The Federal Reserve’s Basel Coordination Committee has issued guidance regarding supervisory expectations for determining the capital requirements on the underlying exposures (KIRB) input to the Supervisory Formula Approach (SFA) for securitization exposures and the flexibility afforded to advanced approaches banking organizations when dealing with data limitations. Federal Reserve and OCC staff worked together on the development of this guidance.
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 (IRB) 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 final rule revises the advanced approaches capital rules to implement Basel III and certain provisions of the Dodd-Frank Act.
SFA: The SFA is one of several approaches in the advanced approaches capital rules for calculating risk-weighted assets for securitization exposures. To implement the SFA for a given securitization exposure, an advanced approaches banking organization must calculate several input parameters: the exposure’s credit enhancement level (L) and thickness (T); the exposure-weighted average loss given default (EWALGD) for the underlying exposures to the securitization transaction; the effective number (N) of underlying exposures; and KIRB. The guidance sets forth supervisory expectations for calculating KIRB.
KIRB: The Federal Reserve observed that calculating KIRB is often the greatest challenge faced by advanced approaches banking organizations when attempting to implement the SFA. KIRB is defined as the ratio of (A) the capital requirement for the underlying exposures, defined as the sum of the risk-based capital requirements for the underlying exposures plus the expected credit losses of the underlying exposures (as determined under the advanced approaches capital rules as if the underlying exposures were directly held by the advanced approaches banking organization) and (B) the amount of the underlying exposures.
Calculating the capital requirement for the underlying exposures (A) can be challenging because banking organizations often do not originate, service or hold the exposures that underlie the securitization transaction. Unlike other input parameters to the SFA, which often can be derived from servicer reports or other sources of information, the calculation of the capital requirement for underlying exposures that are wholesale or retail credit exposures generally relies on detailed information about the individual underlying exposures and a relevant reference data set from which to quantify IRB approach parameters.
U.S. Banking Agencies Recognize Challenge in Calculating KIRB: The preamble to the original 2007 adopting release of the advanced approaches capital rules noted the need for flexibility when evaluating a banking organization’s process for calculating KIRB: “The [U.S. banking] agencies recognize that, in light of data shortcomings, a bank may have to use approaches to estimating KIRB that are less sophisticated than what the bank might use for similar assets that it originates, services, and holds directly. Supervisors generally will review the reasonableness of KIRB estimates in the context of available data, and will expect estimates of KIRB to incorporate appropriate conservatism to address any data shortcomings.”
Basel Coordination Committee Implementation Guidance: The Basel Coordination Committee’s guidance provides that, when determining the KIRB input, an advanced approaches banking organization must adhere to requirements for determining risk-based capital for the underlying exposures, employing sound modeling techniques and using all relevant data that is reasonably obtainable. While advanced approaches banking organizations’ processes for determining KIRB for wholesale and retail underlying exposures must attempt to produce accurate parameter estimates, supervisors recognize that, in many instances, reasonably obtainable exposure and reference data may have limited relevant information.
The guidance goes on to provide that an advanced approaches banking organization must make a good faith effort to obtain data to support its risk quantification processes, including risk characteristic information on the underlying exposures to support the segmentation of exposures by risk and relevant reference data to support sound risk quantification. In some instances, to obtain such data an advanced approaches banking organization may need to explore sources of available information on underlying exposures beyond what is contained within servicing reports, or use the organization’s own historical loss experience for similar types of exposures as a source of relevant reference data.
Given data limitations that introduce material uncertainty and less confidence in the accuracy of the KIRB input, the guidance states that an advanced approaches banking organization is expected to demonstrate that its process for determining KIRB incorporates appropriate conservatism. Consistent with existing supervisory guidance that addresses conservatism when estimating parameters under the IRB framework (Federal Reserve Basel Coordination Committee Bulletin 13-5, Applying the Requirement for Conservatism in Basel II Risk Parameters, (May 2, 2013), available here), this process must be well documented and independently validated. Additionally, consistent with that supervisory guidance, the process should be empirically grounded.
Federal Reserve Basel Coordination Committee Bulletin 13-7, Implementing the Supervisory Formula Approach for Securitization Exposures (Oct. 28, 2013) available here: http://www.federalreserve.gov/bankinforeg/basel/files/bcc1307.pdf