WASHINGTON - Federal banking regulators on Thursday proposed new capital rules for asset securitizations, their third attempt to close a gaping loophole.

In the works since 1990, the new rules would impose higher capital requirements on banks that provide loss protection for investors buying asset-backed securities. The proposal would also use rating agencies to slot these securities into one of five categories and double the capital charge on banks buying riskier debt. On the other hand, it would reduce the capital charge on banks buying highly rated asset-backed securities.

"The overall approach is to better align the capital requirements to the risk in these transactions," said Richard Spillenkothen, the Federal Reserve Board's director of supervision. "We need it because securitization is a larger and larger part of the banking business."

In a bow to industry critics, the regulators would let banks use internal systems or certain software to set capital levels for some unrated assets.

Since the mid-1980s, banks have used securitization to move more and more assets off their books. The market for asset-backed securities has tripled in the last five years, hitting $914 billion at Sept. 30, according to the Fed. (That total does not include mortgage-related securities, which are treated differently under capital rules.)

Asset securitization involves pooling loans and slicing the pool into securities that are sold with varying levels of risk and return. To entice investors and to earn high grades from rating agencies, banks can agree to absorb the portfolio's expected credit losses. Regulators refer to this practice as "selling assets with recourse."

However, the capital requirements are lower if a bank simply pays a third party, usually another bank, to cover the losses. Regulators call this credit enhancement a "direct credit substitute," and it is often delivered in a standby letter of credit.

Under current rules, assets sold with recourse require more capital than these credit substitutes. For example if $100 million of assets are sold and the bank agrees to cover the first 20% of losses, the bank still must hold capital against the full $100 million. But the bank providing a letter of credit to cover the same amount of loss only has to hold capital against $20 million.

To avoid the higher capital charges, banks buy the credit protection rather than providing it themselves.

"The difference in treatment between the two forms of credit enhancement invites banking organizations to obtain direct credit substitutes in place of recourse obligations in order to avoid the capital requirement," according to the proposal.

Under the proposed rule, the capital charge for these direct credit substitutes would be increased to the same level as assets sold with recourse.

It was 1990 when regulators set out to fix this capital anomaly. Their first proposal was issued in 1994, the second in 1997. With each iteration the rule became broader.

The idea of using rating agencies such as Moody's Investors Service and Standard & Poor's to help regulators determine capital requirements first surfaced in the 1997 proposal. Currently, banks must hold 8% capital, or 8 cents for each $1 invested, against all asset-backed securities, whether they are AAA-rated or junk bonds. Under the proposal, securities receiving the two highest ratings, AAA or AA, would require only 1.6 cents of capital for every $1 invested. The third-highest rating, A, would require 4% capital, while the lowest investment grade, BBB, would require 8%. One category below investment grade, BB, would require 16 cents for each $1 invested, while B-rated or unrated securities would require capital equal to the investment.

These five categories are an expansion of the three groupings proposed in 1997. If rating agencies differ, the single highest rating applies, according to the proposal.

Despite a desire by bankers to use their own internal rating systems, it is clear that the government is increasingly convinced that rating agencies will play an important role in setting capital levels.

A broader capital project being pursued by U.S. as well as international regulators through the Basel Committee on Banking Supervision also carves out a key role for rating agencies to assess credit risk.

"Ratings have the advantages of being relatively objective, widely used, and relied upon by investors and other participants in the financial markets," according to the proposed rule. "Ratings provide a flexible, efficient, market-oriented way to measure credit risk."

The proposal does acknowledge the industry's concerns about assets that are not publicly rated.

"To minimize the need for banking organizations to obtain ratings on otherwise unrated enhancement that are provided in asset-backed commercial paper securitizations, the proposal permits banking organizations to use their own qualifying internal risk rating systems in place of ratings from rating agencies for risk-weighting certain direct credit substitutes."

The regulators hope this move will provide banks with an incentive to improve their internal systems for judging risk and deciding how much capital is needed. The proposal outlines nine facets of an effective internal risk rating system and suggests that the government may formally sign off on banks' systems.

"The agencies are also considering whether to develop review and approval procedures governing their respective determinations of whether a particular banking organization may use the internal risk rating process," the proposal states. "The agencies request comment on the appropriate scope and nature of that process."

Letting banks use internal credit rating systems would save money, the regulators noted. However, because the ratings would determine a bank's capital, regulators must be assured the system is accurate.

"We expect very robust systems," the Fed's Mr. Spillenkothen said. Because the market evolves faster than the regulators can write rules, the agencies are proposing to give themselves more authority to adjust an individual bank's capital requirements.

"Banking organizations are developing novel transactions that do not fit well into the risk-weight categories and credit conversion factors set forth in the standards," the proposal states. "Accordingly, the agencies are proposing to … clarify their authority, on a case-by-case basis, to determine the appropriate" capital charge for certain assets.

The detailed proposal - the preamble itself is 40 pages - defines other protections as credit enhancements, including some representations and warranties and early default clauses, which ensure that loans backing the securities will not become more than 30 days delinquent within a state period.

"The agencies find that early-default clauses are often drafted so broadly that they are indistinguishable from a guaranty of financial assets," according to the proposal.

A variety of other, specific practices are covered in the full proposal which may be accessed at http://www.federalreserve.gov /boarddocs/press/Boardacts/2000/20000217.

The agencies - the Fed, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., and the Office of Thrift Supervision - will accept comments until May 26.

According to the proposal, a final rule that forced banks to hold more capital would only apply to new deals. However, any rule change that lowered a bank's capital requirements would be applied to outstanding investments.

Related Information:
Summary of proposed capital rules
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