The capital requirements in the Capital Requirements Directive 2 (CRD2) and CRD3 amendments to the Basel Accords, which are being introduced through 2011 and 2012, look positively draconian when compared to previous legislation. In what represents a double whammy for companies seeking finance, Basel III raises capital ratios significantly (see Table 1), aiming to incentivise banks to enter into lower risk investments to reduce their capital requirements, while the potential penalties for banks engaging in the securitisation and re-securitisation market are hefty.
Moreover, the approach introduced by CRD3 stipulates punitive capital requirements, up to and including capital deductions for securities rated B+ and below. This means that capital requirements for re-securitisations – i.e. transactions where one or more of the underlying exposures is a securitisation exposure – are now roughly double those of securitisations.
Securitisation, which involves long-term bonds being issued backed by cash flows from company assets, was perceived as a major factor contributing to the financial crisis due to the increasingly complex and opaque structures it resulted in. Indeed, Guy Hands once described it as the “crack cocaine” of the financial services industry. An erstwhile pioneer of securitisation, Hands secured the £4bn takeover of EMI in a deal financed with £2.6bn of debt from Citigroup, but was recently forced to cede control to the latter, because the fallout from the credit crisis subsequently prevented Citigroup from selling on any of these loans.
The Rising Cost of Risk
The new capital and liquidity standards for the banking system confirmed in September 2010 make it much more expensive for lenders to hold riskier positions such as securitised products on their balance sheets, or as special purpose off-balance-sheet vehicles. Developed by the Basel Committee on Banking Supervision, the Basel III designation provides a comprehensive set of reform measures designed to strengthen the regulation, supervision, and risk management of the banking sector, and means that the cost of lending is going up, regardless of the creditworthiness of counterparties.
Basel III introduces stronger supervision, risk management, and disclosure standards, with a strengthened Pillar 2 supervisory review process of the Basel capital framework, including in the areas of corporate governance, risk appetite, risk aggregation, and stress testing. Pillar 3 transparency requirements have also been increased for more complex capital markets activities. For example, Basel III includes some specific changes to banks’ treatment of securitisation exposures when calculating their capital requirements, including:
- The application of up to 1250% risk weight to some lower-rated and unrated securitisation exposures.
- The introduction of more conservative collateral haircuts for securitisation collateral with respect to counterparty exposure.
- The introduction of specific risk haircuts for securitisation exposures when calculating the capital requirement related to market risk.
National implementation of Basel III begins on 1 January 2013, at which point, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):
- 3.5% common equity/RWAs.
- 4.5% Tier 1 capital/RWAs.
- 8% total capital/RWAs.
During the pre-crisis years, banks relied heavily on the securitisation market to transfer the risk of loans and mortgages to investors, thus reducing their own balance sheet exposure and allowing them to issue more loans. Post-crisis, there has been a dramatic decline in collateralised debt obligations (CDO) trading activity, and securitisation markets have failed to return to previous levels. Rules for securitisation weights introduced by CRD3, for example, and continued through the implementation of Basel III, could provide the final nail in the coffin for the previously lucrative securitisation market, which has been in decline since 2006 (see Figure 1).
Given that secured and unsecured loans of all purposes, mortgages, credit card debt, and many other debt obligations have in recent years been packaged in CDOs, the fact that CDO origination is almost non-existent will continue to place downward pressure on the availability of the underlying products. Abandoning the securitisation model will see banks engage in more active portfolio management of bilateral lending, rather than the herd investment strategy brought about by securitisation, making it more difficult for a corporate customer to issue new bonds, all the way down to a retail customer being denied a mortgage or credit card. The RMBS market has also effectively stalled, making it difficult for a bank to transfer new mortgage-related credit risk, thus reducing its leverage in the market and, ultimately, the funds that it can offer for borrowing.
Given these factors, the CDO markets, and the CDON markets in particular, look set to remain on their downward spiral. Upon maturity, it seems highly likely that banks will exit these troublesome asset classes altogether. To all intents and purposes, the means for an investor to participate in lending to businesses through these models is therefore at an end. Disintermediation may become a trend, leaving firms to issue their bonds bilaterally, outside of a securitisation model. Those investors subject to Basel rules and not able to rely on a securitisation vehicle to spread their risk will demand a higher premium for their investment. Hedge funds and other shadow-banking institutions are likely to step into the gap to pick up business that, when taking capital allocation into account, does not make economic sense for a bank.
Alternate Incentive Models
Despite the prospect of Basel III securitisation risk-weighted asset rules leading to an exit of the securitisation business by investment banks, there are a number of models that could revitalise the sector. For example, direct exposure – i.e. bilateral lending – between a single-name corporate and a bank or other financial institution seeking to invest remains a viable avenue. However, the undertaken single-name exposure comes at a price – that of counterparty credit risk (CCR). Basel III will strengthen the capital requirements for counterparty credit risk exposures on the trading book arising from derivatives, repos and securities financing activities. This charge, calculated as counterparty value adjustment (CVA), is by definition the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. It can therefore be said to be the price of hedging default risk.
Although capital charges for CVA not applicable to the banking book, banks will seek to protect themselves from CCR when lending bilaterally. By using models similar to those used to calculate Trading book-CVA charges introduced by CRD4 and Basel III, they will seek to pass the cost of CCR protection to their customers. While some of this may be removed by the economies of hedging across multiple customers, and by banks absorbing the risk themselves, it is fair to assume that banks will seek to pass this cost on to corporate clients either through a higher yield on coupon payments, or more onerous covenants on loans.
The intended incentivisation model that this amounts to for a bank is to loan with low risk – i.e. act ultra-conservatively. With the reduced profitability of low-risk investments, higher volumes will be one way banks could increase profitability. Concentration risk becomes a significant issue for banks in this scenario, and an area that, although not addressed directly by Basel III, is likely to become an important part of a bank’s risk agenda.
While the very largest corporations will still be able to issue bonds on favourable terms, others may struggle to attract take-up of bonds issued outside of a portfolio, or securitisation. For small and medium sized firms, whose CCR may fall into an unrated bracket, the cost of borrowing will increase, since all but the highest funded banks or most risk-taking hedge funds will steer away from this market segment. Retail customers will be further squeezed, with only those with favourable credit ratings and history with a financial institution likely to be offered satisfactory borrowing terms. As of 1 February 2011, typical APRs quoted by banks in retail sector marketing need only apply to 51% (down from 66%) of applicants (European Consumer Credit Directive 2008). Banks will exploit this as means to advertise a rate that many customers simply will not be able to borrow at.
Factoring a Further Alternative
Factoring, which is simply explained as swapping discounted accounts receivables (A/R – credit) for cash, is a growth area that could benefit from securitisation’s decline (see Figure 2). Factoring without recourse (i.e. where the factoring agency assumes the default risk of the underlying credit) resembles securitisation – but with a vital difference: it does not involve the issuance of back-to-back bonds (and hence debt). Instead, a lump sum is paid up front, realising the fund-raising needs of the client, which is reclaimed as the factoring arrangement matures.
Factoring is most beneficial to companies that have a large invoice-to-customer ratio, such as those involved in manufacturing, transport, distribution, or wholesaling. The benefits to these companies are clear: they can turn credit into cash quickly and, crucially, avoid surrendering equity or incurring new debt in doing so. Following a ‘without recourse’ model affords certainty of funding, although it comes at the price of transferring default risk to the factoring agency.
Banks or other funding vehicles investing in a diversified array of factoring arrangements can spread their risk over multiple geographies and industries and thus reduce their concentration risk in this asset class. Factoring is also popular in emerging and high-growth markets, as companies seek to gain a predictable revenue stream to enable expansion. This allows banks to gain exposure to the lucrative, but riskier, emerging markets. The default risk associated with these assets should be accounted for by incrementing and advancing existing CVA methodologies to pass the appropriate charges to clients. Crucially, these investments in the above structures are not classed as securitisations, and do not carry the associated capital burdens.
Paying the Price
Basel III is intended to, and will likely succeed in, deleveraging the amount of debt origination by banks and encourage a return to more ‘traditional’ banking. The securitisation market shows no signs of resurrection, with those still in-service being the highest quality on the market (since the rest have defaulted). In the name of stability, an actively managed portfolio of direct investments and loans by a bank will promote more diligent risk management than the risk-transfer policies of the past.
Factoring provides a method for banks to engage in this model, and many of the benefits of securitisation that attracted vast quantities of clients remain. At the same time, more traditional default risk management will be required to manage such a portfolio. Ultimately, this cost will be transferred to customers. For large players in particular, more active counterparty risk management and CVA (or CVA-like) charges will become the norm. Retail customers however, who individually have the most to lose, may be hit hardest by the increased interest rates.
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