Securitisation and Banks

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Securitisation and Banks
ASEAN3 Workshop The Rise of Asset Securitisation
in East Asia

• James H. Lau Jr.Chief Executive OfficerThe Hong
  Kong Mortgage Corporation Limited8 November
  2005

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Contents

• Introduction
• Major securitisation issues for banks
• International accounting standards
• Basel II regulatory framework
• Issues and implications

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INTRODUCTION Why securitise?

• To improve asset-liability management
• To enhance credit risk management
• To improve balance sheet, CAR and financial
  ratios
• To expand funding sources and broaden investor
  base

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What assets to securitise?

• Mortgages
• Credit card receivables
• Auto loans
• Corporate loans
• Any other assets with cashflow

5
Who are the major originators of securitisation
products in Hong Kong?

• The Government, the HKMC, banks, finance
  companies, property developers, etc.
• Hong Kong Mortgage Corporation (HKMC) is an
  active and a regular originator of MBS in the
  Hong Kong market

Source HKMC
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Major investors in securitisation products in
Hong Kong

• Retirement funds, investment funds, insurance
  companies, banks, etc.
• Growing in retirement funds demands more
  long-term HKD debts and securitised products

Source MPFA
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Regulatory framework for banks in Hong Kong

• Hong Kong is a forerunner in securitisation in
  Asia. The Hong Kong Monetary Authority (HKMA)
  issued a set of guidelines titled Supervisory
  treatment on asset securitisation and mortgage
  backed securities on 30 August 1997, which set
  out
• Supervisory tests (true sale tests) applied to
  asset securitisation for deciding whether the
  assets concerned can be excluded from the
  sellers balance sheet for capital adequacy
  purposes
• Criteria for MBS to qualify for 50 risk weight
• The guidelines will be replaced upon the
  implementation of the Basel II framework on
  securitisation on 1 January 2007.

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MAJOR SECURITISATION ISSUES FOR BANKS

• Implementation of the new International
  Accounting Standards (i.e. IAS27, SIC12 and
  IAS39)
• More complicated treatment of account
  consolidation for subsidiaries/SPEs and asset
  derecognition from balance sheet
• Implementation of Basel II in 2007
• More complicated structure in achieving economic
  capital allocation and credit risk transfer

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IAS 27 Applicable to securitisation SPEs

• Concept of control to determine consolidation of
  SPEs or subsidiaries
• Evidence of control more than 50 voting
  rights governing financial and operating
  policiesappointment of majority of board of
  directors
• Indicators of control by an entity over an SPE
  auto pilot mode decision making power over
  board/management right to enjoy majority
  benefits retention of majority of residual risks
  related to the SPE

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IAS 39 Derecognition of securitisation transaction
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Basel II Objectives

• Compared with Basel Accord established in July
  1988, Basel II can
• Better align regulatory capital to underlying
  risk
• Improve risk management capabilities of banks
• Provide a comprehensive coverage of risks

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Basel II Framework on Securitisation

• Choice of approach depends on
• Business focus
• Bank size and complexity
• Capability in setting up systems, modelling and IT

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Standardised Approach

• Amount of capital allocation for securitisation
  exposure depends on credit ratings
• Unrated securitisation exposures to be deducted
  from regulatory capital
• Exceptions
• (i) The most senior exposure in a
  securitisation
• (ii) Exposure in a second-loss position or better
  in ABCP programme
• (iii) Eligible liquidity facilities
• Standardised Approach preferred by small- to
  medium-sized banks

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Standardised Approach Risk Weight
External Credit Assessment (long-term rating) Risk Weight
AAA to AA- 20
A to A- 50
BBB to BBB- 100
BB to BB- 350 / Deduction
B and below or unrated Deduction
Note 350 for Investing Banks, deduction for
Originating Banks
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Internal Ratings-based (IRB) Approach

• More sophisticated and risk sensitive than the
  standardised approach
• Three-tier IRB approach to risk assessment

Rating-based Approach (RBA) For rated securitisation exposure External ratings Inferred ratings
Supervisory Formula Approach (SFA) For unrated exposure KIRB and Supervisory Formula
Internal Assessment Approach (IAA) For unrated liquidity facilities and credit enhancements related to ABCP programmes Exposures at least be investment grade at the beginning of the transaction Based on Rating Agencies methodologies Internal assessment is mapped to an equivalent external credit rating
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Internal Ratings-based ApproachRating-based
Approach - Risk Weights
External Rating (Long-term rating) Risk weights for senior positions and eligible senior IAA exposures Base risk weight Risk weight for tranches backed by non-granular pools
AAA 7 12 20
AA 8 15 25
A 10 18 35
A 12 20 35
A- 20 35 35
BBB 35 50 50
BBB 60 75 75
BBB- 100 100 100
BB 250 250 250
BB 425 425 425
BB- 650 650 650
Below BB- and unrated Deduction Deduction Deduction
Note Banks may apply the risk weights for senior
positions if the effective number of underlying
exposures (N) is 6 or more and the position is
senior. If N is less than 6, the risk weights
under Column 4 of the above table apply. In all
other cases, the risk weights in Column 3 of the
above tables apply.
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Internal Ratings-based approachSupervisory
Formula Approach

• Under Supervisory Formula Approach, capital
  charge for a securitisation tranche depends on
  five factors
• The exposures thickness (T)
• Ratio of nominal size of the tranche in question
  to the notional amount exposures in the pool
• Credit enhancement level (L)
• Ratio of the amount of all securitisation
  exposures subordinate to the tranche in question
  to the amount of exposures in the pool
• The pools reference capital charge (KIRB)
• Ratio of IRB capital requirement including
  expected loss portion for the underlying
  exposures in the pool to the exposure amount of
  the pool
• The pools exposure-weighted average
  loss-given-default (LGD)
• The pools effective number of exposure (N)

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Internal Ratings-based approachInternal
Assessment Approach

• Only for unrated liquidity facilities and credit
  enhancements related to ABCP programmes
• A bank may use its IAA model to evaluate the
  credit quality of the securitisation exposure it
  extends to ABCP programme if the assessment
  process meets the operational requirements
• Internal assessments of exposure provided to ABCP
  programmes must be mapped to equivalent external
  ratings
• Those rating equivalents are used to determine
  the appropriate risk weights under the RBA

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Internal Ratings-based approachInternal
Assessment Approach

• Major operational requirements for internal
  assessment process
• ABCP must be externally rated
• The credit quality of the exposures must at least
  be investment grade at the beginning of the
  transaction
• The internal assessment process must be based on
  the rating agencies methodologies
• The internal assessment process must identify
  gradation of risk
• Banks must perform regular reviews of the
  internal assessment process and assess the
  validity of those internal assessments
• The bank must track the performance of its
  internal assessments over time to evaluate the
  performance of the process and make adjustment,
  if necessary

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Internal Ratings-based approachInternal
Assessment Approach

• Major operational requirements (Continued)
• ABCP must have credit and investment guidelines,
  i.e. underwriting standards
• Credit analysis of the asset sellers risk
  profile must be preformed
• Underwriting policy of ABCP programme must
  establish minimum asset eligibility criteria
• The ABCP programme should have processes
  established to consider the operational
  capability and credit quality of the servicer
• The ABCP programme must consider all sources of
  potential risk in estimating of loss on an asset
  pool
• ABCP programme must incorporate structural
  features into the purchase of assets in order to
  mitigate potential credit deterioration of the
  underlying portfolio

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ISSUES AND IMPLICATIONS

• Accounting standards constraining securitisation
  possibilities
• Regulatory authority for banks treatment of
  IAS-induced changes
• Basel II for better or for worse
• More incentive for elaborate securitisation
  structure to optimise use of risk capital
• Maximise the size of investment grade tranches
  and minimise the size of sub-investment grade
  tranches, particularly equity positions, to
  reduce the utilisation of risk capital

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More issues

• Need clear guidelines on whether significant
  risk transfer takes places
• Need articulation of implicit support
• Selection of appropriate elements of IRB approach
• Banks may be pressured to sell sub-investment
  grade tranches to market participants not bound
  by Basel II

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END OF PRESENTATION

• THANK YOU
• James_H_Lau_at_HKMC.COM.HK