Today, the Office of the Comptroller of the Currency (“OCC”) issued a regulatory capital bulletin (“Bulletin”) stating that the OCC, the Federal Reserve Board, and the Federal Deposit Insurance Corporation have developed an automated tool to help national banks and federal savings associations calculate risk-based capital requirements for securitization exposures. This automated tool is not mandatory and is not a component of regulatory reporting. It is available for all banks that use the simplified supervisory formula approach to calculate associated capital requirements.
When Basel III became effective on January 1, 2015, banks could no longer use a “ratings based” approach for assigning risk-based capital requirements to securitization exposures because Section 939A of the Dodd-Frank Act prohibits reliance on external credit ratings. With the elimination of the “ratings-based” approach, banks are now required to calculate their risk weights internally and are given the option to use the simplified supervisory formula approach (“SSFA”) for this purpose. Although Basel III places banks in different categories for purposes of determining their approach to calculating risk-weighted assets, the SSFA is available to be used by a bank regardless of whether it is an “advanced approach” banking organization or one that qualifies for the “standardized approach.” The SSFA starts with a baseline capital requirement that is based on the risk weights that apply to the exposures underlying a securitization and then adjusts those risk weights based on the level of subordination of a bank’s investment within the structure of a securitization. A 20% floor has been established as a minimum risk weight for any securitization exposure, regardless of the underlying credit risk. According to the Bulletin, the SSFA “is designed to apply relatively higher risk-based capital requirements to the more risky junior tranches of securitizations, which are the first to absorb losses, and relatively lower requirements to the most senior tranches.”
Securitization Due Diligence Requirements
One of the reasons that Section 939A of the Dodd-Frank Act was enacted was to prevent banks from relying excessively on credit ratings in determining their securitization exposures. As a result, Basel III also requires banks to satisfy specific due diligence requirements for securitization exposures. A bank must demonstrate to the satisfaction of its regulator that it has a comprehensive understanding of the risks in a securitization transaction that would materially affect its performance. Specifically, a banking organization must consider the following as part of its due diligence review:
* Structural features of the securitization that materially impact the performance of the transaction;
* Information regarding the performance of the underlying credit exposures;
* Relevant market data for the securitization; and
* For resecuritizations, performance information on the underlying securitization exposures.
If a banking organization cannot satisfy these due diligence requirements to the satisfaction of its regulator, Basel III imposes a 1,250% risk weight to the exposure by default. When the due diligence requirements were first proposed, many commentators criticized these due diligence requirements as difficult for regulators to consistently enforce and potentially difficult for banks to meet if data is unavailable or unreliable. Notwithstanding the criticism, these requirements were adopted and the OCC bulletin makes clear that regulators “continue to expect banks to have a comprehensive understanding of their securitization exposures and to meet all due diligence requirements.”
Reducing a Bank’s Regulatory Burden
The purpose of the automated tool is to help reduce the burden on banks in having to internally calculate the risk-weights for securitization exposures. The tool requires five inputs that are considered by the OCC to be typically available to investors to calculate the minimum required risk-based capital for a securitization exposure. The tool also requires certain manual inputs which are based on the requirements in Basel III. Note, however, that this automated tool can only be used for those banks that use the SSFA to calculate the risk-weight of its securitization exposure. As an alternative to the SSFA, banks may also have the option to apply the approach previously used by the banking regulatory agencies under Basel II. This approach determines an asset’s percentage risk-weight based on the amount of senior tranched assets in the securitization that the bank directly or indirectly supports. This risk-weight is then included in a formula to calculate the risk-weight of the securitization exposure for the bank’s capital requirements. Given the complexity involved in determining many of these “inputs” for purposes of calculating the risk-weights of securitizations, it is too early to tell how much this automated tool will truly reduce the regulatory burden on banks.