by Joshua Ronen and Marti Subrahmanyam
The recently proposed Senate Banking Committee bill requires ". . . any securitizer to retain an economic interest in a material portion of the credit risk for any asset that the securitizer . . . transfers, sales, or conveys to a third party" without the ability of hedging the retained interest. The retained interest is generally required to be at least 5% of the credit risk of the transferred assets with few exceptions. A somewhat similar provision is contained in the House Bill. How will this requirement affect the access to loans by consumers and investors?
Securitization refers to the process by which consumer and business assets, such as mortgage and credit card loans, are pooled and securities are issued in the capital markets against these assets. Securitization has played an expanding role in the US economy, growing over the past 25 years to an important source of credit. The International Monetary Fund recognizes this in its Global Financial Stability Report when it states that "restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis."
The problems with securitization arose because the assets' risk was often transferred with the originators having no skin in the game and hence little or no incentive to apply adequate underwriting standards. The Senate Bill thus rightly requires skin in the game and properly accords regulators discretion to require less than 5% when risk-limiting regulatory underwriting standards are complied with. The flexibility inherent in the regulators' discretion, used appropriately, mitigates the arbitrariness of the 5% rule.
While originators/securitizers had no apparent skin in the game, however, many financial institutions effectively retained risk through explicit or implicit credit enhancements or recourse that are subject to more lenient regulatory capital requirements. This enabled financial institutions to maintain less capital, therefore substantially increasing their leverage. These institutions then became more vulnerable to the decline in housing prices and the ensuing credit freeze, with adverse consequences for systemic risk.
Ironically, however, recent regulatory rules intended to deter the past under-capitalization enabled by securitization, have swung to the other extreme, essentially requiring over-capitalization, which in turn increases the cost of securitization and thereby reducing the availability of credit. While, by doing so, regulators may accomplish the narrow objective of keeping banks safer, they jeopardize recovery by constricting the flow of credit.
Over-capitalization is the result of the regulators having recently ruled that regulatory capital in securitizations be based on the recently issued Financial Accounting Standard Board (FASB) 167, while reserving the right to include in the determination of regulatory capital even assets and liabilities not required to be brought onto the balance sheet under FASB 167.
To clarify, the FASB 167 rule essentially requires that securitizers bring back onto their balance sheets all the assets and liabilities of most of the off-balance-sheet entities sponsored to implement the securitization. At the same time, FASB 167 provisions require a separate presentation in the balance sheet of assets dedicated to the settlement of obligations of the off-balance-sheet entity and of liabilities with no recourse to the financial institution, and hence imposing no risk on the institution.
Unfortunately, the banking regulators have omitted reference to the above provisions and instead have stipulated that all assets and liabilities that are brought onto the institution's balance sheet be used in computing required capital. This stipulation has far-reaching implications: increasing required capital to an extent that is bound to deter securitizations and consequently lending -- severely impeding economic recovery. It could also compromise the competitiveness of US financial institutions vis-à-vis foreign institutions that are not subject to similar over-capitalization requirements.
Given the importance of this issue, we feel it should be addressed directly in the proposals. The basic rule of thumb should be that every $ of economic interest in the securitization, that $ should face the full capital requirements by law. But if the credit risk has truly been transferred, then no capital should be required.
Regulators should and can assess on a case-by-case basis whether non-contractual implicit risks are assumed and capital requirements can be accordingly adjusted. Indeed this would be in line with the Basel Committee on Banking Supervision recommendation that "if at inception or at any point during the life of a special purpose entity (SPE) there is a likelihood or evidence of support by the financial firm, including non-contractual support, then the activities and risks of that SPE should be aggregated with those of the institution for both supervisory assessment and internal risk management purposes". Another alternative we recommend considering with respect to a non-contractual support is that institutions be allowed to commit themselves not to absorb non-contractual risks or losses, under the pain of a penalty. Such a commitment would then exonerate the institution from the capital charges.