Global banking regulators have proposed a new framework for banks to calculate potential losses on asset-back securities that aims to reduce their automatic reliance on credit ratings agencies whose assumptions proved far too optimistic and contributed to the severity of the global financial crises.
The Basel Committee on Banking Supervision said the proposal - "Revisions to the Basel Securitisation Framework - did not include a specific text but was a revision to the framework. The Committee is now asking for industry feedback and will carry out an impact study of the proposals before deciding on the "definite way forward."
The popularity of securitised debt, such as mortgage-backed securities, exploded in the last decade but the financial crises revealed that banks and ratings agencies severely underestimated the expected loss in underlying exposures and the concentration of systemic risk. They were also far too optimistic in their view of the benefits to banks of such diversification.
As the crises started to unfold in 2007, it became clear that capital requirements assigned to both highly-rated and low-rated securitised products were too low. So when ratings agencies downgraded the products as credit quality deteriorated, banks suddenly had to come up with additional regulatory capital and often sought to get rid of their securitisation exposure, further depressing their value.
The Basel Committee didn't put all the blame on credit ratings agencies, saying some banks' internal risk assessment models "performed equally poorly or even worse."
The new securitisation framework seeks to address what regulators have identified as the four main shortcomings of the current method: Mechanistic reliance on external ratings, too low risk weights for highly-rated securitisation exposures, too high risk weights for low-rated securitisation exposures and cliff-effects in capital requirements following deterioration in credit quality of the underlying pool.
The Basel Committee, which represents banking supervisors from the world's main financial centers, is proposing two approaches with different hierarchies, depending on whether the banks use a standardised approach to risk measurement or an internal ratings based approach.
"The two alternative hierarchies would basically use the same approach for assigning capital requirements; however, the application of these approaches would vary, depending on the specific exposure characteristics and other factors," the Basel Committee said.
Comments on the revised framework should be submitted by mid-March 2013.
The new proposed framework is the result of a fundamental review by the Basel Committee of the way banks measure their exposure to securitised products. In July 2009 the committee introduced improvements to the Basel II rules - known as Basel 2.5 - but these mainly addressed immediate shortcomings that became clear during the financial crises.
At that point, the Basel Committee launched a more thorough review of the securitisation framework alongside the publication of the Basel III rules in December 2010.