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Financing of the EU economy - Is the EU securitization proposal up to the challenges?
Non-neutrality is the root of excessive capital for securitisation
By Batchvarov Alexander - PhD, CFA, Head of International Structured Finance and Covered Bond Research, Bank of America Merrill Lynch Global Research
Regulatory capital calibration for securitisation exposures has followed a black-box approach, where the inputs and outputs are known to market participants, but the transformation process in-between has left them with lots of unanswered questions. In theory, securitisation does not change the credit risk of the securitised exposures, but rather redistributes it across the securitisation notes. In practice, its capital calibration contains many instances of double counting of risks, leading to a significant increase in the EU capital requirements for securitisation.
A specific securitisation related risk is the agency risk arising from the perceived misalignment of the interests of securitisation notes investors and securitisation exposures originators. The academic literature quantifies this risk as a marginal increase in the probability of default of the securitised relative to the non-securitised exposures. The EU regulatory framework addresses it by establishing a mandatory minimum retention requirement.
Another risk is associated with the use of models to determine securitisation tranches and the risk redistribution across them. Models are also used for the calibration of capital for individual exposures, for trading book and in the derivation of bank capital instruments, such as cocos, which also require a form of tranching. In those cases, model risk is addressed through an explicit charge. In our view, a similar explicit charge should be used to address modelling risk in securitisation.
Securitisation calibration is subject to an additional adjustment of a maturity charge, which is already factored in the capital level for the exposures to be securitised. This leads to double counting of maturity risk, once in the underlying exposures and twice in their securitisation. The regulatory capital calibration does not give EU securitisations a benefit for their floating rate notes, hence low duration, and assigns such floating rate securitisations a duration equivalent to their legal final maturity, subject to a 5-year cap in CRR and to no cap in Solvency II, and to a 1-year floor in both.
Last but not least, calibration of regulatory capital for securitisation under bank rules incorporates both expected and unexpected loss, while only the latter is used for non-securitised exposures. For insurance companies, the capital calibration incorporates a one-off liquidity event, which is overlooked in other types of exposures, and disregards securitised collateral benefits, which are taken into account for covered bonds and stand-alone residential mortgage portfolios.
Its capital calibration contains many instances of double counting of risks.
The result of this discrepancy in calibration approaches is a material surcharge in securitisation capital and discontinuity and cliffs in the capital charges for securitisation, covered bonds and their underlying exposures.
The solution is simple to conceive and its delivery requires a modification of the calibration methods used to-date. For bank capital calibration, the theoretically sound neutrality can be modified into ‘controlled non-neutrality’ through an explicit surcharge of, say, 0.2% on to the underlying exposure capital, which is then reallocated across tranches on the condition that the capital charge for senior mezzanine securitisation tranches should not exceed that for the underlying exposures. For insurance companies, the realignment of regulatory capital for securitisation and for the underlying exposures is a must. Under both sets of calibration, for banks and for insurers, it is important to realign the capital treatment of securitisation, especially STS, with that of other investment instruments, such as corporate bonds, covered bonds, etc. Material capital requirement discrepancies across them have already led to a distortion in investment and funding decisions in recent years.
We must emphasise, however, that addressing the capital calibration problem alone is a necessary, but not sufficient, condition to restore the EU securitisation market. Other EU regulatory requirements, such as disclosure, due diligence, penalties for non-compliance, etc., should also be levelled across funding and investment instruments, especially for STS securitisations, covered bonds and whole loan portfolios, by eliminating the excessive and unnecessary burdens placed on securitisation.