Posted by Mark Daley on 30 November 2022
Tagged to Basel, regulatory, Securitization

Readers will know about the looming problem of the output floor: a floor under the capital requirements calculated under the Internal Ratings Based Approach. Once fully phased in, it will require that capital requirements under the IRBA may not be less than 72.5% of those calculated using the Standardised Approach. It is due (in accordance with the Basel Framework) to be phased in between 1 January 2022 and 1 January 2027, although the EC has proposed a delayed transitional timetable, and so has the Bank of England/PRA which, on 30 November 2022 issued a consultation proposing that the output floor is phased in over the same transitional period as the EU

1 January 2025 - 50%
1 January 2026 - 55%
1 January 2027 - 60%
1 January 2028 - 65%
1 January 2029 - 70%
1 January 2030 - 72.5%

The PRA says that its proposals contain "limited adjustments to the Basel 3.1 standards to reflect the specific characteristics of the UK where those could better capture risk and support the competitiveness and relative standing of the UK" but that overall its proposal "is consistent with the vast majority of major financial jurisdictions, including for example Australia, Canada, Hong Kong, Singapore and Switzerland". It notes that the USA has not issued its proposals yet, and that the EU proposals "include a number of deviations from the Basel 3.1 standards as part of multi-year transitional arrangements which may be extended subject to further reviews".

The output floor is controversial because, since the IRB reflects the actual experience of the bank in question, in comparison to the one-size-fits-all categories of the SA, a floor based on the SA risk weights (even at 72.5% of them) will require excessive amounts of capital to be allocated to exposures and, since capital has a cost, this either reduces the return on that exposure, or requires it to be repriced and so to become more expensive, and incentivises a bank to remove these assets from its balance sheet and disincentivises a bank from doing that form of lending in the future. There are several ramifications of this, and one particular example concerns credit risk for mortgage loans held on an originating bank’s book in countries like the Nordics, Holland, Germany and (to a degree) France, where culturally and traditionally residential mortgage lending has been conservative and LGDs have been low, and so the IRB capital is too. The SA weight for residential mortgages of 35% was apparently set based on the experience of US residential mortgage lending, and so the argument is that this is unfair for non-US exposures because US mortgage loans have a significant difference from those in the UK and EU, in that they are non-recourse to the borrower - a borrower who cannot repay is entitled to walk away and hand over the keys to the lender; whereas in the EU and UK, the debt obligation binds the borrower until it is fully repaid (or until the borrower goes bankrupt); and, in addition, because initial underwriting criteria such as LTV and income cover may well have been historically more conservative than in the USA (especially in the years leading to the sub-prime crisis).  

The Bank of England 30 November 2022 proposal notes that the IRB can "often generate significantly lower risk weights than the SAs for similar exposures" and it then draws the debatable conclusion that output floor "would support competition" by narrowing the gap between the IRB and the SA.  Query what Adam Smith would have said about increasing competition by forcing more sophisticated market participants to use a less accurate and unsophisticated risk analysis and so forcing them to apply excessive amounts of risk capital to risk assets?

The PRA is going to engage with firms originating SRT securitisations “to understand the impact of the proposed use of standardised methodologies for securitisations for the purposes of the output floor…  [and] with regards to the risk-sensitivity of the SEC-SA relative to the SEC-IRBA, and how the use of the SEC-SA in the output floor calculation may impact the origination of SRT”.

This follows shortly on from a November 2022 AFME-commissioned 70-page number-crunching analysis, “Impact of the SA Output Floor on the European Securitisation Market”, which demonstrated that:

“Corporate securitisations, both for large corporates and SME portfolios, will be largely eliminated by the introduction of the Basel SA Output Floor as currently envisaged.  This could contribute to a significant reduction in the availability of bank funding to European firms…”, “Existing transactions done for risk management purpose, especially corporate ones, are likely to fail the EU Significant Risk Transfer (SRT) test applied by supervisors and, hence, will have to be terminated...”, and “the SA Output Floors regime will encourage greater securitisation activity in residential mortgage and other retail loan portfolios because the increase in capital for loans held on balance sheet will exceed, sometimes disproportionately, that of securitised assets”.

It went on:

“The floor will affect both the capital (under IRBA and SA rules) that the bank must hold if it retains the risks on the loans, as well as the required capital (again under IRBA and SA securitisation rules) for retained tranches of securitisations…  In effect, the impact on securitisations is a ‘horse race’ between the increase in capital for on-balance-sheet loans and the capital increase for retained securitisation positions. How this ‘horse race’ turns out for a particular sub-category of loans depends crucially on the risk parameters of the loans involved, namely the PDs and LGDs. These risk parameters are specific to asset classes and countries because the loan markets in given countries have generic characteristics (high or low PDs or high or low LGDs). They are also bank specific as each IRB bank has its own IRB models”.

It commented that “… few participants in the public debate on CMU appear to understand the likely consequences of SA Output Floors…  the implementation of the SA Output Floors will disfavour one asset class substantially while benefiting another asset class with no clear rationale policy priorities. This is a consequence of adopting regulatory rules that are not soundly rooted in an understanding of the relatively riskiness of different asset classes”. We have to hope that the regulators will take heed of the representations they will be receiving on this subject.

The authors

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