July 20, 2004

To:

Our Clients

Re:

Basel Framework for Securitizations

On June 26, the Basel Committee on Banking Supervision released its final
Consultative Document setting forth the proposed new Accord (Basel II). You can
download the Consultative Document at the Whats New section of http://www.bis.org.
The Committee consists of senior representatives of bank supervisory authorities
and central banks throughout the world. In 1988, the Committee published an Accord
entitled International Convergence of Capital Measurement and Capital Standards. That
accord formed the basis for the risk-based capital standards adopted by bank regulators in
member countries throughout the world.
The Committee has been working on the revisions to the Accord since June 1999.
This final draft remains essentially the same as that proposed in April of last year but has
been updated to reflect the revisions to the Accord that were released in January of this
year. We have summarized the portions of the Consultative Document dealing with
securitizations below and have tried to provide a roadmap to the other relevant portions
of the Consultative Document. Paragraph references included throughout are references
to the applicable paragraphs of the Consultative Document that relate to the matters being
discussed.
Although this purports to be the final Accord, members of the staff of United
States regulators have indicated that they do not consider this version to be final. They
will be conducting a fourth quantitative impact study in the fall of this year and will
release a notice of proposed rulemaking for comment at the end of the second quarter of
next year. After reviewing the results of the study and comments on the proposed
implementation in the United States, they will consider advocating changes to this final
Accord. Although this memorandum summarizes the securitization rules in their entirety,
regulators in the United States have indicated that they plan to adopt a more narrow
version of the Consultative Document. The proposed adoption in the United States
consists of the following: (1) only the advanced IRB, including the internal assessment
approach for ABCP conduits, and the advanced measurement approach will be available

9006858.4

to U.S. banks and (2) the revised Accord would apply only to large, internationally active
banks.1
If you are not already a member of the American Securitization Forum (the
ASF), which has been commenting on the Consultative Document and other proposals
affecting the securitization industry, and would like to explore the possibility of joining
the ASF, please feel free to contact any of the attorneys listed at the end of this
memorandum or visit their website at www.americansecuritization.com.
The remainder of this memorandum is arranged as follows:
Background Elements of the New Proposal
A. Defining the scope of securitization transactions covered
under the securitization framework
B. Defining the various roles played by banks in
securitizations
C. Limitations on the use of clean-up calls
D. Implicit support and its ramifications
E. Application of deductions from capital
F. Qualifying external ratings for use under the securitization
framework
The Securitization Framework
A. The Standardized Approach to Securitizations
B. The Internal Ratings-Based Approach to Securitizations
Exhibit A: IRB Approach for Specialized Lending
Transactions
Exhibit B: Operational criteria for traditional securitizations
Exhibit C: Operational criteria for use of synthetic
securitizations
Exhibit D: Operational criteria for use of external ratings
Exhibit E: Operational criteria for use of the Internal
Assessment Approach

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Background Elements of the New Proposal

A.
Defining the scope of securitization transactions covered under the
securitization framework
Banks will be required to apply the securitization framework for determining
regulatory capital requirements for exposures arising from securitizations or similar
structures that are not specialized loan transactions described below. The Consultative
Document notes that since securitizations exposures may be structured in many ways, the
capital treatment of a securitization exposure must be determined on the basis of its
economic substance rather than its legal form. (538)
1

The initial draft of the proposed U.S. implementation was published in an Advanced Notice of
Proposed Rulemaking released by the Agencies in August of 2003. Our summary of that proposal,
including a link to the proposal itself, is available at www.securitization.net/pdf/mbrm_anpr_08Sep03.pdf.
9006858.4

Specialized lending transactions2 (219-220) are generally defined as follows:

1. Project finance transactions (221-222), described as a method of funding in
which the lender looks primarily to the revenues generated by a single project, both as the
source of repayment and as security for the loan.
2. Object finance transactions (223), described as a method of funding the
acquisition of physical assets (e.g. ships, aircraft, satellites, railcars and fleets) where
repayment is dependent on the cash flows generated by the specific assets which have
been pledged to the lender.
3. Commodities finance transactions (224-225), generally defined as structured
short-term lending to finance reserves, inventories, or receivables of exchange-traded
commodities, where the exposure will be repaid from the proceeds of the sale of the
commodity and the borrower has no independent capacity to repay the exposure.
4. Income-producing real estate transactions (226), described as a method of
providing funding to real estate where the prospects for repayment and recovery on the
exposure depend primarily on the cash flows generated by the asset.
5. High-volatility commercial real estate transactions (227-228), described as
the financing of commercial real estate that exhibits higher loss rate volatility (i.e. higher
asset correlation) compared to other types of specialized lending.
Securitization transactions are subdivided in the framework into two subtypes:
traditional securitizations and synthetic securitizations.
1.
Traditional securitizations are generally described as structures where the
cash flow from an underlying pool of exposures is used to service at least two different
stratified risk positions or tranches reflecting different degrees of credit risk where
payments to investors depend upon the performance of the specified underlying
exposures, as opposed to being derived from an obligation of the entity originating those
exposures. (539) In order to be treated under the securitization framework, a traditional
securitization must satisfy the operational requirements set forth in Exhibit B. Otherwise
an originating bank will be required to treat the underlying credit exposures as if they
remained on its balance sheet. (554)
2.
Synthetic securitizations are generally described as structures with at least
two different stratified risk positions or tranches that reflect different degrees of credit
risk where credit risk of an underlying pool of exposures is transferred through the use of
funded or unfunded credit derivatives or guarantees that serve to hedge the credit risk of
the portfolio. (540) In order to be treated under the securitization framework, a
synthetic securitization must satisfy the operational requirements set forth in Exhibit C.

2
The IRB treatment for specialized lending transactions is described in Exhibit A to this memorandum. Banks
are encouraged to consult with their national supervisors when there is uncertainty about whether a given transaction
should be considered a securitization transaction or a specialized lending transaction. (538)

9006858.4

Otherwise an originating bank will be required to treat the underlying credit exposures as
if they remained on its balance sheet. (555)
B.

Defining the various roles played by banks in securitizations

The application of the securitization framework for positions held by a bank

varies depends on whether a bank is an originator. A bank will be considered to be an
originating bank with regard to a certain securitization if it satisfies either of the
following conditions: (x) the bank originates directly or indirectly exposures included in
the securitization or (y) the bank serves as a sponsor of an asset-backed commercial paper
(ABCP) conduit or similar program that acquires credit exposures from third-party
entities. In the context of the programs described in clause (y), a bank would generally
be considered a sponsor and, in turn, an originator if it, in fact or in substance, manages
or advises the program, places securities into the market or provides liquidity and/or
credit enhancements. (543)
C.

Limitations on the use of clean-up calls

A clean-up call is an option that permits securitization exposures to be called

before all of the underlying exposures or securitization exposures have been repaid.
(545)
No capital will be required to be held related to a clean-up call if it meets the
following conditions: (i) its exercise is not mandatory, in substance or form, but is
exercisable at the discretion of the originating bank, (ii) it is not structured to avoid
allocating losses to be absorbed by credit enhancements or positions held by investors or
otherwise to provide credit enhancement and (iii) it may only be exercised when 10% or
less of the original underlying portfolio or securities issued remain or, for synthetic
securitizations, 10% or less of the reference portfolio value remains. (557)
The presence of a clean-up call that does not conform to the requirements above
will result in capital as follows: (i) for a traditional securitization, the underlying
exposures will be treated as if they were not securitized and banks must not recognize
any gain-on-sale for regulatory capital purposes and (ii) for a synthetic securitization, the
originating bank must hold capital against the entire amount of the securitized exposures
as if they did not benefit from any credit protection. (558) Additionally, if a clean-up
call, when exercised, is found to provide credit support for a securitization, the exercise
of the clean up call will be considered a form of implicit support and will be treated as
described in Paragraph D. below. (559)
D.

Implicit support and its ramifications

Implicit support arises when a bank provides support to a securitization in excess

of its predetermined contractual obligation. (551) If a bank provides implicit support to
a securitization, it will be required, at a minimum, to hold capital against all of the
exposures associated with the securitization transaction as if they had not been
securitized. The bank will also not be permitted to recognize any gain-on-sale for
regulatory capital purposes. Additionally, the bank will be required to publicly disclose
9006858.4

that (a) it has provided non-contractual support to a transaction and (b) the capital impact
of doing so. (564)

E.

Application of deductions from capital

When a bank is required to deduct a securitization position from regulatory

capital, it must be taken 50% from Tier 1 capital and 50% from Tier 2 capital with one
exception. Banks will be required to deduct from Tier 1 capital any increase in equity
capital resulting from a securitization transaction, such as that associated with future
margin income, including credit-enhancing interest-only strips (547), resulting in a
gain-on-sale that has been capitalized and carried as an asset on balance sheet and
recognized in regulatory capital. Such an increase in capital is referred to herein as
gain-on-sale. (561-562)
F.

Qualifying external ratings for use under the securitization framework

Both the Standardized Approach and the IRB Approach provide for the use of
qualifying external ratings. The operational criteria for the use of external credit ratings
are described in Exhibit D.
The Securitization Framework
A.

The Standardized Approach to Securitizations

As it has since its 2001 consultative paper, the Committee proposes a

standardized capital system based on the ratings of securitization tranches provided by
qualified external rating agencies. Note, however, that the standardized approach is not
expected to be available in the United States.3 If a bank applies a standardized approach
to the credit risk for the underlying assets in a securitization, it will be required to apply
the Standardized Approach for the securitization of those assets. (566)
The tables on the next page show the proposed risk weights for rated
securitization tranches. The proposals for the long term ratings do not vary from those
proposed in April of last year. In addition to setting forth proposed risk weights for
exposures with long term ratings, the Committee has included proposed risk weights for
exposures with short term ratings. For comparative purposes, we also set forth a column
showing proposed risk weights for corporate credits, which receive more favorable
treatment at levels below investment grade.

In public statements, U.S. regulators have indicated that because of potential inequities created by not
adopting the Standardized Approach, they may modify the existing Basel framework to take account of Basel II to a
certain extent for banks that do not qualify for the IRB approach.

9006858.4

Exposures with long-term ratings (567)

Credit Rating

Proposed Basel Risk

Weight

Proposed Basel Risk Weight

(Securitization)

(Corporate)
AAA to AA-

20%

20%

A+ to A-

50%

50%

BBB+ to BBB-

100%

100%

BB+ to BB-

100%

350%

B+ or below

150%

Deducted from capital

Unrated

100%

Deducted from capital

Exposures with short-term ratings (567)

Credit Rating

Proposed Basel Risk Weight

A-1/P-1

20%

A-2/P-2

50%

A-3/P-3

100%

other ratings or unrated

Deducted from capital

When applying the standardized approach, only banks acting as third party
investors, as opposed to banks that serve as originators, may use the risk weight set forth
for exposures in the BB+ to BB- range. (569) Originating banks will be required to
deduct all retained exposures that are rated below BBB-. (570)
The proposal provides three exceptions to the general rule that unrated
transactions be deducted from capital:
1.

9006858.4

If the most senior tranche of a securitization is unrated, a bank that holds

or guarantees that exposure may apply a look through approach. Under
the look through approach, a senior position will be assigned a risk weight
equal to the average risk weight of the underlying exposures subject to
supervisory review. Banks are not required to consider interest rate or
currency swaps when determining whether a position is the most senior
for the purpose of applying the look-through approach. The
composition of the underlying pool must be known at all times in order to
apply the look through approach. Additionally, if a bank is unable to
6

assign a risk weight to all underlying assets, the look through approach
may not be used by that bank. (572-574)
2.

Qualifying exposures provided by sponsor banks in ABCP programs may

apply a risk weight that is the greater of (x) 100% and (y) the highest risk
weight assigned to any of the exposures in the underlying asset pool.
(575) To qualify for this exception, the sponsors position must satisfy
the following conditions (574):
(a)
the exposure is economically in a second loss position or better and
the first loss position must provide significant credit protection to the
second loss position;
(b)
the associated credit risk must be the equivalent of investment
grade or better; and
(c)
the bank holding the exposure must not retain or provide the first
loss position.

3.

The treatment of qualifying liquidity facilities is described below.

Liquidity Facilities
Under the Standardized Approach, banks will be required to use the ratings table
to determine the risk weight for a liquidity facility that has been rated. (577) If a
liquidity facility is unrated but is an eligible liquidity facility, the risk weight applicable
to a that liquidity commitments credit equivalent amount will equal the highest risk
weight assigned to any of the underlying exposures covered by the facility. (577).
Otherwise, the liquidity exposure will be required to be deducted from capital. (571)
A liquidity facility must satisfy the following conditions to qualify as an eligible
liquidity facility. (578):

9006858.4

The facility documentation must clearly identify and limit the

circumstances under which it can be drawn. Draws under the facility must
be limited to the amount that is likely to be paid fully from the liquidation
of the underlying exposures and any seller-provided credit enhancements.
The facility must not cover losses already sustained or be structured such
that draw down is certain (as indicated by regular or continuous draws).
Draws on the facility must be subject to an asset quality test that precludes
it from being drawn to cover credit risk exposures that are in default.
A default will be considered to have occurred when either or both of the
following events have taken place with respect to an underlying obligor:
(i) the bank considers that the obligor is unlikely to pay its credit
obligations to the banking group in full, without recourse by the bank to
actions such as realizing security, if any and (ii) the obligor is past due
more than 90 days on any material credit obligation to the banking group
or, for retail and public sector entity (PSE) obligations, a supervisor may
7

substitute a figure up to 180 days past due for different products, as it

considers appropriate to local conditions. (452)
In addition, if the exposures that a liquidity facility is required to fund are
externally rated securities, the facility can only be used to fund securities
that are externally rated investment grade at the time of funding.
The facility cannot be drawn after all applicable credit enhancements (e.g.
transaction specific and program wide) from which the liquidity facility
would benefit have been exhausted.
Draws on the facility must not be subordinated to any interests of any note
holder in the ABCP program or subject to deferral or waiver.

The credit conversion factor for a qualifying liquidity commitment will be 20%,
for commitments with an original maturity of one year or less, and 50%, for
commitments with an original maturity of greater than one year. (579) If a liquidity
commitment is not a qualifying liquidity commitment or if the risk weight for the facility
is based on an external rating of that facility, the credit conversion factor will be 100%.
A liquidity commitment will qualify for a 0% credit conversion factor only if (i) it
satisfies the conditions for a qualifying liquidity commitment set forth above and it can
only be drawn in the event of a general market disruption (i.e. more than one SPE across
different transactions are unable to roll over maturing commercial paper, and that
inability is not the result of an impairment in the SPEs credit quality or in the credit
quality of the underlying exposures) and (ii) funds advanced by the bank to pay holders
of the capital market instruments when there is a general market disruption must be
secured by the underlying assets and must rank at least pari passu with the claims of
holders of the capital market instruments. (580)
Servicer Advances
Subject to national discretion, a commitment by a servicer to make advances will
be considered a servicer advance if (i) the advance is provided for in the underlying
contracts and is made to insure an uninterrupted flow of payments to investors and (ii) the
servicer is entitled to full reimbursement and this right is senior to other claims on cash
flows from the underlying pool of exposures. At national discretion, any such servicer
advance that is unconditionally cancelable without prior notice may be eligible for a 0%
credit conversion factor. (582) Although not clear, it appears that once funded, a
servicer advance commitment that satisfies the criteria for a qualifying liquidity facility
would apply the risk weight applicable to the related underlying pool of assets. If the
servicer advance was not a liquidity facility, it appears that a servicer advance would be
treated as a securitization position and the appropriate risk weight for it would be
calculated as provided in the securitization framework. What continues to be unstated in
the Consultative Document is how the servicer advance commitment is sized.

9006858.4

Credit Risk Mitigants

If a bank (other than the originator) provides a credit protection to a securitization
exposure, it must calculate a capital requirement on the covered exposure as if it were an
investor. If a bank provides protection to an unrated securitization exposure, it must treat
the credit protection provided as if it were the direct holder of the unrated credit
enhancement. (584)
If a bank has obtained a credit risk mitigant (such as guarantees, credit
derivatives, collateral and on-balance sheet netting), the impact that such credit risk
mitigant will have on the required capital it must hold on its position will be determined
as set forth in paragraphs 109-210 of the Consultative Document. (583-589). Generally
speaking, banks may either opt for the simple approach, which, like the current Accord,
substitutes the risk weight of qualifying collateral/synthetic counterparty (for derivative
credit risk mitigants) for the risk weight of the exposure for a covered exposure or may
opt for the comprehensive approach set forth in the Consultative Document that allows
fuller offset of collateral against exposures by effectively reducing the exposure amount
by the value ascribed to the collateral.
Securitizations with Early Amortization Provisions
In additional to holding capital against any retained interest determined as
described above, an originating bank will be required to hold capital against all or a
portion of the investors interest arising from revolving securitizations that contain an
early amortization feature. (590)
This additional capital requirement will not apply to the following securitizations
(593):

replenishing securitizations where the underlying credits do not revolve

and the effect of an early amortization provision is to end the ability of a
bank to transfer new exposures to a securitization;
securitizations of revolving credits with early amortization features that
mimic term structures (i.e. where the risk on the underlying facilities does
not return to the originating bank);
securitizations where a bank securitizes one or more credit lines for which
investors remain fully exposed to future draws by borrowers even after an
early amortization event has occurred;
Securitizations where the early amortization clause is solely triggered by
events not related to the performance of the securitized assets or the
selling bank, such as material changes in tax laws or regulations.

If a securitization consists of revolving and term credit exposures, a bank must

apply the additional capital rules described below to that portion of the underlying pool
containing revolving retail credit exposures. (592)
If a bank is subject to an additional capital charge described below, there will be a
cap on the required capital charge to that bank for the securitization that will be equal to
9006858.4
9

the greater of (x) the capital that is required for the retained exposures in that
securitization and (y) the capital that would have been required to be held had the
exposures not been securitized. Deduction of any gain-on-sale and credit enhancing I/Os
will not be subject to this cap. (594)
The additional capital charge for covered securitizations with early amortization
provisions for the investors interest is determined by multiplying the notional amount of
the investors interest times the applicable credit conversion factor times the risk weight
appropriate for the underlying exposure type as if the underlying exposures had not been
securitized. (595)
The applicable credit conversion factor will differ based on (x) whether the early
amortization repays investors through a controlled or non-controlled mechanism and
(y) whether the securitized exposures are uncommitted retail credit lines that are
unconditionally cancelable without prior notice (e.g. credit card receivables) or other
credit lines (e.g. revolving corporate facilities). (595)
An early amortization provision must satisfy the following conditions to be
characterized as controlled (548 & 596):

The originating bank must have an appropriate capital/liquidity plan in

place to ensure that it has sufficient capital and liquidity available in the
event of an early amortization.
Throughout the duration of the transaction, including the amortization
period, there must be a pro rata sharing of interest, principal, expenses,
losses and recoveries based on the balances of receivables outstanding at
the beginning of each month.
The originating bank must set a period for amortization that would be
sufficient for 90% of the total debt outstanding at the beginning of the
early amortization period to have been repaid or recognized as in default.
The pace of repayment should not be any more rapid than would be
allowed by straight-line amortization over the period set out in the
preceding bullet point.

An early amortization provision that does not satisfy these conditions will be
treated as non-controlled.
The mechanics for determining the credit conversion factor for early amortization
structures have been revised since the April, 2003 draft. To determine the capital to be
held against the investors interests in a securitization of uncommitted retail exposures, a
bank must compare the three-month average excess spread to the point at which the bank
is required to trap excess spread as economically required by the structure (or, if not
required by the transaction, this point will be deemed to be 4.5 percentage points). (597598)
The bank must divide the excess spread level by the trapping point to determine
which conversion factor is applicable. (599). The following conversion factors based
9006858.4

10

on whether the securitization had a controlled or non-controlled early amortization

provision would apply (599 and 604):
Treatment for Uncommitted Retail Revolving Credits
3 Month Average
Excess Spread

Controlled Early
Amortization

Non-controlled Early
Amortization

133.33% of trapping
point or more

0%

0%

Less than 133.33% to

100% of trapping point

1%

5%

Less than 100% to 75%

of trapping point

2%

15%

Less than 75% to 50%

of trapping point

10%

50%

Less than 50% to 25%

of trapping point

20%

100%

Less than 25% of

trapping point

40%

100%

Except as provided above for uncommitted retail credits, (x) revolving

securitizations of committed revolving retail commitments and uncommitted revolving
non-retail commitments with a controlled early amortization feature will have a credit
conversion factor of 90% and (y) all other revolving securitizations with a non-controlled
early amortization feature will have a credit conversion factor of 100%. (599 and 604)
B.

The Internal Ratings-Based Approach to Securitizations

The Internal Ratings-Based Approach (IRB) includes three potential

approaches: (i) an approach based on ratings assigned by an external credit rating agency
(RBA), (ii) an approach based on the application of a supervisory formula (SFA), and
(iii) for exposures to ABCP conduits, an internal assessment approach (IAA) based on
the internal rating system of the bank (IAA). To be eligible for the IRB, a bank will be
required to meet minimum requirements set forth in paragraphs 387 through 537 of the
Consultative Document. (349)
A bank that has received approval to use the IRB approach for the type of
underlying credit exposures being securitized must use the IRB for securitizations.
(606). If there is no specific IRB treatment for an underlying asset type, an originating
bank that has received approval to use the IRB approach must calculate the related
securitization under the Standardized Approach. Investing banks that have approval to
use the IRB approach, however, would be required to use the RBA. (608)

9006858.4

11

If a bank is to apply the IRB for a securitization, whether it must apply the RBA,
the SFA or the IAA, will be determined as follows:
Banks must use the RBA if an external rating is available or a rating can be
inferred. Otherwise, the position must be deducted unless a bank may use the SFA or
IAA approach, if applicable for ABCP conduit exposures. (609)
Application of the RBA
The tables below set forth the methodology for assigning risk weights to
externally rated positions that have been assigned long term ratings and for those
positions that have been assigned short term ratings. Included in the table for
comparative purposes were the risk weights applicable under the April 2003 draft.
Circled risk weights in the final risk weight column highlight changes since the prior
draft.
Exposures with long-term ratings (615)

April 2003 Risk Weights

(%)
Rating
Grade
(Illustrative)
Aaa
Aa
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
Below-Ba3

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Highlygranular
pools, thick
tranches
7
10

Final Risk Weights

(%)

Base Case

12
15
20

Nongranular
Pool
20
25
35

Senior
Tranches
and eligible
senior IAA
7
8
10
12
20
35
60

50
75
100
250
425
650
Deduction

Base Case

12
15
18

35

20
35
50
75
100
250
425
650
Deduction

12

Nongranular
Pool
20
25

Exposures with short-term ratings (616)

(1)
External rating

A-1/P-1
A-2/P-2
A-3/P-3
Other
ratings and
unrated

(2)
Risk weights for
senior positions and
eligible senior IAA
exposures

7%
12%
60%
Deducted

(3)
Base risk
weights

(4)
Risk weights for
tranches backed by
non-granular pools

12%
20%
75%
Deducted

20%
35%
75%
Deducted

Under the RBA, the applicable risk weight will depend on (i) the external rating
and whether that rating is a long term rating or a short term rating, (ii) the granularity of
the underlying pool and (iii) the level of seniority of the position. (612)
A position will be treated as senior if it is effectively backed or secured by
a first claim on the entire amount of the assets in the underlying pool. The new focus on
seniority poses problems for transactions with super-senior tranches, in that only the
relatively thin super senior tranche qualifies for the lowest risk weight calculation, thus
leaving the relatively thick senior tranche qualifying only for the base case risk weights.
Although staff hand indicated a willingness to examine this issue, no change has been
made in this final draft. (613)
Senior positions will be eligible for the more favorable treatment in the
left columns above only if the effective number of underlying exposures is 6 or more.
When the effective number is less than 6, the risk weights in the right columns will apply.
In all other cases, the base case risk weights will apply. (615)
Under the proposed RBA, if there is an externally rated subordinated position in
the same securitization that satisfies the minimal operational requirements set forth
below, a bank must attribute an inferred rating to an unrated senior position. If a rating
is inferred for an unrated position, the risk weight for that position will be that of the
rated position in the securitization (the reference position) used to infer the rating.
(617)
The requirements for assigning an inferred rating in a securitization are as
follows (618):

9006858.4

The reference position must be subordinate in all respects to the unrated position.
Credit enhancements, if any, must be taken into account when assessing the
relative subordination of the unrated position and the reference position. For
example, if the proposed reference position benefits from any third party guaranty
or other credit enhancement that is not available to the unrated position, the
proposed reference position may not be used to assign an inferred rating.
13

The maturity of the reference position must be equal to or longer than that of the
unrated position.
On an ongoing basis, any inferred rating must be updated continuously to reflect
any changes in the external rating of the reference position.
The external rating of the reference position must satisfy the general requirements
for recognition of external ratings required in the Standardized Approach.
Application of the IAA

A bank may use its internal assessments of the credit quality of securitization
exposures to ABCP programs if the banks internal assessment process meets the
operation requirements set forth in Exhibit E. Internal risk assessments to these
exposures must be mapped to an equivalent external rating. Those rating equivalents will
then be used to determine the applicable risk weight using the risk weight tables
described above. (619). Once a banks internal system has been approved, it will
continue to be subject to regulatory review. If supervisors no long think a system is
adequate, the banks ability to use the IAA will be suspended until its system has been
revised and approved by the applicable regulators. (622).
Application of the SFA
Under the SFA, risk-weighted assets are calculated by multiplying the capital
charge by 12.5. The capital charge for a securitization position will depend on five banksupplied inputs: the Kirb of the underlying securitized exposures if they had not been
securitized, the positions credit enhancement level (L) and thickness (T), the
underlying pools effective number of exposures (N) and the pools exposure-weighted
average loss-given-default (LGD). (623)
Kirb is the ratio of (a) the IRB capital requirement for the underlying exposures in
a pool to (b) the notional or loan equivalent amount of exposures in the pool (e.g. the sum
of drawn amounts plus undrawn commitments). The IRB capital requirement component
of Kirb of the underlying exposures is to be determined in accordance with the IRB
approach for that type of exposure.4 The calculation should reflect the effects of any
credit risk mitigant that is applied on the underlying exposures and thus benefits all of the
securitization exposures. (627)
The capital charge for any securitization position will be calculated using these
inputs as follows (623):
capital charge=

(i) the greater of (a) (Supervisory formula[L+T]Supervisory formula[L]) and (b) 0.0056*T times (ii) the
notional amount of credit exposures that have been
securitized.

The supervisory formula used in calculating the capital charge under the SFA
remains unchanged from the April 2003 draft and is described in paragraphs 623 to 636
4

The IRB approach for each type of exposure can be found in Part 3 of the Consultative Document entitled
Credit RiskThe Internal Ratings Based Approach.
9006858.4

14

of the Consultative Documents. If a bank is permitted to use the IRB, the capital
requirement against all positions held by that bank in a securitization will be capped at an
amount equal to the product of the IRB capital treatment of the underlying pool of
exposures as if such exposures had not been securitized. (610)
The treatment for servicer advances and controlled amortization features is the
same under the IRB as under the Standardized Approach. ( 641 and 643). Additionally,
both the RBA and the SFA treat credit risk mitigants in a similar fashion as the
Standardized Approach. (642).
Except as described below, under the IRB, a liquidity facility is to be treated as
any other securitization exposure with a credit conversion factor of 100%. If the facility
is externally rated, the bank may rely on the external rating under the RBA. (637)5 If
the facility is not rated, the bank must apply the SFA unless the IAA can be applied.
(637) An eligible liquidity facility that can be drawn only in the event of a general
market disruption will be assigned a credit conversion factor of 20% under the SFA.
(638)
Banks qualifying for use of the top-down approach described below will be able
to use that approach for liquidity commitments when using the SFA. In addition, when it
is not practical for a bank to use either the bottom-up approach or the top-down
approach, the bank may, on an exceptional basis and subject to supervisory consent,
temporarily be allowed to use an alternative method. If a liquidity facility meets the
eligibility criteria described above on page 7 or is unconditionally cancelable, the highest
risk weight assigned under the standardized approach to any of the underlying individual
exposures covered by that facility will be used as the risk weight for that facility. If the
liquidity commitment is unconditionally cancelable, a 20% credit conversion factor will
apply. Otherwise, a 50% credit conversion factor will apply for an eligible liquidity
commitment of one year or less and a 100% credit conversion factor will apply for
commitments of more than a year. (639)
Finally, the Consultative Document sets forth guidelines to address how a bank
would determine required capital for overlapping commitments (i.e. conduit transactions
where there is both specific liquidity and pool wide liquidity and credit enhancement). If
the same bank provides overlapping facilities, it is only required to hold capital once for
the overlapping facilities (whether liquidity or credit enhancement). Where the
overlapping facilities are subject to different conversion factors, the bank must attribute
the overlapping part to the facility with the highest conversion factor. (581)
Top-Down Approach for Corporate Receivables
A particular challenge in applying the SFA to some securitization positions is that
the general IRB for corporate exposures incorporates a bottom-up approach. A bank
applying the IRB to its corporate portfolio is required to calculate a separate probability
of default (PD) for each obligor in the portfolio and either use a supervisory
assumption of loss given default (LGD), exposure at default (EAD) and maturity
(M) for each exposure (in the Foundation IRB) or also calculate a separate LGD, EAD
5

9006858.4

Based on our reading of paragraph 609, we believe that the RBA is mandatory for rated liquidity facilities.

15

and M for each exposure (in the Advanced IRB). The required capital for the pool is
calculated based on these individual exposure-level inputs. In securitizations of third
party-originated assets, the bottom-up approach could be problematic, as some banks that
wish or are required to apply the SFA may not have individual exposure level data
sufficient to perform this calculation.
The Consultative Document addresses this problem by permitting banks (with
specific supervisory approval) to employ a top-down approach to eligible purchased
corporate exposures. The top-down approach is described at paragraphs 365 through 370
of the Consultative Document. When this approach is available, the top-down approach
would be used to calculate Kirb. To be eligible for the top-down treatment, purchased
corporate receivables must meet the following minimal conditions (242):
(i)

the receivables are purchased from unrelated, third party sellers and not
originated by the bank;

(ii)

the receivables must be generated on an arms-length basis between the

seller and the obligor (intercompany and receivables subject to contraaccounts between firms that buy and sell to each other will be ineligible);

(iii)

the purchasing bank has a claim on all proceeds from the pool of
receivables or a pro-rata interest in the proceeds; and

(iv)

concentration levels do not exceed those established by national

supervisors using minimal requirements for the bottom-up approach for
the banks own corporate exposures. Such concentration limits may refer
to one or a combination of the following measures; the size of one
individual exposure relative to the total pool, the size of the pool of
receivables as a percentage of regulatory capital or the maximum size of
an individual exposure to the pool.

Securitizations of third party retail receivables should not present the same issue,
since the IRB for retail exposures already contemplates a top-down approach.
Nevertheless, the rules for purchased receivables contain some guidance that may be
relevant to these securitizations also. Specifically, the estimates for PD and LGD used in
applying the normal top-down approach to purchased retail receivables must be
calculated for the receivables on a stand-alone basis, without taking into account recourse
or guarantees. Presumably, recourse and guaranties can be taken into account under the
normal credit mitigation rules, though the Consultative Document does not specifically
say this in its discussion of retail receivables. (364)
The top-down approach for purchased corporate receivables requires a bank to
estimate the pools one year expected loss (EL) separately for default risk and dilution
risk. Under the Foundation IRB, the EL for default risk will then be decomposed into PD
and LGD components. If a bank is not able to reliably decompose these components, the
following assumptions will apply: (i) if a bank can demonstrate that the exposures are
exclusively senior claims to corporate borrowers, an LGD of 45% may be used; PD will
be calculated by dividing the EL using the assumed LGD; and EAD will be calculated as
the outstanding amount minus the capital charge for dilution prior to credit risk
mitigation and (ii) if the bank cannot use the assumptions in clause (i), PD is assumed to
9006858.4
16

be the banks estimate of EL; LGD will be 100% and EAD will be the amount
outstanding minus the capital charge for dilution prior to credit risk mitigation. In the
Advanced IRB, a bank will be permitted to use its own estimated weighted-average PD
and LGD as inputs. As with retail receivables, all of these inputs are to be calculated on a
stand-alone basis. Any recourse or guaranties are taken into account separately based on
the general rules for credit risk mitigation. (366-368)
* * *
If you have any questions with regard to the above memorandum, please feel free
to contact Mary Barry (312/701-8460), Rob Hugi (312/701-7121), Jason Kravitt
(212/506-2622), Mark Nicolaides (011-44-207-782-6232) or any of your regular contacts
at the firm.
Mayer, Brown, Rowe & Maw Memoranda provide comments on new
developments and issues of interest to our clients and friends. These memoranda do not
purport to provide comprehensive coverage of the subject matter and are not intended to
provide legal advice. Readers should seek specific legal advice before taking any action
with regard to the matters covered.
MAYER, BROWN, ROWE & MAW

9006858.4

17

Exhibit A
IRB Approach for Specialized Lending Transactions
Specialized lending transactions are treated as a subgroup of corporate exposures.
The general rule for applying the IRB to corporate exposures is that a bank will be
required to calculate a separate probability of default (PD) for each exposure and either
use a supervisory assumption of loss given default (LGD), exposure at default (EAD)
and maturity (M) for each exposure (in the Foundation IRB) or also calculate a separate
LGD, EAD and M for each exposure (in the Advanced IRB). (247)
There are two exceptions to the general rule: (i) if a bank is not able to calculate
the PD of a position under the foundation approach, it will be required to map its internal
risk grades to five supervisory categories described in the first table below and use the
risk weight associated with those categories for specialized lending transactions other
than high-volatility commercial real estate transactions and (ii) the only approach
available to a bank for high volatility commercial real estate transactions (HVCREs)
will be to map its internal risk grades to five supervisory categories described in the
second table below and use the risk weight associated with those categories for HVCREs.
Otherwise, banks will follow the general rules for corporate exposures when calculating
the required capital for specialized lending transactions. (249-251)

Risk Weights for Supervisory Categories

(other than for HVCREs) (275)
Strong

Good

Satisfactory

Weak

Default

70%

90%

115%

250%

0%

For exposures covered by the table above, a national supervisor will have
discretion to allow banks to assign a risk weight of 50% to strong exposures and a risk
weight of 70% for good exposures if such exposures have an original maturity of less
than 2.5 years. (277)

Risk Weights for Supervisory Categories

(for HVCREs) (280)

9006858.4

Strong

Good

Satisfactory

Weak

Default

95%

120%

140%

250%

0%

18

Exhibit B
Operational criteria for traditional securitizations (554)
An originating bank may exclude securitized exposures from the calculation of riskweighted assets only if the following conditions have been met. Banks meeting these
conditions must still hold regulatory capital against any securitization exposures they
retain.
(a)
Significant credit risk associated with the securitized exposures has been
transferred to third parties.
(b)
The transferor does not maintain effective or indirect control over the
transferred exposures. The assets are legally isolated from the transferor in such a
way (e.g. through the sale of assets or through subparticipation) that the exposures
are put beyond the reach of the transferor and its creditors, even in bankruptcy or
receivership. These conditions must be supported by an opinion provided by a
qualified legal counsel. The transferor is deemed to have maintained effective
control over the transferred credit risk exposures if it: (i) is able to repurchase
from the transferee the previously transferred exposures in order to realize their
benefits; or (ii) is obligated to retain the risk of the transferred exposures. The
transferors retention of servicing rights to the exposures will not necessarily
constitute indirect control of the exposures;
(c)
The securities issued are not obligations of the transferor. Thus, investors
who purchase the securities only have claim to the underlying pool of exposures;
(d)
The transferee is an SPE and the holders of the beneficial interests in that
entity have the right to pledge or exchange them without restriction. An SPE is
a special purpose entity organized for a specific purpose, the activities of which
are limited to those appropriate to accomplish that purpose, and the structure of
which is intended to isolate the special purpose entity from the credit risk of an
originator or seller of exposures;
(e)
Any clean-up calls that are contractually permitted must satisfy the
conditions outlined in the text of this memorandum; and
(f)
The securitization does not contain clauses that (i) require the originating
bank to alter systematically the underlying exposures such that the pools
weighted average credit quality is improved unless this is achieved by selling
assets to independent and third parties at market prices; (ii) allow for increases in
a retained first loss position or credit enhancement provided by the originating
bank after the transactions inception; or (iii) increase the yield payable to parties
other than the originating bank, such as investors and third-party providers of
credit enhancements, in response to a deterioration in the credit quality of the
underlying pool.

9006858.4

19

Exhibit C
Operational criteria for use of synthetic securitizations (555)
For synthetic securitizations, the use of credit risk mitigation techniques (i.e.
collateral, guarantees and credit derivatives) for hedging the underlying exposure may be
recognized for risk-based capital purposes only if the conditions outlined below are
satisfied:
(a)
Credit risk mitigants must comply with the requirements as set out in
paragraphs 109-210 of the Consultative Document. Eligible collateral pledged by
SPEs may be recognized.
(b)
Eligible collateral is limited to that specified in paragraphs 145 and 146 of
the standardized approach for credit risk mitigants in the Consultative Document.
(c)
Eligible guarantors are defined in paragraph 195 of the standardized
approach for credit risk mitigants in the Consultative Document. Banks may not
recognize SPEs as eligible guarantors in the securitization framework.
(d)
Banks must transfer significant credit risk associated with the underlying
exposure to third parties.
(e)
The instruments used to transfer credit risk may not contain terms or
conditions that limit the amount of credit risk transferred, such as those provided
below:
Clauses that materially limit the credit protection or credit risk
transference (e.g. significant materiality thresholds below which credit
protection is deemed not to be triggered even if a credit event occurs or
those that allow for the termination of the protection due to deterioration
in the credit quality of the underlying exposures);
Clauses that require the originating bank to alter the underlying exposures
to improve the pools weighted average credit quality;
Clauses that increase the banks cost of credit protection in response to
deterioration in the pools quality;
Clauses that increase the yield payable to parties other than the originating
banks, such as investors and third-party providers of credit enhancements
in response to a deterioration in the credit quality of the underlying pool;
and
Clauses that provide for increases in a retained first loss position or credit
enhancement provided by the originating bank after the transactions
inception.

9006858.4

20

(f)
An opinion must be obtained from a qualified legal counsel that confirms
the enforceability of the contracts in all relevant jurisdictions.
(g)
Clean-up calls must satisfy the conditions outlined in the text of this
memorandum.

9006858.4

21

Exhibit D
Operation criteria for use of external credit ratings
The operational criteria for the use of external credit ratings are as follows (565):

the external rating must take into account and reflect the entire amount of
credit risk exposure with regard to all payments owed to the holder of a
subject position;
the external rating must be from an eligible external credit rating agency
recognized by the banks national supervisory authority as more fully
described in the Consultative Document and the rating assigned must be
publicly available to the market and included in the applicable rating
agencys transition matrix;
the external rating agency must have demonstrated expertise in
securitizations, which may be evidenced by strong market acceptance;
a bank must apply external ratings consistently across a given type of
securitization transaction and a bank may not use one rating agencys
rating for one tranche of a securitization and another rating agencys rating
of a different tranche of the same securitization to determine regulatory
capital, regardless of whether the second position is rated by the first
rating agency;
if two ratings are available for the same position and they map to different
risk weights, the higher risk weight will apply;
if three or more ratings are available for the same position, the
assessments corresponding to the two lowest risk weights should be
referred to and the higher of those risk weights should be applied;
if a credit risk mitigant is provided directly to the issuing SPE by a
provider that is rated A- or better (or that is a sovereign entity, a PSE,
bank or securities firm with a lower risk weight than the counterparty) and
that credit risk mitigant is reflected in the rating assigned to the
securitization exposure, the risk weight for that exposure will be that of
the assigned rating. In this case, there will be no additional capital
recognition of the credit risk mitigant. If the provider of the credit risk
mitigant is rated below A- (or is not an entity specified above), the
securitization exposure will be considered as unrated and the credit risk
mitigation rules discussed below will apply.

a bank will not be permitted to use an external rating of a securitization tranche if

the external rating reflects the benefits of a credit risk mitigant that has been
provided only to that tranche. In such cases, the credit risk mitigation rules
discussed on page 9 will apply.

9006858.4

22

Exhibit E
Operational Requirements for IAA
A banks internal assessment process must meet the following operational
requirements in order to use internal assessments in determining the IRB capital
requirement arising from liquidity facilities, credit enhancements, or other exposures
extended to an ABCP program, with the exception of the commercial paper itself. The
ABCP must be externally rated for the unrated exposure to qualify for the IAA. In
addition, banks must adhere to any other applicable supervisory guidance related to
ABCP programs. (620)
(a)

The internal assessment of a the credit quality of a securitization exposure

to the ABCP program must be based on an external credit assessment
institutions (ECAI) criteria for the asset type purchased and must be the
equivalent of at least investment grade when initially assigned to an
exposure. In addition, the internal assessment must be used in the banks
internal risk management processes, including management information
and economic capital systems, and generally must meet all the relevant
requirements in order to be eligible for use under the IRB framework.

(b)

In order for banks to use the IAA, their supervisors must be satisfied (1)
that the ECAI meets the ECAI eligibility outlined in paragraphs 90 to 108
of the Consultative Document and (2) with the ECAI rating methodologies
used in the process. In addition, banks have the responsibility to
demonstrate to the satisfaction of their supervisors how these internal
assessments correspond with the ECAI standards used as the framework
for use of this internal assessment approach.
For instance, when calculating the credit enhancement level in the context
of the IAA, supervisors may, if warranted, disallow on a full or partial
basis any seller provided recourse guarantees or excess spread, or any
other first loss credit enhancements that provide limited protection to the
bank.

9006858.4

(c)

The banks internal assessment process must identify gradations of risk.

Internal assessments must correspond to the external ratings of ECAIs so
that supervisors can determine which internal assessment corresponds to
each external rating category of the ECAIs.

(d)

The banks internal assessment process, particularly the stress factors for
determining credit enhancement requirements, must be at least as
conservative as the publicly available rating criteria of the major ECAIs
that are externally rating the ABCP programs commercial paper for the
asset type being purchased by the program. However, banks should
consider, to some extent, all publicly available ECAI ratings
methodologies in developing their internal assessments.

23

In the case where (i) the commercial paper issued by an

ABCP program is externally rated by two or more ECAIs and (ii) the
different ECAIs benchmark stress factors require different levels of credit
enhancement to achieve the same external rating equivalent, the bank must
apply the ECAI stress factor that requires the most conservative or highest
level of credit protection. For example, if on ECAI required enhancement
of 2.5 to 3.5 times historical losses for an asset type to obtain a single A
rating equivalent and another required 2 to 3 times historical losses, the
bank must use the higher range of stress factors in determining the
appropriate level of seller-provide credit enhancement.
When selecting ECAIs to externally rate an ABCP, a bank must not
choose only those ECAIs that generally have relatively less restrictive
rating methodologies. In addition, if there are changes in the methodology
of one of the selected ECAIs, including the stress factors, that adversely
affect the external rating of the programs commercial paper, then the
revised rating methodology must be considered in evaluating whether the
internal assessments assigned to the ABCP program exposures are in need
of revision.
A bank cannot utilize an ECAIs rating methodology to derive an internal
assessment if the ECAIs process or rating criteria is not publicly
available. However, banks should consider the non-publicly available
methodologyto the extent that they have access to such informationin
developing their internal assessments, particularly if it is more
conservative than the publicly available criteria.
In general, if the ECAI rating methodologies for an asset or exposure are
not publicly available, then the IAA may not be used. However, in certain
instances, for example, for new or uniquely structured transactions, which
are not currently addressed by the rating criteria of an ECAI rating the
programs commercial paper, a bank may discuss the specific transaction
with its supervisor to determine whether the IAA may be applied to the
related exposures.

9006858.4

(e)

Internal or external auditors, an ECAI, or the banks internal credit review

or risk management function must perform regular reviews of the internal
assessment process and the validity of those internal assessments. If the
banks internal audit, credit review, or risk management functions perform
the reviews of the internal assessment process, then these functions must
be independent of the ABCP program business line, as well as the
underlying customer relationships.

(f)

The bank must track the performance of its internal ratings over time to
evaluate the performance of the assigned internal assessments and make
adjustments, as necessary, to its assessment process when the performance
of the exposures routinely diverges from the assigned internal assessments
on those exposures.
24

9006858.4

(g)

The ABCP program must establish credit and investment guidelines, i.e.,
underwriting standards, for the ABCP program. In the consideration of an
asset purchase, the ABCP program (i.e., the program administrator) should
develop an outline of the structure of the purchase transaction. Factors that
should be discussed include the type of asset being purchased; type and
monetary value of the exposures arising from the provision of liquidity
facilities and credit enhancements; loss waterfall; and legal and economic
isolation of the transferred assets from the entity selling the assets.

(h)

A credit analysis of the asset sellers risk profile must be performed and
should consider, for example, past and expected future financial
performance; current market position; expected future competitiveness;
leverage, cash flow, and interest coverage; and debt rating. In addition, a
review of the sellers underwriting standards, servicing capabilities, and
collection processes should be performed.

(i)

The ABCP programs underwriting policy must establish minimum asset

eligibility criteria that, among other things,

excludes the purchase of assets that are significantly past due or defaulted;
limits excess concentration to individual obligor or geographic area; and
limits the tenor of the assets to be purchased.

(j)

The ABCP program should have collections processes established that

considers the operational capability and credit quality of the servicer. The
program should mitigate to the extent possible seller/servicer risk through
various methods, such as triggers based on current credit quality that
would preclude co-mingling of funds and impose lockbox arrangements
that would help ensure the continuity of payments to the ABCP program.

(k)

The aggregated estimate of loss on an asset pool that the ABCP program is
considering purchasing must consider all sources of potential risk, such as
credit and dilution risk. If the seller-provided credit enhancement is sized
based on only credit-related losses, then a separate reserve should be
established for dilution risk, if dilution risk is material for the particular
exposure pool. In addition, in sizing the required enhancement level, the
program should review several years of historical information, including
losses, delinquencies, dilutions, and the turnover rate of the receivables.
Furthermore, the ABCP program should evaluate the characteristics of the
underlying asset pool, e.g., weighted average credit score, identify any
concentrations to an individual obligor or geographic region, and the
granularity of the asset pool.

(l)

The ABCP program must incorporate structural features into the purchase
of assets in order to mitigate potential credit deterioration of the
underlying portfolio. Such features may include stop-issuance triggers that
immediately cease the issuance of commercial paper to the market or wind
down triggers.
25