Basel 2.5: US ratings workaround criticised

US regulators published a proposal in December that would enable domestic banks to implement market risk capital rules without relying on credit ratings. But bankers claim the rules are overly conservative and put them at a competitive disadvantage. Do they have a point? Mark Pengelly investigates

US supervisors made what seemed like an important breakthrough at the end of last year. Having been forced to delay full implementation of Basel 2.5 due to a Dodd-Frank Act requirement that forces them to remove any reference to credit ratings from their regulations, they finally came out with a proposed workaround in December – one that would allow US banks to implement the Basel 2.5 rules on securitisation and resecuritisation exposures, as well as other ratings-dependent elements of the Basel framework.

The problem – if US banks are to be believed – is that the new proposal is overly conservative, creates inconsistencies with other jurisdictions and puts an unfair burden on smaller banks. Some go even further: the new rules will lead to punitive capital requirements that will put US firms at a competitive disadvantage, and may even kill off the domestic securitisation market, they claim.

“These proposals will lead to higher capital charges, creating an overall regulatory capital charge that is too punitive,” says a senior executive at a US bank.

But finding an alternative way to implement those parts of the Basel framework that rely on ratings inputs was never going to be easy. US supervisors released a notice of proposed rule-making in January 2011 that covered various revisions to the Basel market risk framework, including Basel 2.5, but ducked out of proposing a solution to the ratings-based elements.

When it comes to Basel 2.5, it meant there was no proposal for the treatment of securitisation and resecuritisation positions. In its revisions to the market risk framework in July 2009, the Basel Committee on Banking Supervision ruled that banks would not be allowed to model specific risk for rated securitisation and resecuritisation exposures, but instead must use risk weights based on credit ratings. For unrated positions, banks with approval to run the internal ratings-based (IRB) approaches for the asset classes underlying the exposure have to apply a so-called supervisory formula approach – essentially, a method that requires a number of inputs, including the IRB capital charge had the underlying exposures not been securitised, the credit enhancement and thickness of the tranche, and the exposure-weighted average loss given default of the pool. Those firms without IRB approval simply had to make a deduction from capital for unrated exposures.

The December 7 proposal from the Office of the Comptroller of the Currency (OCC), the Department of the Treasury, Federal Reserve Board and Federal Deposit Insurance Corporation (FDIC) basically adapts the supervisory formula approach and applies it to both rated and unrated securitisation and resecuritisation exposures. Called the simplified supervisory formula approach (SSFA), the method uses several key inputs: the weighted average capital requirement under the general risk-based capital rules that would be assigned to the underlying exposures if they were held directly by the bank; the attachment and detachment points; and the cumulative losses on the underlying pool. The formula also includes a supervisory calibration parameter, set at 0.5 for securitisation positions and 1.5 for resecuritisation positions.

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Basel 2.5: US ratings workaround criticised