallyrisk-weighted at 100%. The conversion factor should be applied to either the fixed notionalamount of the facility or, if no amount is set, the entire asset pool size.
Minimum operational requirements for revolving securitisations with earlyamortisation features The securitisation process is complex and, in the view of some supervisors, adhering to the minimum criteria does not necessarily achieve a “clean break” from thesecuritised assets. When assets are securitised, the extent to which the originating bankingorganisation transfers the risks associated with the assets depends on the structure of thesecuritisation and the type of assets involved. For example, the amount of risk that istransferred from a banking organisation securitising assets is limited for most securitisationsinvolving loans drawn under commitments to lend, i.e. revolving credits.6 Specifically, thisincludes, but may not be limited to, credit card securitisations as well as commercial loansdrawn down under long-term commitments that are securitised as collateralised loanobligations (CLOs). In an attempt to mitigate the risks, some supervisors impose additionalregulatory requirements that place constraints upon the structure of such a securitisation to Servicing assets that are not credit enhancements should be assigned the appropriate risk weight.
6 The term revolving credits refers to loan facilities that permit borrowers to vary the drawn amount within an agreed limit.
The amount of monthly payments may be at the borrower’s discretion subject in some cases to a minimum amount perpayment period, or by fixed schedule.
limit the roles that a sponsoring and originating bank may perform with regard to revolvingcredit securitisation.
Most revolving credit securitisations contain early amortisation provisions that are designed to force an early wind-down of the securitisation program if the credit quality of theunderlying asset pool deteriorates significantly, e.g. an economic trigger.7 In somejurisdictions, early amortisation features ensure that investors will be repaid before beingsubject to any risk of significant credit losses. For example, if a securitised asset pool beginsto experience credit deterioration to the point where the early amortisation feature istriggered, then the ABS held by investors will begin to pay down. This occurs because, afteran early amortisation feature is triggered, new receivables that are generated are retainedon the sponsoring institution's balance sheet.
Early amortisation features raise several distinct concerns about risks to the originating banking organisation that sells the revolving receivables. First, early amortisationprovisions require the originating institution to fund on-balance sheet newly generatedreceivables at a time when the credit quality of the asset pool is deteriorating. In addition,some regimes permit rapid early amortisation, which results in the originator’s interest in thesecuritised assets effectively being subordinated to the interests of the investors by thepayment allocation formula. If rapid amortisation is permitted, the investors effectively getpaid out first, which may result in the originator’s interest absorbing a disproportionate shareof credit losses, depending upon the severity of losses and length of time the lossescontinue. However, in some jurisdictions, the prohibition on rapid amortisation may precludethe originator from being exposed to a disproportionate share of the losses. In alljurisdictions, early amortisation provisions are considered to be credit enhancements by themarket. In all amortisations, the funding of newly originated assets on-balance-sheet mayalso create capital adequacy concerns for the originating bank, as the newly generated, on-balance-sheet receivables require risk-based capital. This may require the bank to raise newcapital during a difficult time. Second, as with all amortisations, early ones may createliquidity problems for the originating banking organisation. For example, a credit card issuermust fund a steady stream of new credit card receivables. When a securitisation trust is nolonger able to purchase new receivables due to early amortisation, the seller must either findan alternative buyer for the receivables. Otherwise, the receivables will accumulate on theoriginator’s balance sheet, creating the need for another source of funding just at a time thatfunding costs have likely increased.
The two risks to the originator as discussed above might create an incentive for the originator to provide implicit recourse – credit enhancement beyond any pre-existingcontractual obligation – to prevent early amortisation, regardless of pre-existing operationalconstraints. Although incentives to provide implicit recourse are to some extent present inother securitisations, the early amortisation feature creates additional and more directfinancial incentives to prevent early amortisation through implicit recourse because ofconcerns about damage to the originator’s reputation if one of its securitisations performspoorly.
There are effectively two general approaches that are currently employed by supervisors with respect to revolving securitisations.
7 Early amortisation also may be triggered for non-economic reasons that are related to the securitised assets. For example, non-economic events could include the seller/servicer failing to make required deposits or payments, or the seller/servicerentering into bankruptcy or receivership.
Under the first approach, in addition to the clean break criteria discussed above,supervisors also have additional operational requirements that must be met beforethe transferred assets can be considered to have been truly transferred therebyavoiding risk-based capital requirements.
The second approach enforces essentially the same operational criteria through thesupervisory process, i.e. the Second Pillar, and requirements established by theprivate sector.
The First Consultative Paper suggested that when uncontrolled early amortisation or master trust agreements pose special problems to the originating bank, the off-balancesheet securitised assets could be converted, at the discretion of the national supervisor, to acredit equivalent amount at 20% and risk weighted based on the obligor’s weighting.
After further consideration, the Committee has confirmed the need to address these risks resulting from revolving securitisations with early amortisation provisions andconcluded that a minimum capital requirement for these transactions was warranted.
Therefore the Committee proposes to apply a minimum conversion factor of 10% to thenotional amount of the off-balance sheet securitised asset pool in the transaction(sometimes referred to as the “investors’ interest”).8 Subject to national discretion, thisminimum conversion factor may be increased to a higher percentage (e.g. 20%) dependingon the insufficiency of any operational requirements. Such determination will depend onnumerous factors, such as provisions regarding rapid amortisation (e.g. how quicklyinvestors may be repaid) and the permitted size of clean up calls.
The treatment for investing banks
Investing banks are usually third parties, but subject to national discretion, originating banks may occasionally invest in some of the ABS based on pools of assets theyhave originated. In such cases, unless specifically stated otherwise in paragraphs 15 to 17above, the following considerations apply to the originating banks as well.
Minimum capital requirements for investments in ABS In setting capital requirements for banks’ investments in ABS, the Committee is proposing a revision of the Accord that makes use of ratings by eligible external creditassessment institutions.9 In this regard, the proposal is primarily addressing transactions thatresult in an SPV issuing paper secured by a pool of assets. The Committee notes that thesecuritisation market is a global market, in which a significant number of internationallyactive banks participate. Furthermore, asset-backed securities issued in the internationalmarket typically have a credit rating. Thus, using external credit assessments for assessingcapital against risks arising from securitisation transactions would further promote theAccord’s objective of ensuring competitive equality. However, beyond meeting the generaleligibility criteria described in the Supporting Technical Document on the StandardisedApproach, the external credit assessments institutions deemed eligible in the area ofsecuritisation must demonstrate their expertise in this field, as may be evidenced inparticular by a strong market acceptance.
In addition, the on-balance sheet assets (the “originators’ interest”) will be assigned the appropriate risk weight.
9 This capital treatment will apply regardless of the asset type that has been securitised.
The Committee is proposing that securitisation tranches: rated AAA to AA- (using, for example Standard & Poor’s methodology) would berisk weighted at 20%; rated A+ to A- would be risk weighted at 50%; rated BBB+ to BBB- would be risk weighted at 100%; rated BB+ to BB- would be risk weighted at 150%; and rated B+ or below or unrated would be regarded as credit enhancement andaccordingly deducted from capital.10 The Committee continues to study this area and may revisit these proposed risk-weights,especially for the BB- rated tranches.
However, not all securitisation structures are rated, such as in the case where securities are privately placed. If no specific regulation is implemented for these types ofstructures, the resulting unrated ABS would be assigned to the 100% risk weight category asthey represent claims on private counterparties, e.g. the SPVs. In addition, in order toachieve greater risk-sensitivity, the Committee may evaluate whether supervisors could relyon a bank’s internal credit ratings in order to assess the credit quality of the creditenhancement. In this respect, third-party enhancements deemed to be investment grademight be treated as a direct credit substitute and risk weighted at 100%. Third-partyenhancements deemed to be below investment grade would be treated as creditenhancement and deducted from capital.
Treatment of unrated securitisations In any event, the Committee believes it is appropriate to incorporate a so-called “look-through approach” in the New Capital Adequacy Framework so that senior ABS, whichare part of a securitisation structure that is not rated, may be treated as indirect holdings ofthe underlying asset pools. The Committee proposes the following conditions that must bemet in order for the senior ABS, which are part of a securitisation structure that is not rated,to be accorded the look-through treatment, i.e. to be assigned to the risk categoryappropriate to the underlying assets. The principal criterion for this “preferential treatment”would be to ensure that the investors are effectively exposed to the risk of the underlyingasset pool and not to the issuer. This will deemed to be the case if these conditions are met: rights on the underlying assets are held either directly by investors in the ABS or ontheir behalf by an independent trustee (e.g. by having a first priority perfectedsecurity interest in the underlying assets) or by a mandated representative. In caseof a direct claim, the holder of the securities has an undivided pro rata ownershipinterest in the underlying assets. In case of an indirect claim, the trust or singlepurpose entity (or conduit) that issues the securities has no liabilities unrelated tothe issued securities; the underlying assets must be fully performing when the securities are issued; This implies that credit enhancements provided by either originators or third parties will be deducted from capital.
the securities are structured such that the cash flow from the underlying assets fullymeets the cash flow requirements of the securities without undue reliance on anyreinvestment income; and the funds, earmarked for the investors but not yet disbursed, do not carry a materialreinvestment risk.
Even if the above conditions are met, any mezzanine or subordinated tranches in which banks invest should still be assigned to the 100% risk category. Further, if anoriginator retains any subordinated ABS or a subordinated interest, such positions areconsidered first-loss enhancements and should be deducted from capital.
An underlying asset pool of an asset-backed security that qualifies for the look- through approach (as discussed above) may be composed of assets that are assigned todifferent risk weight categories. In such a situation, the unrated senior ABS are assigned arisk weighting according to the highest risk-weighted asset that is included in the underlyingasset pool.
Given the fact that the assessment of the rights on the underlying assets is dependent to a high degree on the local legal framework/regulations, national supervisoryauthorities will be responsible for the application of the look-through criteria to structureswithin their jurisdiction.
The treatment for sponsoring banks in conduit programs
In certain securitisation structures, such as asset-backed commercial paper programs, a bank sponsors an SPV that purchases assets from business entities, whichtypically are non-banks. Sponsoring banks generally are not originators or loan servicers:this is usually the function of the various asset sellers. However, they may provide creditenhancement and liquidity facilities, manage the conduit program and place the conduit’ssecurities into the market.
With regard to credit enhancements, the Committee holds to the view that a first- loss credit enhancement provided by a sponsor must be deducted from capital. If possible,second loss enhancements should be risk weighted based on their external ratings. If theyare not externally rated or if the assets are in multiple buckets, they should be risk-weightedaccording to the highest weighting of the underlying assets for which they are providing lossprotection. If sponsoring banks sell their own assets to the conduit, then they also haveassumed the role of originator. Thus, in the event that sponsors/originators also providecredit enhancement to the conduit program, they must deduct the full amount of the lossprotection from capital.
Other commitments, i.e. liquidity facilities, usually are short term and, therefore, effectively are currently not assessed a capital charge since they are converted at zeropercent to an on-balance sheet credit equivalent amount as required by the 1988 BaselAccord.
While all commitments – even short-term commitments – have a degree of credit risk exposure, commitments that provide liquidity may be structured so that they also providecredit protection to investors in the asset-backed paper. As a result, the current capitaltreatment accorded to commitments may not be appropriate. Credit protection may beextended in several ways. For example, the liquidity facility may be designed as anagreement to purchase specific pools of assets from an asset-backed commercial paper(ABCP) conduit when the conduit is in need of liquidity because it is unable to roll-overoutstanding commercial paper. Under such an arrangement, if the liquidity facility purchases at par assets that have defaulted, then the facility not only provides liquidity against marketdisruption but also credit protection to the commercial paper investors.
However, it is not always clear whether a particular liquidity facility is acting as a credit enhancement (i.e. a direct credit substitute or a guarantee), even though it mayexpose the extending bank to credit risk. There is a continuum between liquidity facilities andcredit enhancements where the degree of credit risk in the transaction increases as onemoves towards the credit enhancement end of the spectrum. The difficulty lies indetermining when a liquidity facility has moved beyond the point where it ceases to beprimarily for liquidity and functions more as a credit enhancement.
In general, a liquidity facility enables an ABCP conduit to ensure investors of timely payments on the issued ABS by smoothing timing differences in the payment of interest andprincipal on the pooled assets or to ensure payments in the event of market disruptions.
Liquidity facilities typically are provided to amortising securitisations, such as residential andcommercial mortgage-backed securities, and ongoing ABCP conduits.
If the loan servicer reasonably expects to be repaid, cash advances may be madeby the servicer/originator to securitisation transactions in order to ensure anuninterrupted flow of payments to investors or the timely collection of the securitisedassets. Such advances are reimbursed from subsequent collections or in the formof a general claim on the party (i.e. credit enhancer) obligated to reimburse theservicer, and are not subordinated to other claims on the cash flows from theunderlying cash flows or the credit enhancement.
Liquidity support to ABCP conduits generally takes one of the two following forms: Backstop Line or Loan Agreement – When a draw under the facility isrequired, the bank lends to the ABCP conduit and receives as collateral thecash flow of the underlying asset pools.
Asset Purchase Agreement – When a draw under the facility is required,instead of extending a loan, the bank purchases a specific underlying pool ofassets from the ABCP conduit. Assets that are past due 90 days or more orthat have defaulted are not purchased. The liquidity provider is repaid fromthe cash flow on the purchased assets. In some instances, however, theassets may be resold to the conduit when it is able to obtain funding from themarket.
Each deal or purchase of a specific asset pool from a third-party seller by an ABCP conduit is structured in a manner similar to a securitisation transaction and generally placesthe sponsoring bank in an investment grade position. ABCP conduits typically have well-developed credit and investment policies to manage liquidity and control the size, quality,and diversity of sellers and obligors that participate in the program.
Usually, ABCP conduits have two levels of credit protection. The first is pool- specific reserves established by the selling organisation, e.g. overcollateralisation, orrecourse back to the seller. The pool-specific enhancement generally covers defaults andabsorbs subsequent credit losses, as well as dilution of assets. Each asset pool that theconduit acquires must be structured to the credit quality level consistent with the program’srating. This enhancement only covers defaults on a specific asset pool and may not be usedto absorb losses on other pools in the conduit.
The amount of the first-loss pool-specific enhancement for each particular pool is dependent upon the seller’s risk profile and covers a multiple of historical losses and dilution.
Consideration is given to the seller’s quality as a servicer; obligor concentrations; the largest obligor’s credit quality; and, possibly, whether the credit enhancement is dynamic (i.e.
increases as the asset pool’s performance deteriorates) or static (i.e. a fixed percentage).
The second level of credit protection is the program-wide enhancement, which may take the form of an irrevocable loan facility, standby letter of credit, surety bond from amonoline insurer or subordinated debt. As with the pool-specific enhancements, theprogram-wide credit protection is sized based on a multiple of losses on the portfolio of poolsin the conduit; multiple of largest seller; and, if necessary, excess over the obligorconcentration limits. In addition, the rating agencies consider the stress tests performed onthe conduit’s portfolio when determining the appropriate amount of overall credit protection.
Structural Diagram
(Usually nonbanks)
(Usually nonbanks)
(Provides pool specific
(Provides pool specific
credit enhancement)
credit enhancement)
Advances against
new assets
Collections on
Credit Enhancement
previously sold
ABCP Conduit
Liquidity, if
Payments for
Payments on
Purchase price
of new ABCP
As alluded to above, liquidity banks commit to extend funds to the ABCP conduit in the event of timing mismatches or market disruptions, including an issuer’s inability to roll itscommercial paper to ensure the timely payment to investors. Often, a conduit will have twolevels of liquidity enhancement – pool-specific and program-wide liquidity.
A pool specific liquidity facility is associated directly with a particular pool of assets and the related commercial paper that was issued to fund the purchase of the assets. Suchan enhancement is usually provided by the sponsoring bank, which may provideapproximately 80% to 90% of the conduit’s specific liquidity facilities. This type of facility isnot fungible and may not be used to provide liquidity support to other asset pools. Typically,liquidity banks do not fund defaulted assets, if the issuer or conduit goes into bankruptcy, orif the credit enhancement is exhausted. The credit protection is sized to cover such worst-case scenarios.
Typically, program-wide liquidity is provided in an amount sufficient to support 100% of the face amount of all the commercial paper that is issued by the conduit.
In the First Consultative Paper, the Committee proposed converting all commitments, regardless of original maturity, at 20% to on-balance sheet credit equivalentamounts. An exception would be applied to commitments that are unconditionallycancellable, or that effectively provide for automatic cancellation, due to deterioration in aborrower's creditworthiness, at any time by the bank without prior notice. In such cases, azero capital charge would apply. For instance, a liquidity facility that can only be drawn in theevent of general market disruption (i.e. paper could not be issued at any price by any issuer)could be considered unconditionally cancellable and, therefore, may qualify for a zero capitalcharge. Adoption of a positive, non-zero capital charge for all commitments may mitigatepotential concern that liquidity facilities extended to certain securitisation transactions maybe exposed to some degree of credit risk.
The 1988 Accord generally requires that long-term commitments (those with an original maturity over one year) be subject to a 50% conversion factor, and that short-termcommitments (those with an original maturity of one year or less) or those which can beunconditionally cancelled at any time be converted at zero percent. In developing the risk-based capital framework, it was recognised that a maturity break for the credit conversionfactors of loan commitments might create an incentive for banks to structure theircommitments in such a manner as to avoid a capital requirement. This outcome wasconsidered acceptable provided it led banks to genuinely reduce the duration of theircommitments, and thus their potential credit risk, to a maximum of one year from the date onwhich the commitments were made.
Some supervisors have defined original maturity as, "the length of time between the date the commitment is issued and the earliest date on which 1) the banking organisationcan, at its option, unconditionally (without cause) cancel the commitment and 2) the bankingorganisation is scheduled to (and as a normal practice actually does) review the facility todetermine whether or not it should be extended." Thus, a long-term facility with a nominalmaturity of over one year could be converted at zero percent, if, within the first year of thecommitment, the bank performs a credit review and at that point can unconditionally cancelthe commitment without cause. Commitments that meet these criteria may be considered tohave an original maturity of one year or less for risk-based capital purposes.
Under the 1988 Accord, direct credit substitutes include those arrangements that substitute for loans, including standby letters of credit and other forms of guarantees. Abroader definition, used by some supervisors, includes any irrevocable arrangements thatguarantee repayment of financial obligations, including asset-backed commercial paper.
Thus, any commitment (by whatever name) that involves an irrevocable obligation to make apayment to a third party in the event of a failure to repay an outstanding debt obligation istreated, for risk-based capital purposes, as a financial guarantee. Such an arrangement isconverted at 100% to an on-balance sheet credit equivalent amount and assigned to the riskcategory appropriate to the underlying obligor, which is typically the 100% category.
Under the 1988 Accord, banks may have an incentive to structure embedded credit enhancements in short-term commitments or liquidity facilities in order to avoid beingassessed a capital charge. While all commitments, either short-term or long-term, inherentlyexpose the extending bank to credit risk, certain liquidity facilities may go beyond providingliquidity and cover a sufficient degree of credit risk to warrant treatment as a guarantee forcapital purposes. To date, supervisors have been making this determination in a variety ofways.
Supervisors in certain jurisdictions have established operational requirements that must be met in order for there to be a “clean break” between an originating bank and theassets that it has sold and securitised. Under these restrictions, originating banks areprohibited from providing liquidity (or a cash advance) to one of its securitisationtransactions. The rational is that the provision of a liquidity facility renders void the minimalrequirements of “clean break” because, in substance, the assets return to the bank in theevent of a drawing under a facility. Thus, an originating bank that provides a liquidity facilityto an SPV retains an ongoing relationship with the securitised assets. In suchcircumstances, a bank cannot be regarded as having achieved legal isolation or havingsurrendered control over the assets.
However, supervisors in other jurisdictions believe that such cash advances are an important and well-established part of the servicing function. As long as the cash advance isisolated from the credit risk of the serviced assets it is considered a commitment.
More importantly, supervisors are concerned that the terms and conditions of a liquidity facility extended to an amortising securitisation or an ABCP program may be draftedso that the facility not only provides liquidity enhancement, but also credit protection. Tocounteract this problem, some regulatory authorities have drawn up a list of requirementsthat must be complied with before a facility will be recognised as being provided purely forthe purposes of liquidity.
The Committee has endeavoured to develop a common approach for determining when commitments that are purportedly extended for purposes of liquidity are, in fact, moreakin to guarantees and should be treated as such for regulatory capital. More specifically,the Committee has agreed that liquidity facilities provided by sponsors to conduit programsgenerally should be used to cover short-term market disruptions that prohibit the roll-over ofcommercial paper or issuance of notes but should not in any way constitute credit lossprotection available to investors. In order to ensure that the facility is used purely for liquiditypurposes, the Committee has developed the following requirements: a facility must be a separately documented agreement provided to an SPV – not tothe investors – at arm’s length, on market terms, at market rates and subject to thebank's normal credit approval and review processes; the SPV must have the clear right to be able to select a third party to provide thefacility; a facility must be fixed in amount and duration, with no recourse to the bank beyondthe fixed contractual obligations provided for in the facility; the terms of the facility must clearly identify and limit the circumstances under whichit may be drawn and, in particular, the facility must not be used to provide creditsupport, cover losses sustained, or act as permanent revolving funding; the drawings under the facility should not be subordinated to the interests of thenoteholders and the payment of the fee for the facility should not be furthersubordinated or subject to a waiver or deferral; and the facility should include either a reasonable asset quality test to ensure that adrawing would not cover deteriorated or defaulted assets or a term requiring thetermination or reduction of the facility for a specified decline in asset quality.
The Committee proposes that these facilities be converted to an on-balance sheet amount and risk-weighted based on the supervisory determination, which includesconsideration of the above criteria, of whether the facility is primarily for liquidity or creditenhancement, as well as on its credit quality. Facilities that are determined to be primarilyliquidity enhancements may be treated as commitments for capital purposes that are converted at 20% and generally risk-weighted at 100%. Facilities that are determined to beprimarily credit enhancements should be treated according to the risk-weighting scheme forsecuritisation positions as set forth in paragraph 27 above. For example, facilitiesdetermined to be credit enhancements and rated BBB, would be assigned to the 100% riskcategory; those rated BB would be assigned to the 150% category; and those exposuresrated B+ or below or not rated would be deducted from capital.
As these positions are unlikely to be rated or traded, the Committee will further explore whether supervisors could rely on a bank’s internal credit ratings in order to assessthe credit quality of the liquidity facilities (as previously discussed in paragraph 28). Forinstance, facilities deemed to be investment grade could be treated as commitments and riskweighted accordingly. Facilities deemed to be below investment grade could be deductedfrom capital.
Securitisation under IRB: A Hybrid Approach
The Committee has developed the outline of a securitisation treatment for IRB that follows the same economic logic used for the standardised approach. At the same time, theCommittee wishes to take advantage of the greater capacity for risk-sensitivity under the IRBframework. The specific mechanism depends on whether the bank in question is an issuer oran investor in securitisation tranches. The treatment described here would apply totraditional securitisation transactions under both the foundation and advanced IRBapproaches.
The Committee will continue its work to refine the IRB treatment of securitisation during the consultative period, and to address key outstanding issues. These issues,including operating standards and the treatment to be accorded to synthetic securitisationtransactions, are discussed below.
The treatment for issuing banks
For banks issuing securitisation tranches, the full amount of retained first-loss positions would be deducted from capital, regardless of the IRB capital requirement thatwould otherwise be assessed against the underlying pool of securitised assets.
The Committee is also considering whether issuing banks that retain tranches with an explicit rating from a recognised external credit assessment institution could apply an IRBcapital requirement tied to that rating by mapping this assessment into the PD/LGDframework. This treatment effectively follows the approach for externally rated tranches heldby an investor bank described below.
The treatment for investing banks
banks investing in securitisation tranches issued by other institutions, the Committee proposes to rely primarily on ratings for such tranches provided by external creditassessment institutions (ECAIs). Specifically, the bank would treat the tranche as a singlecredit exposure like other exposures, and apply a capital requirement on the basis of the PDand LGD appropriate to the tranche. The appropriate PD would be that associated with theexternal rating on the tranche in question. This PD could be measured directly as the long-term historical overall default rate of instruments in that rating category for the ECAI inquestion measured with an appropriately conservative bias. Alternatively, it could bemeasured indirectly as the PD estimated by the bank for its own internal grade that is “comparable” to that external rating based on a mapping analysis that is approved bysupervisors. Although the Committee will continue to refine its analysis over the consultativeperiod, it proposes for the sake of conservatism to apply a 100% LGD to such tranches. This100% LGD would apply to both foundation and advanced-approach banks.
If the tranche is unrated (e.g. associated with a bilateral transaction), which can be viewed as evidence of the position’s low credit quality, the investing bank would be expectedto deduct the tranche from capital.
Issues for further work
The Committee is looking to several specific issue areas as it continues its work to refine this proposal. For instance, the assumption of 100% LGD is extremely conservativeand does not differentiate between first-loss and more senior loss positions. Nor does itdifferentiate between those banks on the foundation or advanced approach for theestimation of LGD.
The Committee will continue to study alternative approaches, such as, the “two-legged” or “sliding-scale” approach that would require the issuing bank firstto calculate the IRB capital requirement on the entire pool of securitised exposures,and then to adjust that requirement to reflect the risk that has been transferred toinvestors in that pool. For example, under this approach, retained first-loss positionsup to an amount equal to the IRB capital requirement on the underlying pool ofsecuritised exposures, the degree of adjustment – termed “s” – would be equal toone, which is equivalent to a deduction from capital. For that portion of the retainedpositions in excess of the IRB capital requirement on the underlying pool, the “s”factor could conceivably be set at less than one to reflect the transfer of some creditrisk to investors in securitisation tranches. And, a broader application of a PD/LGD treatment for individual securitisation tranchesthat would not require these tranches to be externally rated. Among the issues thatwould have to be addressed is how banks or supervisors could attribute a single PDestimate to an unrated tranche in a way that could be validated.
In the case of investments in unrated tranches, including bilateral transactions, deduction from capital may be unwarranted. Thus, the Committee is considering to whatextent an implied rating could be applied to the unrated tranche, based on the ratings ofother tranches in the securitisation transaction. Such an approach would need to beimplemented with considerable caution and conservatism. An additional option could requirethe investing bank to perform sufficient due diligence to determine the IRB capitalrequirement on the entire pool, and to apply the “two-legged” or sliding-scale treatmentdescribed for issuing banks above. The Committee will continue to develop and refine theseoptions during the consultative period.
The Committee believes that the operating standards proposed for the revised standardised approach would also be applicable to the IRB treatment, although there maybe some small number of additional considerations specific to the IRB context.
Complex transactions present further challenges to the simple treatment described above. In particular, capital treatment under an IRB approach for synthetic securitisationsraises issues that parallel those of credit derivatives.
Specific Issues/Questions for Comment:
1. What are the industry’s views on the best way forward for the development of a more risk-sensitive approach to securitisation in the IRB approach? 2. With respect to the two-legged or sliding-scale approach, what are the industry’s views on possible methods for calibrating numbers for the adjustment factor consistent with lessthan dollar-for-dollar deduction of first-loss positions? 3. Does the differentiation in treatment on the basis of being an issuer or investor bank provide a balanced and consistent economic approach? 4. In a framework that relies on the presence of an external rating, how could PDs be attributed either by banks or supervisors to unrated securitisation tranches? Does the useof external ratings create the possibility of regulatory capital arbitrage under an IRBapproach because of the potential difference between the default correlations imbeddedin the IRB framework and those used by ECAIs? The treatment of explicit risks associated with synthetic

“Synthetic securitisation” refers to structured transactions in which banks use credit derivatives to transfer the credit risk of a specified pool of assets to third parties, such asinsurance companies, other banks, and unregulated entities. The transfer may be eitherfunded, for example, by issuing credit-linked securities in tranches with various seniorities(“collateralised loan obligations” or CLOs) or unfunded, for example, using credit defaultswaps. Synthetic securitisation can replicate the economic risk transfer characteristics ofsecuritisation without removing assets from the originating bank’s balance sheet or recordedbanking book exposures.
Synthetic securitisation may also be used more flexibly than traditional securitisation. For example, to transfer the junior (first and second loss) element of credit
risk and retain a senior tranche; to embed extra features such as leverage or foreign
currency payouts; and to package for sale the credit risk of a portfolio (or reference portfolio)
not originated by the bank. Banks may also exchange the credit risk on parts of their
portfolios bilaterally without any issuance of rated notes to the market. Another variant is to
use credit derivatives to transfer the risk of a small number of corporate “names” (e.g. ten)
rather than that of a larger portfolio.
Four schematic transaction types are illustrated in Annex 1: Entire notional amount of the reference portfolio is hedged; High quality, senior risk position in the reference portfolio is retained along with afirst-loss position; Utilisation of a highly rated intermediary institution.
From the originators’ perspective, the incentives to use such products, apart from the greater flexibility, are that they are cheaper and quicker to arrange and they side-steplegal and confidentiality difficulties in transferring assets. However, certain basis risks canreduce the completeness of risk transference. These risks arise from asset mismatches (when the underlying portfolio of assets differs somewhat from the assets referenced in thecredit derivative), as well as currency and maturity mismatches, and materiality thresholds(below which a credit event is not called or no protection payment is paid out).
From the investors’ perspective, notes can be structured to achieve a desired portfolio profile and seniority/rating. At the same time, due to confidentiality constraints forthe sponsoring bank, the notes may be referenced to blind pool structures whose underlyingcomponents are not disclosed to investors. In these cases investors may know only thediversity score and average quality of the pool.
Synthetic securitisation is a comparatively cost-effective mechanism for repackaging credit risk portfolios in response to incentives in regulatory capital requirements.
However, it should be noted that, under an internal ratings based approach, the incentive toengage in synthetic securitisations may very well be mitigated since, in theory, the regulatorycapital requirements would be closer to the economic capital actually required against therisk of the reference portfolio. Given the convergence of the two capital measures, thetransaction costs also tend to reduce the incentive banks have to engage in a syntheticsecuritisation in order to minimise their capital requirements.
However, small, less sophisticated banks that are not eligible for the internal ratings based approach may legitimately wish to engage in synthetic securitisations for purposesother than arbitraging the capital requirements, such as transferring large exposures. Thus,a treatment for synthetic securitisations may be needed in the standardised approach,subject to robust operational requirements.
The Committee intends to finalise its work on the capital requirements and the operational requirements related to synthetic securitisations in the near term. Theoperational requirements would be in addition to those for credit risk mitigation, which, giventhe nature of synthetic securitisations, are applicable to these instruments.
However, the Committee has already identified a number of issues that will need to be resolved in order to develop a consistent and comprehensive treatment of these syntheticsecuritisations, for both the standardised and internal ratings-based approaches.
Degree of risk transference
A key issue to be considered is the amount of credit risk that is transferred to third parties and whether a large degree of risk transference is necessary in order to obtainregulatory capital relief. There are three aspects to this: (i) retention of first-loss risk (ignoringsenior risk); (ii) retention or repurchase of senior/mezzanine risk (ignoring first-loss risk) and(iii) the retention of first-loss and senior risk.
Retention of first-loss
Credit enhancement is a feature of both traditional and synthetic securitisations (a rating agency’s requirement for investor protection). First-loss positions are usually held bythe originating institution. In the context of traditional securitisations, first-loss positionsgenerally tend to take the form of subordinated debt. In synthetic securitisations theygenerally take the form of a payout clause of the contract. The size of the first-loss piece isdriven primarily by a combination of the ratings requirements of the originating institution andthe underlying asset quality (in traditional securitisations this tends to be a multiple ofexpected losses). The question, therefore, arises as to whether the level of creditenhancement retained by the originating institution should be restricted to ensure a reasonable degree of risk transference or whether the proposed capital treatment for first-loss positions (i.e. deduction from capital) negates the need for this. Factors to consider inrelation to both approaches are set out below.
Restricting any retained first-loss to expected losses on the reference pool, which would then be deducted from capital, would ensure that there would be real risk transferencein the form of unexpected losses. In addition, it is a prudent treatment for retained first-losspositions held by originators. However, such an approach would require supervisoryresources and continual judgements to determine whether proposed retention correspondsto a reasonable estimate of expected losses on a number of different reference portfolios.
Furthermore, it is inconsistent with the current capital treatment applicable to traditionalsecuritisations.
An alternative approach would not limit the size of retained first-loss risk positions to a reasonable estimate of expected losses on a particular portfolio, i.e. such positions couldbe several multiples of expected losses and would require deduction of any first-lossexposures from capital. This appears to be a prudent treatment of retained first-losspositions since any potential losses are deducted up-front, it is simple to implement, and isconsistent with the existing approach for traditional securitisations. However, as withtraditional securitisations, there is little, if any, real risk transference in transactionsstructured as described.
Retained/repurchased senior/mezzanine risk
In traditional securitisation structures all of the assets’ risk (above first-loss) is transferred to an SPV for onward issuance to the market. However, in syntheticsecuritisations, only the mezzanine risk (which could be as little as 5% or 6% of the nominalamount of the portfolio) tends to be transferred to the SPV. The senior risk is eithertransferred in a bilateral agreement to another bank or investment firm or retained by theoriginating institution. Given this structural difference, the Committee is considering whetherthe senior risk should be required to be transferred and the implications for the proposals ontraditional securitisation.
The Committee discussed the principles and operational requirements which would make it acceptable for the originating bank to retain the most senior risk exposure in asynthetic structure. These principles could include: 1) that the senior risk position is of highquality, 2) that there are sufficient operational requirements to ensure that the mezzaninerisk has been effectively transferred to the SPV and 3) that there is sufficient marketdiscipline (i.e. the originator should not be able to buy back or retain any positions other thanthe most senior11) on the paper issued by the SPV. The Committee continues to explorewhether these operational requirements warrant an effective transfer of risk and the questionof whether these operational requirements are consistent with the clean break criteriaproposed for traditional asset securitisation.
Retention of both first-loss and senior risk
The final scenario that the Committee considered in relation to the required degree of risk transference in order to obtain capital relief is whether it makes a difference if the 11 Although some small derogation may be necessary for the purposes of market making.
originator holds both the senior risk and the first-loss risk positions. The most extremeexample of this would be to effectively hold the entire portfolio with only an extremely smallportion of mezzanine risk transferred to the market, e.g. $1. In this scenario, the originatingbank could reduce its capital requirements significantly and still effectively maintain the samerisks. The Committee is still considering a number of options, including the following: require that the retained first-loss be restricted to expected loss in order for theretained senior risk to qualify for the lower capital requirement; require a minimum percentage of the nominal amount of the portfolio to betransferred to the market (say, 10%); require a minimum transfer of risk to the market, i.e. notes issued to the marketmust be AAA; impose a minimum time period for which notes must be in issue prior to repurchase; do not recognise any implicit rating on retained or repurchased senior positions butapply the capital charges as set out for unrated structures in traditional asset-backed security structures.
Consistency with CRM
In addition, the Committee is considering the extent to which the treatment of synthetic securitisation should be consistent with the Credit Risk Mitigation Techniques setforth in this Second Consultative Paper. This points to a number of issues, including thetreatment of collateral (asset and currency mismatch, eligibility and “w” mechanics),guarantees and credit derivatives (eligibility, substitution-plus approach and partialguarantees) and maturity mismatches.
Operational requirements
The Committee has considered a number of criteria that would need to be met in order to obtain a preferential capital charge. These would potentially consist of structural,risk management and disclosure criteria.
Structural criteria
Such criteria could include the following: Ensure the absence of any early amortisation or other credit performancecontingent clauses;12 Subject the transaction to market discipline through the issuance of a substantiveamount of AAA-rated notes or securities to the capital markets; Have notes or securities rated by two rating agencies; 12 An early amortisation clause may generally be defined as a feature that is designed to force a wind-down of a securitisation program and rapid repayment of principal to investors of ABS if the credit quality of the underlying asset pool deterioratessignificantly.
The SPV, even though highly rated, would not be considered to be an eligibleguarantor that would reduce the risk weight of the portion of the reference portfoliohedged credit derivative. In order for this portion of the reference portfolio to obtaincapital relief, the vehicle must pledge eligible collateral (i.e. cash or zero-weightedcentral government securities) to the beneficiary bank; Ensure that sponsoring banks do not reassume any credit risk from the investorsthrough another credit derivative or any other means. The structure should notcontain terms or conditions that would significantly limit the credit protectionprovided against the underlying assets; Credit derivative documentation should follow generally accepted market practicewhere possible. If there is no established market norm, documentation should befully vetted through new product procedures. Credit events (which trigger paymentunder the transaction) should at a minimum include default of the underlying assetprotected, or default of an obligation of the underlying name where cross referenceclauses exist with the underlying asset protected. The contract should make clearwhich sources of public information would be used to determine the occurrence of acredit event; A legal opinion is required to ascertain that the synthetic securitisation structureworks as specified to the supervisor and the market.
Risk management criteria
Beyond the above structural criteria, the Committee would seek to ensure that the originating institution has adequate capital for the credit risk of its unhedged exposures.
Therefore, institutions – even those operating under the standardised approach – would beexpected to have adequate systems that fully take into account the effect of suchtransactions on the institutions’ risk profiles and capital adequacy. In particular, thosesystems should be capable of fully differentiating the nature and quality of the risk exposurestransferred by an institution from the nature and quality of the risk exposures it retains.
Disclosure criteria
Finally, the Committee would expect originating institutions to provide adequate disclosure to the marketplace in their (semi) annual reports on the accounting, economic,and regulatory consequences of such transactions. These requirements would fall into thegeneral framework for disclosure for securitisation.
Implicit and residual risks
The Committee recognises that even when a securitisation complies with the clean break criteria as specified in paragraph 13 above, originators may be subject to “moral” orreputational risk, thereby providing implicit support to a securitisation transaction whoseunderlying asset pool is experiencing credit deterioration. This implicit support is typicallydemonstrated by a bank’s actions beyond any contractual obligations. Actions that mayconstitute implicit support include selling assets to a trust or SPV at a discount from bookvalue, exchanging performing for non-performing assets or other actions that result in asignificant transfer of value in response to deterioration in the credit quality of the securitisedasset pool.
The Committee has considered the question of what constitutes an appropriate capital treatment for such implicit and residual risks, and holds to the view that the followingapproach should be regarded as the basis for addressing these risks. This approach wouldconsist of applying the following measures when an institution is determined to haveprovided implicit recourse: If it is determined that an institution has provided implicit recourse to any portion ortranche of a securitisation that it has originated, then all of the assets associatedwith this structure (i.e. not only a specific tranche but all tranches of the structure)will be treated as if they were on the bank’s balance sheet. These assets will thenbe risk-weighted accordingly for purposes of capital calculation. Illustrativeexamples of the types of additional recourse include the purchase/substitution ofassets that were securitised, lending to the structure (outside of contractualprovisions for providing short-term liquidity) and deferral of fee income associatedwith the structure.
If a supervisor determines that an institution has provided implicit recourse on asecond and subsequent occasion, then all of this institution’s securitised assets –not just the structure for which implicit support was provided – will be treated as ifthey were on its balance sheet and risk-weighted accordingly. The bank will beprevented from gaining capital relief through the securitisation process for a periodto be determined by the bank’s supervisor.
In both instances, a bank will disclose publicly that it was found to have providedimplicit recourse and the consequences of such actions as outlined above. Thisdisclosure will include the impact of the securitised assets reverting to the bank’sbalance sheet for capital calculation purposes and the potential for furthersupervisory action, as appropriate.
The Committee believes that at a minimum, these measures will help address the
issue of banks taking on more risk than that for which they are contractually liable. However,the Committee is conducting further work to fully assess the nature, frequency andconsequences of banks providing implicit recourse. The Committee is also studying otherresidual risks not captured in an explicit capital charge as well as unacceptable capitalarbitrage opportunities arising through the securitisation process. The results of theCommittee’s study in these areas may allow an assessment of an ex ante minimum capitalcharge for securitisation transactions to fully address implicit and residual risks. TheCommittee will also consider the possibility of measuring the amount of risk transferred byoriginating banks through the use of external ratings given to those tranches not retained bythe originating bank. In any event, when setting such a capital charge, the Committee wouldensure that it is risk-based and would take account of all other capital provided under theminimum capital requirements framework as well as the potential impact on thesecuritisation market.
This proposed treatment of implicit recourse and other residual risks would supplement the other requirements concerning securitisation, including clean break criteria,liquidity facility criteria, treatment of unrated securitisations, the deduction from capital offirst-loss risk positions and the treatment for revolving securitisations with early amortisationfeatures. The Committee recognises the value of the consultative process in developing anappropriate treatment for asset securitisation and seeks meaningful dialogue with theindustry in this regard.
Disclosure requirements
The Committee proposes that banks be required to publicly disclose certain quantitative and qualitative information in order to gain preferential capital treatment withrespect to asset securitisations. The following tables outline the required disclosures thatmust be made by originating banks, sponsoring banks and SPVs established by banks.
Many of the proposed disclosure requirements reflect the level of information currentlydisclosed to the market.
Disclosures by originators
Desired Location
Information on the amount of assets securitised would Aggregate amount of loans and commitments provide a bank’s counterparties an indication of the level securitised (nominal, notional and outstanding of the bank’s activity in the securitisation market and the amount of risk transferred. Data on the amount of traditional securitisation categories.
funding provided will indicate extent of reliance on If appropriate, this should be broken down further Where revolving, the amount of seller interestshould be disclosed.
Amount of funding provided by securitisationactivity.
All data should be disclosed by deal if material.
Asset types securitised. By deal if material Disclosure would assist in ascertaining the risk profile of Roles played by the originator in relation to its Provide information as to the extent of the links between securitisation activities (e.g. servicer, provider of credit the originator and the scheme and therefore highlight enhancement, liquidity provider, swap provider etc.) potential scope for implicit recourse.
Aggregate data regarding the maximum amount of In order to give counterparties a true picture of a bank’s credit exposure arising from recourse/credit risk profile, the amount of recourse/enhancements must enhancement provided to the transactions coupled with be disclosed. A declaration regarding further support a declaration that support is limited to these contractual should assist in preventing further support.
Disclose data on credit enhancement by deal if material.
Aggregate date regarding the size and nature of liquidity Where a jurisdiction allows originators to provide liquidity facilities provided. Disclose by deal if material.
facilities to their own securitisations, this would provide information as to the links with the scheme and also theliquidity profile of the bank.
* A – Aggregate, D – By Deal or both Disclosures by sponsors/third parties
The following disclosures are proposed for all sponsors (and for some third parties). These disclosures are required for those securitisationswhere the bank has a material involvement in the transaction i.e. providing liquidity or credit enhancement. If a bank performs only roles withregard to that securitisation, those roles should be disclosed. However where a bank simply performs a non-material role, e.g. as swapcounterparty, the bank is not be required to make any securitisation-specific disclosures.
Desired Location
Data regarding the maximum amount of credit In order to give counterparties a true picture of a bank’s exposure arising from recourse/credit enhancement risk profile the amount of recourse/enhancements must provided to the transactions coupled with a be disclosed if sponsor wishes to provide such facilities.
declaration that enhancement is limited to the A declaration regarding further support should assist in contractual amounts specified. Disclose by deal if Size and nature of liquidity facilities. By deal if Where a bank provides liquidity facilities to commercial paper conduits, the size and nature of the commitments should be disclosed. The aim of this disclosure is togive counterparties an indication of a bank’s contingentliabilities.
* A – Aggregate, D – By Deal or both Disclosures by Issuers (i.e. SPVs)
The following disclosures are proposed for all issuers.
Desired Location
The names of all rating agencies or other sources of Disclosure is required to ensure that only reputable agencies external assessment used for risk weighting (those with market credibility) are employed A summary of the legal structure of the transaction.
Where the legal structure of a transaction is transparent, the risks involved in that the transaction become clearer to investors.
The form of transfer used, in particular any residual The method of transfer can have an important bearing upon the links to or rights held by the originator risks assumed by the buyer and the seller, as different methodsachieve a “cleaner break” than others.
Asset types securitised, selection criteria and Ensure investors understand the risk that they are undertaking The names of all parties participating in the structure Disclosure of the parties involved in the transaction would assist of the transaction and their associated role including the investor in assessing the robustness of the transaction.
originator, servicing agent, provider of creditenhancement, provider of liquidity, swapcounterparties, provider of GICs, security trustee,underwriter and marketmaker.
The amount and form, rating (where obtained) of the In order to assess the adequacy of expected loss cover on the credit support within the transaction. With declaration portfolio, an issuer should disclose the structure of enhancements.
that credit support is only as outlined – no further Where enhancements are unfunded, e.g. by an insurer, the identity of the counterparty should be disclosed.
The amount, form, rating (where obtained) and Investors must be made aware of the size and type of facility position in payment ranking of the liquidity facility (if incorporated into the transaction, so that they can assess the quality of protection in the event of market disruption. The priorityof the liquidity facility in the payment waterfall must also bedisclosed.
The early amortisation triggers on the pool.
Investors should be made aware of the triggers on the pool to ensure that they understand the limit to the risk that they areaccepting.
* A – Aggregate, D – By Deal or both Synthetic securitisation examples
Entire notional amount of the reference portfolio is hedged
In this type of synthetic securitisation, an SPV acquires the credit risk on a reference portfolioby purchasing credit-linked notes (CLNs) issued by the sponsoring banking organisation. TheSPV funds the purchase of the CLNs by issuing a series of notes in several tranches to thirdparty investors. The investor notes are in effect collateralised by the CLNs. Each CLNrepresents one obligor and the bank’s credit risk exposure to that obligor, which may take theform of, for example, bonds, commitments, loans, and counterparty exposures. Since thenoteholders are exposed to the full amount of credit risk associated with the individualreference obligors, all of the credit risk of the reference portfolio is shifted from thesponsoring bank to the capital markets. The dollar amount of notes issued to investorsequals the notional amount of the reference portfolio. In the example shown in Figure 1below, this amount is $1.5 billion.
$1.5 billion cash
Holds Portfolio
$1.5 billion cash
$1.5 billion
Credit Portfolio
$1.5 billion of
CLNs issued by
$1.5 billion of
If there is a default of any obligor linked to a CLN in the SPV, the institution will call theindividual note and redeem it based on the repayment terms specified in the note agreement.
The term of each CLN is set such that the credit exposure to which it is linked matures priorto the maturity of the CLN. This ensures that the CLN will be in place for the full term of theexposure to which it is linked.
An investor in the notes issued by the SPV is exposed to the risk of default of the underlyingreference assets, as well as to the risk that the sponsoring institution will not repay principalat the maturity of the notes. Because of the linkage between the credit quality of thesponsoring institution and the issued notes, a downgrade of the sponsor’s credit rating mostlikely will result in the notes also being downgraded.
High quality, senior risk position in the reference portfolio is
retained including a small first-loss position equal to expected

In some recent synthetic CLOs, the sponsoring banking organisation uses a combination ofcredit default swaps and CLNs to essentially transfer to the capital markets the credit risk ofa designated portfolio of the organisation’s credit exposures. In this structure, the sponsoringbanking organisation purchases default protection from an SPV for a specifically identifiedportfolio of banking book credit exposures, which may include letters of credit and loancommitments. The credit risk on the identified reference portfolio (which continues to remainin the sponsor’s banking book) is transferred to the SPV through the use of credit defaultswaps. In exchange for the credit protection, the sponsoring institution pays the SPV anannual fee. The default swaps on each of the obligors in the reference portfolio arestructured to pay the average default losses on all senior unsecured obligations of defaultedborrowers. (See Figure 2 below for an example of this structure.) In order to support its guarantee, the SPV sells CLNs to investors and uses the cashproceeds to purchase central government securities. The SPV then pledges the governmentsecurities to the sponsoring banking organisation to cover any default losses.13 The CLNsare often issued in multiple tranches of differing seniority and in an aggregate amount that issignificantly less than the notional amount of the reference portfolio. The amount of notesissued typically is set at a level sufficient to cover some multiple of expected losses, but wellbelow the notional amount of the reference portfolio being hedged.
Default Payment and
Pledge of Central
Government Securities
Holds $400 million of
$5 billion
pledged Government
Credit Portfolio
$5 billion of credit default
Annual fee
$400 million
$400 million of
Retained first-loss
(funded reserve or
reduction in the
The first-loss position may be a small cash reserve, which may be equal to or greater thanexpected losses in the reference portfolio. This cash reserve accumulates over a period of 13 The names of corporate obligors included in the reference portfolio may be disclosed to investors in the CLNs.
years and is funded from the excess of the SPV’s income (i.e. the yield on the centralgovernment securities plus the credit default swap fee) over the interest paid to investors onthe notes. The investors in the SPV assume a second-loss position through their investmentin the SPV’s senior and junior notes, which tend to be rated AAA and BB, respectively.
Finally, the sponsoring banking organisation retains a high quality senior risk position thatwould absorb any credit losses in the reference portfolio that exceed the first- and second-loss positions.
Typically, no default payments are made until the overall transaction’s maturity, regardless ofwhen a reference obligor defaults. While operationally important to the sponsoring bankingorganisation, this feature has the effect of ignoring the time value of money. Thus,supervisors expect that when the reference obligor defaults under the terms of the creditderivative and the reference asset falls significantly in value, the sponsoring bankingorganisation should, make appropriate adjustments in its regulatory reports to reflect theestimated loss relating to the time value of money. These adjustments should be inaccordance with generally accepted accounting principles Bilateral transactions
Some recent transactions transferred the credit risk via credit default swaps between thebank and different highly rated counterparties. These transactions provide credit protectionfor the entire notional amount of the reference portfolio where the credit protection sellingentities acquire tranches of credit exposure that have different levels of seniority. Forexample, one institution may purchase a first-loss position while a second institutionpurchases a second loss position. These tranches of purchased credit risk are not subject tomarket discipline since they are not rated by a rating agency and usually not traded. Becausethe tranches of this bilateral transaction are not rated, it may be difficult to ascertain theircredit quality.
First to default pmt (first-loss)
Highly rated
Credit Default
$5 billion Credit
Reference Portfolio
Second to default payment
Highly rated
Credit Default
One variation of this bilateral structure involves the sponsoring bank retaining a first-lossposition that may be equal to or greater than the expected loss on the underlying referenceportfolio.
Utilisation of an highly rated intermediary institution
In certain synthetic transactions, the sponsoring banking organisation may retain the creditrisk associated with a first-loss position and, through the use of credit default swaps, passthe second and senior loss positions to a third-party entity, most often an OECD bank. Thethird-party entity, acting as an intermediary, enters into offsetting credit default swaps with anSPV, thus transferring its credit risk associated with the second loss position to the SPV.14 Asdescribed in the previous transaction type, the SPV then issues CLNs to the capital marketsfor a portion of the reference portfolio and purchases Treasury collateral to cover somemultiple of expected losses on the underlying exposures.
Credit Default Swap
Fee (bps per year)
Highly rated
Holds $400 M of
Default pmt & Pledge
pledged Treasuries
of Treasuries
Default pmt &
pledge of
Treasuries equal
$400 million of
$400 million
to $400 million to
cover losses
above 1% of the
reference assets
$5 billion Credit
14 Because the credit risk of the senior position is not transferred to the capital markets, but instead, remains with the intermediary bank, the sponsoring banking organisation should ensure that its counterparty is of high credit quality, e.g. atleast investment grade.


Microsoft word - midterm-reveiw-fall-2005-answers.doc

Midterm Review -answers I. Define: 1. Valid Argument: An argument such that if the premises are true, then the conclusion must be true. 2. Invalid Argument: An argument where it is possible to have all true premises and a false conclusion. II. Assume the premises of the following arguments are true. Determine if: a) The argument is invalid or valid (write valid, or invalid) b) If th

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