VI. Effects of securitisation on the loan portfolio composition (loan book), credit risk exposure, asset funding of banks and banking regulation.

• Author: Jobst, Andreas A.
• Position: Collateralised Loan Obligations (CLOs

1. Regulatory Change and Its Effects

   Loan securitisation harnesses the adversity of both the current one-size-fits-all regulatory straightjacket and the competition in lending markets, which renders the cost-effective origination of loan for the bank portfolio (especially of investment-grade credits) increasingly difficult. This predicament has prompted banks to consider balance sheet restructuring for purposes of mitigating regulator), capital as well as improving overall economic efficiency (Punjabi and Tierney, 1999).

   The main channel through which banks arbitraged the regulatory provisions of the 1988 Basle Capital Accord was by securitising their better quality assets and retaining their riskier assets on their own books. Barring future modifications by the Basle Committee the equitable treatment of risk categories under the Capital Accord of 1988 (i.e. a constant capital risk weighting, which does not distinguish between different qualities of loans) still represents a perennial source of regulatory and institutional arbitrage. Consequently, the market for securitised assets grew dramatically from the early 1990s onwards and attracted a large following with all major investment banks for purposes of obtaining capital relief; gaining liquidity or exploiting regulator), capital arbitrage opportunities in the securitisation of loans. Since it is less efficient for banks to retain highly rated loans due to their tight spreads relative to the regulatory capital requirement (unlike high-risk loans with an interest sufficiently high to sustain a flat capital charge), the indiscriminate risk-weighting of loans has led a growing number of national and regional banks to concentrate on the securitisation of investment grade credits, whose inefficient relationship between associated regulatory capital requirements and interest yield constitutes an arbitrage opportunity. Only banks with a developed trading portfolio capability are in the position to remove credit risk of non-investment grade loans from their loan books as a result of this disparity between the regulatory regime and the economics of financial intermediation governing the benefits from loan business.

   With the new proposal of the 1988 Basle Accord suggesting the implementation of discriminatory risk-weightings across rating categories, the prospective change of the current regulatory regime will censure institutional arbitrage on regulatory capital requirements, which has hitherto motivated asset-backed securitisation. The new proposal of the Basle Committee incorporates advances in credit risk measurement, as it allows minimum capital requirements for credit risk to be determined by an internal ratings-based approach (IRB). Consequently, different loan grades will attract different commensurate risk weights in the future, e.g. low credit risk of investment grade loans is transposed into a lower level of regulatory capital. If the previous broad-brushed regulatory treatment of loans rules out arbitrage opportunities of low-risk assets under the current risk-based regulatory framework, banks are very likely to dispense with investment grade loans at large in securitisation transactions. (45)

   Conversely, as a higher capital charge levied on risky assets will carry larger risk-based capital haircuts, the incentive to securitise non-investment grade loans will rise. The relationship between the risk level of non-investment grade loans and the associated economic capital cost will determine the extent to which banks and other financial institutions are prepared to substitute high-risk assets (i.e. non-investment grade loans with presumably high capital haircuts) for investment grade-related credit exposures on their loan books--a reversal of the present drainage of low-risk loans off the balance sheet. Hence, loan securitisation, originally devised as remedy to inflexible regulatory capital charges, will be instrumental in the efficient management of economic capital for purposes adequate asset allocation. Therefore, the erosion of regulatory arbitrage by means of replacing the present regime of one-size-fits-all risk-based capital requirements is intimately related to improvements in credit risk management of banks and financial institutions.

   Although the latest Basle proposal aims to moderate future regulatory incentives of banks to dispense with low-yielding assets through securitisation on an excessive scale, the market is now too large and important just to disappear. The unabated popularity of asset-backed securities raises some complex questions about how such securitisation should be treated for risk control purposes. The envisaged scrutiny of internal credit risk assessment presented in the new Basle Accord does not only probe a comprehensive examination of the bank-based computation of capital requirements of loan books as to the explicit treatment internal rating mechanisms. It also warrants contemplating the development of financial intermediation with respect to loan securitisation. This is a difficult question, especially since securitisation can be structured in a wide variety of ways, eventuating disparate risk profiles for both the originating bank and capital market investors. Unless rules on risk management, transparency and investor protection prove adequate, such form of structured finance could possibly pose a significant threat to the stability of financial markets.

   While the benefits from regulatory arbitrage on investment grade loans fade in view of the new proposal to a new Basle Accord, the new reality of a more responsive regulatory setting does not invalidate but rather strengthen the argument of risk-adjusted efficiency gains (of economic capital) in the process of loan securitisation. Securitisation maintains its economic edge, as it enables banks and non-bank financial institutions to reap the rewards from advanced approaches in controlling credit risk and reduce inessential non-interest rate expenses.

2. Changes in the Configuration of Securitisation (46)

   1. Standardisation

      The growing standardisation of loan terms and credit scoring processes does not only lead to operational efficiency and transparency of credit risk management routines but also fosters mitigation of inherent uncertainty in both the estimation of the cumulative distribution function of default probabilities and loss severity associated with various loan pools. Simulation models to estimate the performance of the reference portfolios of synthetic and conventional loan secutitisation as well as improved analytical systems for the credit risk assessment of portfolios, such as KMV's Portfolio Manager, address much desired properties of credit risk management. Higher precision in the estimation of credit risk (i.e. a declining marginal increase of total variance of estimates as expected losses rise) is tantamount to reduced credit risk exposure to unexpected loss.

      Given the inherent complexity and diversity of structured transactions, Burghardt (2001) states that a case-by-case basis evaluation of structured products with a derivative element (46) (such as synthetic CLOs) or pure derivative transactions is inevitably warranted from both a risk and regulatory perspective. Therefore, greater transparency of credit risk through standardisation bodes well with the conservative procedures of rating agencies in the determination of default probabilities and the pricing of synthetic asset-backed securities. So far, especially in cases of new types of reference portfolio assets (most prominent in synthetic CLO structures), relatively low structured ratings for mezzanine tranches (intermediate credit tranches) have resulted in spreads well above those found for comparably rated corporate bonds with arguably lower uncertainty about asset quality. The proposed regulatory framework, however, instils greater efforts in closing the information gap between issuers of CLOs and rating agencies due to a greater degree of transparency and standardisation of credit risk assessment by means of second-generation models of credit risk analytics.

      Although credit rating agencies as the prime source of credit risk analysis for CLO transactions will not be rendered redundant, the increase in bank-based credit risk assessment is most likely to improve the efficiency of CLOs. This, in turn, allows investors to draw comfort from an increased understanding of the credit risk inherent in CLO transactions (as informed buyers), whose diversity and complexity tends to cause problems in analysing the risk-return relationship for loss of appropriate analytical approaches (Burghardt...