Banking Industry and the Issue of NPAs NPA Management Need for Asset Reconstruction Companies Global Scenario Interaction with Banks' Executives    Introduction to Securitisation: The Framework Global Securitisation Market Securitisation in india SARFAESI ACT 2002: An Assessment Impact of Basel II on Securitisation PREFACE | FOREWORD | EXECUTIVE SUMMARY | SECURITISATION - AN OVERVIEW | THE INDIAN BANKING INDUSTRY AND NPA's NPA MANAGEMENT AND ARC's| THE BANKING PERSPECTIVE| COMPANY LISTING & PROFILES| LAUNCH EVENT| SPONSORS Alphabetical Listing Total Advances Net NPAs Amount Net NPA Advances Ratio Profiles

Introduction

The Basel accord was introduced in the late 1990s as a standardised manner for ensuring financial stability and preventing global financial contagion by formulating guidelines to measure risk. The original Basel accord only focused on credit or counterparty risk. A later extension of Basel took into account the trading activity of banks and incorporated rules to address market risk. Basel II is the latest enhancement incorporating operational risk in the ambit of risk quantification and also introduces different degrees of risk sophistication. Basel II is designed to align a bank’s regulatory capital with its economic risk profile.

Since banks originate assets which are securitised and also invest in structured instruments, it is imperative to analyze the impact of Basel II on the securitisation activity.

Guideline Summary for Securitisation Exposures

Under the Basel II approach there are mainly two approaches to computing regulatory capital: Standardised approach and Internal Rating Based (IRB) approach which is shown below:

• Standardised Approach: Under the standardised approach, the risk weighted asset is computed by multiplying the outstanding investment in the securitised instrument and the supervisory risk weight which is assigned based on long and short term ratings assigned by external credit assessment institutions. For banks subscribing to instruments below investment grade (BB+ to BB-) the risk weight is 350% and deduction in eligible capital for unrated investments or rated B+ or below.
• Internal Ratings Based Approach (IRB): This method is outlined for banks having greater sophistication in terms of systems and processes to identify and quantify risk. Originating banks will use standardised approach while investing banks will use the Rating Based Approach (RBA).

• RBA approach shall be used where securitisation exposures are rated or can be inferred. Under the RBA, the risk weights depend on:
  

  • The credit rating of the securitisation exposure

  • The tenure of the rating (short term or long term)

  • The granularity of the underlying asset pool

  • The seniority of position

• When ratings cannot be inferred, either Supervisory Formula (SF) or the Internal Assessment Approach (IAA) must be applied. The IAA can be applied only to liquidity or credit enhancement facilities provided for Asset Backed Commercial Paper (ABCP) programs. Under the IAA, banks must carry out their own risk assessment and map their internal rating to those provided by external rating agencies. Once the mapping is established the risk weight corresponding to the external rating is applied.

• Under the Supervisory Formula, the regulator provides only the formula to compute the capital charge. Inputs into the formula such as tranche’s credit enhancement level and thickness, the pool’s effective number of exposures, average Loss Given Default (LGD) of the pool are to be provided by the bank based on internal data collection and modelling.

• Securitisation that doesn’t qualify under any of these approaches must be deducted from the eligible regulatory capital.

There are many operational requirements that banks must satisfy in order to qualify under any approach and the adherence to these requirements must be documented and justified before the national regulator.

Implications for Securitisation

• Basel II is a framework where capital charge is computed based on the substance rather than form of the securitisation transaction. In order to get capital relief, banks must clearly demonstrate risk transference. Retention of riskier tranches is punitive under Basel II that leads to a very high risk weightage or capital deduction.

• In case of credit risk mitigants such as guarantees, collateral and credit derivatives, these must qualify under the Basel II guidelines in order to be considered eligible mitigants. Hence bank originators must be careful while structuring the securitisation transaction.

• Basel II also provides some opportunities to reduce the capital charge by changing the way banks structure their exposures. Some impact studies have shown that banks will benefit from holding securitised tranches of a retail pool rather than holding the unsecuritised pool.

• The margins from ABCP programs might get affected as the cost of providing liquidity support to these conduits will increase due to higher capital charge.

• ABCP may consider purchasing trade receivables of Small and Medium Enterprises (SMEs) instead of SME loans as the latter is likely to attract a higher capital charge in many cases.

• In case of covered bonds where the investor has recourse to the balance sheet of the originator, the counterparty rating is used instead of the covered bond rating. Hence highly rated banks are likely to benefit.

Securitisation and Subprime Crisis

Fundamental Change in the Lending Approach

The US Subprime mortgage crisis which began in the late 2006 has been one of the major factors which gave an indication of a likely US economic recession. The crisis originated from subprime lending which seeks to make loans to borrowers who have poor credit history. Subprime lending is more risk prone for both the lenders and the borrowers with poor credit history, high interest rates and the adverse financial conditions of the borrowers.

The genesis of the sub-prime crisis lies in the way market based restraints and basic underwriting principles were done away with. The traditional approach to disbursing housing mortgages involved only the bank (lender) and the home buyer (borrower), wherein the lender would carry out a thorough evaluation and income check of the borrower and then process the loan accordingly. The lenders were required to hold the assets (loans disbursed) till maturity, thereby blocking the funds. In order to meet the growing demand for funds, banks started to use securitisation as an able tool for unlocking the blocked funds. The bank would transfer the blocked funds (assets) to a special purpose vehicle (SPV) and invite investors to invest in the securities issued by the SPV, thus generating more funds for further disbursements.

With the rise of securitisation, bond insurers constrained subprime lenders from making too risky loans through their pricing of risk. With the further maturity of securitisation, sophisticated investors started investing in mezzanine tranches which were uninsured and hence risky. These investors too were industry experts who curtailed the proliferation of risky loans through their risk appetite and pricing. From 2004, CDOs started dominating the market and CDO investors slowly displaced the role of bond insurers and sub-ordinate tranche investors. The CDOs consisted of motley of MBS and other structured instruments. The nature of the underlying risky assets from which MBS and hence CDOs originated were not appreciated by the CDO investors. In the absence of restraints, lenders started originating risky loans and this continued in 2006 and 2007.

Riskiness of the subprime loans originated stems from three issues: Low repayment ability of the subprime sector, relaxation in documentation norms and value of the underlying mortgage collateral value. While securitisation, especially the advent and growth of CDOs, may have had a role to play in removing the restraints on choosing the assets, the mortgage market bubble bursting was equally to blame for this crisis.

The securitised share of subprime lending grew from almost 50% in 2001 to around 75% in 2006. The share of subprime mortgages to total mortgage originations also increased from 5% in 1994 to around 20% in 2007.

According to a study by Wholesale Access Mortgage Research & Consulting Inc., in 2004 Mortgage brokers originated 68% of all residential loans in the US, with subprime loans accounting to almost 40% of the total production volume. Also, almost 40% of the subprime loans originated in 2007 were generated by automated underwriting.

The US Mortgage Bond Market is around USD 7.2 trillion. Of this around 58% is government backed. The subprime market is pegged at USD 1.3 trillion. It is estimated that the ultimate losses incurred by financial institutions is likely to be USD 250 – 450 bn. Already financial institutions have written off subprime loans worth USD 60 bn.

The subprime crisis in the US had its spillover effects on the global markets. Mortgage lenders were the worst hit, however, the effect carried on to other sectors such as home building, mining, metal industries, etc. Major Indian banks like SBI, ICICI have already booked losses on the exposures of their foreign offices to credit derivatives in the third quarter of 2007.

Outlook on Securitisation

Securitisation has emerged as an important tool for balance sheet, liquidity, capital and risk management for financial services entities. Recent growth in volumes and market activity evidence the growing issuer and investor interest in the transactions. However, the market has not been able to realise its full potential due to several structural and legal impediments. Asset classes have remained limited to consumer and corporate loans, even though securitisation, like technology, is applicable to various financing situations.

It is expected that in the near future the securitisation market in India is likely to remain subdued due to the global sub-prime effect which has an impact on liquidity and credit spreads. However in the medium to long term various structural reforms on the bond market development along with the retail boom is likely to have a beneficial impact on the Indian securitisation market. The advent of Basel II is also likely to propel the growth of retail receivable securitisation. Due to capital charge consequences of securitisation under the Basel II accord, there is a strong case for issuance of tranches with different seniority.

The immediate next steps for market development would be:

• Rationalisation of Stamp Duty: Though some states have lowered the stamp duty applicable on securitisation transactions there needs to be a standard policy regarding the same. Also issues such as double incidence of stamp duty for CDO structures also need to be addressed

• Widening the investor base to include multiple investor classes to deepen the market. Opening up of the market to international investors at least for junior tranches

• Permitting trusts to enter into derivative contracts – significant for structuring of MBS deals

• Clarity on tax treatment for various forms of securitisation

• Permit flexibility of different legal structures that can purchase receivables and issue securities

• Permit greater enforceability in case of foreclosure of assets.