LAVANDERÍA

For the perceived benefits of the risk transfer, an increase in credit supply and reduction in the liquidity pressures, securitisation was initially endorsed by the regulatory bodies (BCBS, 2005; IAIS, 2003). Securitisation, along with other forms of financial innovation, was welcomed by the market and regulators (BIS, 2003). Most of the regulations before the eruption of the GFC were securitisation supportive. The regulators were following an indirect approach

and direct regulations for securitisation market were missing.7Most of the transactions were taking place under the contractual arrangements. There were no defined limits regarding securitisation and taking exposures in the securitised instruments.

Basel I defined Risk Weights (RWs) for various classes of assets held by a bank. Corporate loans were given 100% RWs in Basel I and banks issuing these loans were required to hold higher capital against them. This situation adversely affected credit supply to corporate sector. There was widespread criticism by academicians and practitioners on the rigidity of these RWs. It was argued that the credit risk rating of corporate borrowers should also be considered. These guidelines were revised in 1999. The purpose of revisions in the Basel I Accord was to promote safety and soundness of the banking system along with enhancing the competitive quality of banks (Fabozzi, Davis, & Choudhry, 2006). However, these rules were still considered inflexible and Basel II was introduced to overcome the shortcomings of Basel I. Basel II was based on three pillars:

1. New capital requirements for credit and operational risks; 2. Supervisory actions for higher risk as compared to the capital;

3. Greater disclosure requirements for banks to promote the market discipline.

Basel II followed a model based and a rating based approach. For the calculation of capital requirements, two approaches were introduced in the Basel II i.e. Standardised Approach (SA) and Internal Ratings Based (IRB) approach. By following the SA, banks can split assets as per their credit ratings. There are two sub-approaches in IRB i.e. foundation approach and advanced approach. The categorization of the assets is based on internal assessment of the bank. However, relevant supervisory body should identify internal systems to use this approach. The banks in EU were provided with the freedom to choose any of these approaches. This approach based mechanism provided banks with a justification for their thinner capitalisation. Banks in Basel II were not allowed to follow their internal risk assessment mechanism for evaluating the risk related to their securitisation exposures. This increased their reliance on the Credit Rating Agencies (CRAs) that are widely maligned for playing a significant role in the debacle of securitisation market.

Basel I provided a flat treatment to various asset classes to many of the bank assets. Consequently, regulatory capital for many of the (high-quality) assets was higher than the

7The regulators were focusing on lending standards, risk classification of various assets (loans) classes and investment exposures. These regulations indirectly played a supportive role in the exponential growth of secu- ritisation market. As a set of regulations directly targeting the securitisation market was not existent, therefore, banks allegedly used the loopholes present in indirect regulations and securitised their assets enormously.

required capital to cover the economic risk. Hence, Basel I provided banks with an incentive to remove those assets from their balance sheet through securitisation to reduce regulatory capital requirements.8 However, it is pertinent to note here that banks were reducing the regulatory capital requirement but not the economic risk because of the retention of first loss position in the lower tranches in securitisation deals (Gorton & Pennacchi, 1995). Basel II was meant to reduce this incentive or regulatory capital arbitrage. However, stringent capital requirements were applied to the lower securitisation tranches those were mainly retained by the banks. This incited banks not to retain these tranches (Fabozzi et al., 2006) or reduce the size of these tranches.9

Under the Basel II Framework, similar RWs were assigned to corporate bonds and ABS of similar rating. The similar RWs to these assets classes incited the interest of investors in the latter class as it was perceived safe being backed by specific assets and generating higher yield at the same time. However, non-investment grade ABS attracted higher RWs. The issuers of ABS started working closely with CRAs to increase the proportion of investment grade ABS in the economy. This resulted in an economy flooded with ABS and many of them were too complex to understand for investors and regulators [e.g. Collateralised Debt Obligations (CDOs) and Collateralised Mortgage Obligations (CMOs)] (C. W. Calomiris, 2009; DeMarzo & Duffie, 1999; Griffin et al., 2013; Schwarcz, 2013c).

The differences in the capital charges against the senior and junior tranches of securitisation were significant in the Basel II framework. This framework created a scope for engineering specific tranches to maximise the leverage. The banks decreased the size of lower tranches because of significantly high capital charges on these lower tranches.10The protection offered through subordination was adversely affected because of this situation. Moreover, Basel II framework led to the generation of ‘cliff effects’.11 The changes in the capital charges because of downgrades in the rating of any single type of security or tranche were not smooth, rather such downgrades resulted in disproportionate cascading effects on other tranches and securities. This has been identified in the recent securitisation framework in Basel III. The above discussion explicates that banks have been continuously involved in countervailing financial engineering in response to the changes in regulatory framework.

8Banks were able to reduce the regulatory capital requirements by removing some assets from their balance. 9The new securitisation framework of Basel III focuses on the thickness of tranches while assigning RWs to overcome this issue.

10This has been identified in the recent securitisation framework in Basel III and size of the tranches have also been taken into consideration while allocating RWs (BCBS, 2016).

11‘Cliff effect’ can be referred to a positive feedback loop. Small changes in ratings of the securitised instrument led to significant changes in the capital. Banks had to substantially increase their capital when many ratings were downgraded during the GFC.