By Vinod Kothari

More on the Basle II for Securitization

Generally on Basle II

Securitisation and Basle II

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End-June 2004, the Bank for International Settlements (BIS, Basle or Basel) issued the revised framework for capital adequacy by banks, popularly known as Basle II. The issuance of Basle II has been a long-stretching process, spanning over almost 4 years of work. Several versions of the standard were issued, revised, reworked and reissued. In the process, the statement has become longer, arguably more complicated. Quite obviously banks will have to place a high reliance on technology to work out capital under the new rules.

The development of capital standards for securitisation has been a long process. The Bank for International Settlements (BIS) on 16th Jan 2001 came out with a revised proposal for capital requirements for securitisation. See news item here.Before this, there were proposals dating to 2000 which contained some statement on securtisation, but were completely silent on synthetic securitisations. Securitisation, particularly synthetic securitisation has grown tremendously over this time, and therefore, for the Basle committee, dealing with securitisation must have been like dealing with a moving target.

The present proposals, in their final shape, are substantially similar to the consultative paper issued in April 2003 and the revisions made earlier in 2004 – see links in the box on top. 

Traditional securitisations:

Traditional securitisation refers to cases of cash transactions, that is, those which are not synthetic. At lease two different tranches or strata have been taken as the defining feature of securitisation – this seems to be necessary to distinguish securitisation from plain asset sales or portfolio acquisitions.

Securitisation exposures of banks may come in various forms – either as originators, investors, credit enhancers, liquidity providers etc. The securitisation framework is applicable in every such case.

Originating banks:

It is important to understand that in Basle II, originating bank includes not only the bank that created or underwrote the transactions being which are sought to be securitised, but also, in case of ABCP conduits or similar programs (arbitrage transacions?), the sponsor of the conduit or program. A bank would normally be taken to be sponsor if it advises the conduit, takes it to market, provides liquidity or credit enhancements.

Minimum conditions

Base II consultative paper 3, issued on 29th April, broadly requires that in order for the transaction to go off the books, it must have "ecnonomic substance". These conditions have subsequently been included in the final statement. The following are the important conditions, which must be satisfied by all originating banks:

(a) Significant credit risk associated with the securitised exposures has been transferred to third parties.

(b) The transferor does not maintain effective or indirect control over the transferred exposures, which must be isolated by using legal methods of true sale. Qualified legal counsel's opinion must support this view. If the transferor is obligated to retain the risk of the transferred asset, surrender of control does not apply.

(c) The securities issued are not obligations of the transferor but those of the transferee, which must be an SPE. The securities of the SPE must be transferable. The BIS does not lay down, unlike the FAS 140, detailed qualifications of the SPE.

(d) Effective control may be presumed if:

  • the transferor has right to repurchase the assets to realise benefits.
  • is obligated to retain the risk of the transferred exposures.

(e) Clean-up calls must satisfy the following conditions: it must be an option of the originator, must not be a risk-mitigation device and must be exercisable only where the outstanding balance falls below 10% or more.

(f) The transaction does not require the transferor to maintain the quality of the pool or increase the credit enhancement or increase the yield of the buyer.

In case of synthetic securitisations, the transaction must further comply with the requirements relating to risk mitigation. For details of these, refer to Vinod Kothari's credit derivatives website here.

The rules below are applicable to both originator and investing banks. In case of the standardised approach, the provisions for deduction of capital are different for originators and investing banks. Barring this, the approach is largely the same for both originator and investor banks.

Capital charge/capital relief

Where the bank provides any implicit support to a securitisation transaction, that is, implicitly guarantees payments to investors, it does not qualify for any capital relief. At the same time, any gain on sale recognised by the bank will not be admitted for regulatory purposes.

In addition, the conditions listed above are necessary for capital relief.

The capital charge/relief will depend on whether the bank adopts the standardised approach or the Internal ratings-based (IRB) approach. If the securitised portfolio was risk-weighted under the standardised approach, securitisation capital will also be computed under the standardised approach; the same is applicable in case of IRB approach.

Standardised approach

The capital charge in case of the standardised approach is as follows. The table below sets out the risk weights, and to the risk weighted exposure, capital is computed by applying the capital requirement, viz. 8%.

Long-term category

External Credit Assessment

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to BB-

B+ and below or unrated

Risk Weight






Short-term rating category

External Credit Assessment




All other ratings or unrated

Risk Weight





The 350% risk weight prescribed for BB+ to BB- ratings above is only relevant for investors. As for the originator bank, all classes rated below BBB-, that is, below investment grade, are to be deducted from capital straightaway.Unrated tranches are also to be deducted from capital.

One amendment to the rule relating to super-senior classes is that super senior classes do not require any rating [Para 571]. The rule provides that the most senior class may be unrated. Therefore, automatically, the 20% risk weight would be applicable to such classes. This avoids one of the wasteful expenses in synthetic transactions.

Where does deduction in capital come from?

In cases where a deduction from capital is required, the deduction must be 50% from Tier I capital and 50% from Tier II capital. However, if the bank has done any "gain on sale" accounting whereby an increase is Tier I capital has resulted out of a securitisation transaction, the bank must deduct the same from Tier I. Note that this is applicable only in case of deduction from capital, required as per norms above.

 Credit enhancements:

The proposals require the extent of first loss credit enhancement provided by the bank to be deducted straight from the capital of the bank. For example, if a bank transfers assets worth USD 1000 and provides a recourse to the extent of USD 50, USD 50 will be the capital required for the transaction as that is the capital loss or reduction the bank suffers due to the first loss recourse.

However, for second or subsequent loss protection, the BIS proposals are prepared to accept the enhancement as a direct credit substitute, provided significant level of first loss protection is available. As a credit substitute, the capital requirement will be the same as for the original asset, usually 8%.

Example: Say a bank transfers assets worth USD 1000, which has a first loss protection (subordinated notes or a guarantee) to the extent of USD 50 being taken up by an external credit enhancer. The bank itself provides second loss protection to the extent of USD 100. The bank will be required to keep capital to the extent of 8% of USD 100, that is, 0.8% of the assets transferred.

Liquidity facility:

The April 2003 consultative paper came out with detailed guidelines on eligible liquidity support – these have been retained in the final rules, with some additions and elaborations. The premise is that if the liquidity support is not eligible as per the guidelines, it will amount to putting the assets on the balance sheet. The basic principles of the liquidity facilities are that they are merely liquidity enhancers and not credit support. Therefore, a liquidity facility should be tapped only where it is expectd to be redeemed out of the collections. It should not be subordinated, and should not be drawn after all credit enhancements have been tapped. To the extent used, the facility should stand depleted.

There should not be a certainty of drawdown of the liquidity support – as indicated by regular or continuous draws. The facility must not be used to support securities that are below investment grade.

There is a 20% credit conversion factor prescribed under the CP 3 for liquidity facilities. 50% credit conversion factor should be applied if the facility has a term of more than 1 year. If the facility is itself being rated and the risk weights are based on the rating, 100% credit conversion factor should be used. In case the liquidity facility is merely to be used in the event of general market disruption, 0% credit conversion factor may be used. 0% credit conversion factor may also be used for servicer advances.

The BIS has apparently frowned upon any liquidity or credit support granted to the SPV, but at the same time permits making of temporary advances to the SPV to ensure uninterrupted payments to investors. However, these advances must be reimbursible, that is, the servicer must retain a right to retain cash from subsequent collections to recoup the temporary advance given. Besides, "the payment to any investors from the cash flows stemming from the underlying asset pool and the credit enhancement must be subordinated to the reimbursement of the cash advance."

Revolving asset securitisations and early amortisation provisiosn:

The April 2003 consultative paper put up detailed requirements for early amoritisation triggers in revolving transactions. Provisions for early amortisation have been incorporated in the final rules. A revolving asset securitisation for a bank is like a revolving line of credit – the bank taps the facility on an ongoing basis. However, the early amotisation trigger puts the facility on guillotine. The risk of early amortisation is essentially a liquidity risk for the bank.

Accordingly, banks are required to keep capital for revolving asset securitisations, except in the following 2 cases:

(a) Replenishment structures where the underlying exposures do not revolve and the early amortisation ends the ability of the bank to add new exposures are not covered by this section and would not receive an additional capital charge under the early amortisation treatment. The terms "revolving" and "replenishing" type securitisations are quite often used interchangeably in practice. However, "revolving" qulifies the nature of the credit facility – where an obligor can draw upto a certain limit under a facility. Credit card, business working capital credits, etc are revolving credits. "Replenishing" relates to the nature of the securitisation transaction – where the assets to the extent amortised or paid up are replenished by the transferor by putting in more assets. Many CDOs use a replenishment structure. Generally, replenishment structure is a sort of reinvestment fo cashflows of the transaction back into the originator's assets.

(b) Transactions of revolving assets containing early amortisation features that mimic term structures (i.e. where the risk on the underlying facilities does not return to the originating bank) are also excluded from this treatment.

(c) structures where a bank securitises one or more credit line(s) for which investors remain fully exposed to future draws by borrowers even after an early amortisation event has occurred;

(d) the trigger relates to external exigencies and not the quality of the collateral – for example, tax law changes.

The capital charge for early amoritisation triggers depends on whether the EAT was (a) controlled or (b) uncontrolled. It also depends on whether the underlying revolving facility was (a) committed or (b) uncommitted.

A controlled EAT is essentially one where the bank can demonstrate having risk mitigants in place to tide over the liquidity risk arising out of EATs. It is defined as one that satisfies several conditions, viz., (a) that the bank has liquidity arrangements in place shoud the EATs be triggered, (b) during the early amortisation period, losses, excess spread etc are proportionately distributed as between seller share and investor share; (c) the early amortisation does not result into a steeper fall in the outstanding balance than a straightline deduction over a period over which 90% of the balance would have been paid as from the point where the EAT was hit.

A committed revolving credit in one where the lender cannot unconditionally withdraw the credit. Else, it is uncommitted.

In either case, the credit conversion factors are based on the excess spread trapping point. The requirements are both cumbersome and too much detailed.

IRB approach:

The IRB approach is available only where the underlying assets are risk weighted under the IRB approach.

Under the IRB approach, there are three mutually exclusive alternatives: the Ratings-based approach (RBA), supervisory formula (SF) or the Internal assessment approach ( IAA). Where the securitisation exposures are rated, the RBA should be used. Where ratings or inferred ratings are not available, the SF or the IAA should be used, with the IAA being restricted to only liquidity or credit enhancement facilities granted by banks to ABCP programs.

The Ratings-based approach:

The RBA risk-weights are applicable for a tranche which is either rated or has an inferred rating. These risk weighs were based on three factors: ratings, granularity (N) and the relative seniority of the subject tranche (Q). Accordingly, for several rating classes, there were 3 columns of risk weights under CP3, which have been incorporated in the final guidelines, but several more rows were added later in Jan 2004. The first column, with the least risk weights, was applicable for highly granular pools (N being 500 or more) with a highly senior tranche. Column 3 was applicable for a concentric pool with N being les than 6. Column 2 was applicable for all other classes.

The 3 columns below set out the risk weights for different combinations of ratings, , but the risk weights for the senior classes have now been further differentiated. In other words, there are more rows in the Table now. The revised Table is as under:

External Rating

Risk weights for
senior tranches
& eligible IAA

   Base risk   

Risk weights for
tranches backed by
non-granular pools











































Below Ba3 and unrated




There is also a table applcable to short term ratings.

The Internal assessment approach;

This approach is relevant for non-funded facilities extended by banks to ABCP conduits such as liquidity and credit enhancements. Here,if banks meet several operational conditions listed in the rules, banks may use their internal assessment of the risks as equivalent of ratings by external rating agencies. Here, the banks internal assessment assigns the ratings, and the risk weights are accordingly determined.

The supervisory formula;

The supervisory formula, applicable in cases where the bank qualifies for the IRB approach but the exposure is not rated, computes capital based on the use of a recursive mathematical model.