Capital allocation for securitizations with uncertainty in loss prioritization - Basel Committee - December 2002

This paper sets forth a simple method for estimating the credit risk economic capital associated with securitization exposures, which are defined as credit exposures created by repackaging the cash flows from a pool of assets into various tranches or asset-backed securities. Our approach is motivated by the need for an effective and easily implemented regulatory capital rule for securitization exposures. Consequently, it is designed to be fully compatible with the model underpinning the Basel Committee’s (2001) proposed Internal Ratings-Based Approach (“IRBA”) to regulatory capital requirements against whole loans and other bank assets. Cost-effective application to a wide variety of securitizations and participating institutions dictates that our approach be parsimonious, in the sense of using minimal information on the contents of the securitized pool and on the contractual design of the securitization, as well as computationally tractable. The role played by securitizations in unraveling the 1988 Capital Accord demonstrates the need for a regulatory capital regime that is based on an internally consistent approach to quantifying portfolio credit risk. Since 1988, securitizations have become a major funding vehicle and portfolio risk management tool for banks. Concurrently, however, banks also have learned to exploit inconsistencies within the current Accord, under which credit risks assumed through securitization transactions often entail much lower regulatory capital charges than similar risks assumed through traditional loan portfolios (see Jones 2000). Curtailing such regulatory arbitrage, while at the same time encouraging the effective hedging of credit risks through securitization and other techniques, are primary objectives behind the Basel Committee’s efforts to revamp the Accord. The model foundation for the IRBA is a special case of the class of credit-VaR risk models exemplified by CreditMetrics (Gupton, Finger and Bhatia 1997) and KMVs Portfolio Manager (Kealhofer and Bohn 2001). Economic capital is set to cover total mark-to-market credit losses over a one-year horizon with probability q.1 It is assumed (1) that the credit portfolio is infinitely fine-grained in the sense that any single obligor represents a negligible share of the portfolio’s total exposure, and (2) that a single, common systematic risk factor drives all dependence across credit ∗The opinions expressed here are those of the authors, and do not reflect the views of the Board of Governors or its staff. We thank Erik Heitfield and William Perraudin for helpful comments. In this context, credit losses reflect valuation changes that result from credit quality migrations or defaults by obligors, but exclude valuation changes arising from general movements of interest rates and the market price of risk.