On July 27, 2023, the US banking regulators1 issued a notice of proposed rulemaking (the "NPR")2 to revise significantly the risk-based capital requirements applicable to large banks3 and to banks with significant trading activity. The NPR would generally implement the Basel Committee's revisions to its regulatory capital standards colloquially referred to as "Basel III Endgame" or "Basel IV," with some key differences.

Comments on the NPR are due on November 30, 2023.

If adopted, the proposal would generally take effect on July 1, 2025. Banks would be given three years to phase-in compliance with the changes to the credit risk and operational requirements, including those discussed in this article.

This article focuses on the securitization-related changes proposed by the NPR. To put our detailed discussion of some of those changes into context, we refer you to our comprehensive article on the NPR4 and note that:

  • Under the NPR, the existing "standardized approach" for credit risks would continue to apply to all banks. The standardized approach utilizes the Simplified Supervisory Formula Approach (SSFA) and the gross-up approach to assign risk weights to securitization exposures.5 The NPR does not propose to change the existing SSFA or gross-up approach to assigning risk weights for securitization exposures under the standardized approach.

  • Under the NPR, the existing internal ratings-based and advanced measurement approaches for credit risks are being replaced by an expanded risk-based approach, which we refer to as the proposed "expanded standardized approach." The expanded standardized approach would apply only to banks with $100 billion or more in assets. That approach includes a new "securitization standardized approach" (SEC-SA) to calculate risk weights for securitization exposures. The SEC-SA method is based on SSFA, with some important differences. The expanded standardized approach is, in the aggregate, a more stringent version of the Basel III Endgame standard.6

  • Banks subject to the expanded standardized approach (i.e., banks with $100 billion or more in assets) would be required to calculate risk weighted assets (all assets, not just securitization exposures) under both the existing standardized approach and the new expanded standardized approach and use the higher of the two.7 This is referred to as a "dual stack" requirement.8

  • For credit exposures in the aggregate, we expect risk weights under the expanded standardized approach would be higher than those under the standardized approach. Because of the dual stack requirement, we expect that most banks subject to the expanded standardized approach would be required to use the risk weights assigned by the expanded standardized approach, including risk weights assigned to securitization exposures under SEC-SA, to calculate total capital ratios.

  • We expect that SEC-SA would lead to generally higher risk weights for securitization exposures compared to SSFA.

  • Banks not subject to the expanded standardized approach (banks with less than $100 billion in assets) would continue using the standardized approach, including the existing SSFA and gross up methods to assign risk weights to securitization exposures, as well as underlying exposures.

  • Finally, we note that for any market risk bank,9 the risk weights assigned to securitization exposures residing on its trading book would be determined under separate market risk capital requirements, which are beyond the scope of this article.10 For a market risk bank, SSFA11 and SEC-SA would be used to calculate credit risk weights for securitization exposures that reside on its banking book, not its trading book.

A "securitization exposure" is (1) an on-balance sheet or off-balance sheet credit exposure arising from a traditional securitization or synthetic securitization (including a resecuritization), or (2) an exposure that directly or indirectly references a securitization exposure described in clause (1).12 As the NPR notes, securitization exposures "could include, among other things, asset-backed securities and mortgage-backed securities, loans, lines of credit, liquidity facilities, financial standby letters of credit, credit derivatives and guarantees, loan servicing assets, [and] servicer cash advance facilities."13

Summary

The following is a brief summary of the key points in this article, which focuses on comparing SEC-SA with SSFA. We expect each of these points will receive significant attention in the comment letters that market participants submit to the US banking regulators.

Increase in ??, the Supervisory Calibration Parameter. Both the existing SSFA and the proposed SEC-SA utilize a supervisory parameter, ??, that governs the rate at which risk weights decline as tranche seniority increases. For securitizations, SEC-SA applies a ?? value of 1.0 while SSFA applies a value of 0.5. For resecuritizations, both approaches apply a ?? value of 1.5.

  • Although the NPR does not characterize it as such, the value of the supervisory parameter ?? governs the amount of a securitization capital surcharge imposed by the SSFA and SEC-SA models. By "securitization capital surcharge," we mean the percentage amount by which a bank's capital requirement would increase if the bank held every tranche of a securitization, rather than holding the underlying exposures directly in its unsecuritized portfolio.14

    • Where ?? = 0.5, the securitization capital surcharge is 50%.
    • Where ?? = 1.0, the securitization capital surcharge is 100%.
    • Where ?? = 1.5, the securitization capital surcharge is 150%.

  • The amount of this surcharge is higher if a risk weight floor applies to any tranche.

  • The amount of this surcharge increases sharply as underlying exposures default.

Different Supervisory Risk Weight Floors. Despite the increase in ???? as noted above, SEC-SA retains supervisory risk weight floors. For securitizations, the risk weight floor under SEC-SA is 15% as compared to 20% under SSFA. SEC-SA has a 100% risk weight floor for resecuritizations (as well as NPL securitizations), as compared to 20% under SSFA. (Page 15)

Different Risk Weights on Underlying Exposures. The risk weights assigned to many commonly securitized assets are significantly different under the proposed expanded standardized approach compared to those assigned under the existing standardized approach. Risk weights on underlying exposures are inputs into the SEC-SA and SSFA models and thus have a significant impact on the risk weights assigned to securitization exposures. (Page 16)

Different Attachment Point and Detachment Point Calculations. The NPR defines attachment and detachment points for SEC-SA differently than under SSFA. Notably, the NPR would include any nonrefundable purchase price discount in the calculation of attachment and detachment points. As there is an exponential relationship between risk weights and tranche seniority under SEC-SA and SSFA, even small changes to attachment and detachment points can have a significant effect. (Page 18)

New Look-Through Approach. For a "senior securitization exposure" that is not a resecuritization exposure, the expanded standardized approach would allow banks to assign a risk weight equal to the greater of (1) 15% and (2) the weighted average risk weight of all the underlying exposures. As we explain, the proposed look-through approach would be useful in only limited circumstances. (Page 21)

Additional Operational Criteria for Synthetic Securitizations. The NPR proposes to add three new operational requirements for synthetic securitizations under the expanded standardized approach. The most important of these is a requirement that would prohibit an originating bank from recognizing the risk-mitigating benefits of a synthetic securitization that includes synthetic excess spread. (Page 24)

Different Credit Conversion Factors (CCFs) for Commitments. Unconditionally cancelable commitments would have a CCF equal to 10% under the expanded standardized approach (as opposed to 0% under the standardized approach). Commitments that are not unconditionally cancellable will have a CCF equal to 40% (as opposed to the standardized approach, which specifies 20% for such commitments that are less than or equal to one year, and 40% for such commitments that are greater than one year). (Page 26)

New Capital Charge on Fees and Income. The NPR proposes a capital requirement for operational risk with respect to a bank's fee and commission income. This capital charge would apply to the fees and commissions that banks earn in connection with securitizations, such as underwriting fees, commitment fees, third-party servicing fees and servicing fees under off-balance sheet securitizations. (Page 27)

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Footnotes

1. The US banking regulators consist of the Board of Governors of the Federal Reserve System ("Federal Reserve"), Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation ("FDIC").

2. Regulatory capital rule: Amendments applicable to large banking organizations and to banking organizations with significant trading activity (July 27, 2023), available at: https://www.federalreserve.gov/aboutthefed/boardmeetings/frn-basel-iii-20230727.pdf. The rules establishing minimum capital requirements and overall capital adequacy standards for US banks, commonly referred to as the "capital rule," are set forth in 12 CFR §3.1 et seq. (for banks regulated by the OCC), 12 CFR §217.1 et seq. (for banks regulated by the Board), and 12 CFR §324.1 et seq. (for banks regulated by the FDIC).

3. As used in this article, the term "bank" generally refers to a banking organization regulated by a US Banking Regulator. The OCC regulates national banks and Federal savings associations. The Board regulates state member banks, bank holding companies and savings and loan holding companies. The FDIC regulates insured depository institutions.

4. See Overhaul of Regulatory Capital Requirements Proposed by US Banking Regulators (the "MB Comprehensive Update"). In a subsequent article, we highlight some key differences between the NPR and Basel. See A Road Not Taken: Where the US Capital Proposal Differs from Basel. As noted in the MB Comprehensive Update, despite early statements from the US banking regulators, the approach reflected in the NPR is not capital-neutral and would increase capital requirements significantly. The NPR would also affect banks with significant fee income. The G-SIB Proposal, which is discussed in the MB Comprehensive Update, would impact banks with substantial cross-border activity. When taken together, all of this may have the effect of causing banks to (i) review their loan exposures, (ii) consider loan originations and (iii) rotate into securities. The NPR may also lead to a shift of certain origination activities from banks to nonbanks, and result in nonbanks becoming more significant participants in the short-term wholesale funding markets that support securitization.

5. Under the standardized approach, banks that are not market risk banks may use the gross up approach instead of SSFA. Under the gross up approach, a bank calculates the "credit equivalent amount" of its securitization exposures and applies a risk weight to those exposures. Most banks apply SSFA rather than the gross up approach, and we expect that to continue to be the case. Thus, this article will generally refer to SSFA when discussing the standardized approach.

6. See MB Comprehensive Update, at 2.

7. Note that banks are not required to use the higher of the standardized approach risk weight and the expanded standardized approach risk weight on an exposure-by-exposure basis. Rather, banks are required to compare total risk-weighted assets as calculated under each approach.

8. The dual-stack approach is controversial due to its complexity and its inconsistent impact across banks. FDIC board member Jonathan McKernan voted against issuing the NPR and noted in his dissent that "This dual-requirement structure forgoes an opportunity to simplify an already complicated capital framework. The dual-requirement structure also introduces internal inconsistencies that compound into incoherence. Some large banks would have one capital requirement for a securitization exposure, while other large banks would have a different capital requirement for the same exposure."

9. As we note in our MB Comprehensive Update, a bank currently is subject to the market risk capital requirement if its aggregate trading assets and trading liabilities equal 10% or more of total assets or $1 billion or more. About 40 banking organizations currently are subject to the market risk capital requirement. The NPR would change the threshold for applying the market risk capital requirements by increasing the absolute threshold trigger from $1 billion to $5 billion in aggregate trading assets and trading liabilities.

10. See MB Comprehensive Update, pp. 10-12 for a description of the NPR's proposed changes to the market risk capital requirements. See also our discussion below concerning the "overlapping exposures" exception to SEC-SA.

11. Note that market risk banks may not use the gross-up approach under the standardized approach.

12. See 12 CFR §217.2.

13. See NPR, p. 429.

14. For example, if the capital requirement associated with holding the assets directly is 8% and the capital requirement for holding every tranche of a securitization of those assets is 16%, the securitization capital surcharge would be 100%.

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