The Federal Reserve’s Basel Coordination Committee has issued guidance to advanced approaches banking organizations with respect to excluding certain exposures to investment firms from the definition of “traditional securitization” in the advanced approaches capital rules. This blog post focuses on the exclusion for investment firms that exercise unfettered control over their underlying exposures.
Background: The advanced approaches capital rules, originally adopted by the U.S. banking agencies in 2007, apply to the largest and most internationally active U.S. banking organizations (advanced approaches banking organizations) and implement the Basel capital framework’s internal ratings-based approach for calculating risk-weighted assets for credit risk and advanced measurement approaches for calculating risk-weighted assets for operational risk. Subject to a number of rigorous qualitative and quantitative requirements, the advanced approaches capital rules permit banking organizations to use supervisor-approved, internally-developed models and methodologies to calculate risk parameters used to determine risk-weighted assets. The U.S. Basel III proposals would revise the advanced approaches capital rules to implement Basel III and certain provisions of the Dodd-Frank Act.
Definition of “Traditional Securitization”: Under the advanced approaches capital rules, the definition of traditional securitization captures a broader set of exposures than those commonly understood by banking organizations and other market participants to be a securitization. For example, certain exposures to investment firms may meet this definition because exposures to these entities may involve the tranching of credit risk. The Federal Reserve deliberately defined traditional securitization broadly in order “to create a level playing field across the securitization, credit derivative, and other financial markets.”
Exclusion for Investment Firms that Exercise Unfettered Control over their Underlying Exposures: The advanced approaches capital rules provide a banking organization’s primary federal banking regulator with discretion to exclude from the definition of “traditional securitization” investment firms that exercise substantially unfettered control over the size and composition of their assets, liabilities and off-balance sheet transactions. The U.S. banking regulators have stated that they will consider a number of factors in the exercise of this discretion, including an assessment of the investment firm’s leverage, risk profile, and economic substance. This supervisory exclusion is intended to provide discretion to a banking organization’s primary federal banking regulator to distinguish structured finance transactions, to which the securitization framework was designed to apply, from more flexible investment firms such as many hedge funds and private equity funds.
Basel Coordination Committee Implementation Guidance: The guidance provides that, based on experience with exposures involving certain investment firms, Federal Reserve staff would recommend that the Federal Reserve determine that a full recourse exposure to an investment firm would not be considered a traditional securitization based on the transaction’s leverage, risk profile, and economic substance if all of the following criteria are satisfied:
- The investment firm is actively managed by one or more investment advisers such that the composition of its investment portfolio can change over time in furtherance of the firm’s investment strategy, and is not static;
- The investment firm, as managed by its investment adviser, retains broad discretion to execute or change the manner in which it executes its investment strategy, including with respect to the composition of its investment portfolio and the type and amount of leverage employed in its investment strategy;
- The investment firm, as managed by its investment adviser, retains broad discretion to use a variety of instruments and transactions to execute its investment strategy;
- The investment firm, as managed by its investment adviser, has the broad discretion and ability to control the size of the firm through the issuance of variable amounts of debt, or through the issuance and redemption of shares or ownership interests; and
- The investment firm, as managed by its investment adviser, retains broad discretion to distribute or reinvest cash proceeds generated by the firm’s underlying assets.
If all of these criteria are satisfied, an advanced approaches banking organization would be allowed to treat the exposure as an equity or wholesale exposure under the advanced approaches capital rules. If these criteria are not satisfied, a banking organization would be required to (1) otherwise demonstrate to the satisfaction of the Federal Reserve that the transaction should not be considered a traditional securitization or (2) use the hierarchy of approaches for securitization exposures to determine the risk-based capital requirement associated with the exposure.
Federal Reserve Basel Coordination Committee Bulletin 13-2, Excluding Exposures to Investment Firms from the Definition of “Traditional Securitization” (Mar. 21, 2013) available here: http://www.federalreserve.gov/bankinforeg/basel/files/bcc1302.pdf