The Basel Committee on Banking Supervision released its second consultative document to revise Basel III's securitization framework. Either because it was released a few days before Christmas or because most readers might find its dry language a cure for insomnia, this important document has not received the significant attention it deserves.
Given the securitization market is reviving with a strength not seen since Lazarus' resurrection, securitization rules eventually to come from this consultative document are extremely important for banks and anyone investing in securitized products. Because of the important role that securitized products such as mortgage-backed securities and asset-backed securities can play in injecting liquidity into an economy, European governments in particular are interested in increasing securitizations' issuance. Of course, the final rules will also be very important for bank supervisors and examiners responsible for monitoring the risk management, or lack thereof, around these products.
In releasing the document, the Basel Committee continues to engage market participants by eliciting their comments in the hopes of strengthening the existing framework while balancing its risk sensitivity, simplicity and comparability. While attempting this balance is admirable, it is very difficult to achieve. By the time the Basel Committee accommodates the needs of all market participants in different jurisdictions and fine tunes complex mathematical models, the final securitization framework will end up being anything but simple.
In order to address the existing framework's shortcomings, the committee is asking market participants to opine on its objectives to reduce reliance on external ratings, increase risk weights for highly rated securitizations, lower risk weights for low-rated securitizations, reduce the framework's cliff effects in capital requirements and enhance its risk sensitivity. The Basel Committee is recommending a revised hierarchy of approaches to measure the risk in securitization exposures. The three proposed approaches, in order of the Committee's preference are the internal-ratings-based approach, the external-ratings-based approach and the standardized approach. Having three different approaches already means outside professionals will have some difficulty knowing which one a bank is using and whether banks' results, even when transparent, are comparable at all.
In the hopes of balancing risk sensitivity and simplicity, the Basel Committee is replacing the Modified Supervisory Formula Approach with the Internal Ratings Based Approach. Recommending using the internal ratings based approach, which is hardly a simple approach, is a significant challenge for modelers at banks and for bank supervisors and examiners.
Banks struggle to produce high quality and consistent data for their securitization risk measurement models. Every time I poll a classroom of market participants on how they value securitized products or how they measure the products' risk, the choices are more numerous than at Baskin Robbins. Even the Basel Committee's own studies last year confirmed that risk-weighted assets vary significantly between banks even when they have similar exposures.
Importantly, since Basel III's Pillar III, Market Discipline, has not been fully implemented uniformly, transparency about banks' exposure to securitizations, as either sponsors or investors, remains very poor. Additionally, there is only a minority of auditors and examiners who understand how banks produce data for risk drivers – such as probabilities of default, loss severities and exposures of default – modelers use for the internal ratings-based approach. If bank examiners cannot adequately and consistently determine the risks banks have with securitizations, any securitization framework will only end up being words on a paper.
The second approach, the External Ratings Based Approach, does not solve the problem of having market participants who may rely too heavily on rating agencies. In the U.S., the largest issuer and trader of securitized products, market participants are prohibited under Dodd-Frank from relying solely on ratings for their risk measurement frameworks. In Europe and other jurisdictions, market participants can still use ratings to determine risk weights, but that is tantamount to outsourcing their credit risk due diligence to the ratings agencies. Outsourcing your own due diligence is an important component of operational risk, which, as I have previously written, is the most poorly identified and measured risk at banks.
The last approach, the Standardized Approach, again relies on ratings. Large, internationally active banks will certainly fight against using that approach. Their preference is to use the internal-ratings-based approach so that they can have flexibility in deriving their risk driver inputs. At any rate, this approach is too simplistic for the likes of global systemically important banks, which have significant securitization portfolios.
I highly encourage market practitioners, regulators and the media to take a close look at this consultative document and the comments submitted to the committee. The commenting period closes on March 11. Securitization issuance is not just growing in the U.S. and Europe. It is growing in emerging markets in Latin America and Asia, where less product liquidity compounds the ability to price and value these instruments well and measure risk correctly.
The timing is very important. The further away we move from the global financial crisis, the less likely people are to remember the painful effect banks' poor risk management and lack of disclosure surrounding securitized products had on all of us.
Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World.