135.The supervision of banks is not an exact science, and therefore, discretionary elements within the supervisory review process are inevitable. The Central Bank will carry out its obligations in a transparent and accountable manner. The Central Bank will make publicly available the criteria (defined in the accompanying Guidance) to be used in the review of banks’ internal capital assessments. If the Central Bank chooses to set higher minimum capital requirements or to set categories of capital in excess of the regulatory minimum, factors that may be considered in doing so will be publicly available. Where the capital requirements are set above the minimum for an individual bank, the Central Bank will explain to the bank the risk characteristics specific to the bank, which resulted in the requirement and any remedial action necessary.

136.Further to the Pillar 1 principle that banks must take account of the economic substance of transactions in their determination of capital adequacy, the Central Bank will monitor, as appropriate, whether banks have done so adequately. As a result, regulatory capital treatments for specific securitisation exposures might differ from those specified in Pillar 1 of the Framework, particularly in instances where the general capital requirement would not adequately and sufficiently reflect the risks to which an individual banking organisation is exposed.

137.Amongst other things, the Central Bank will review where relevant a bank’s own assessment of its capital needs and how that has been reflected in the capital calculation as well as the documentation of certain transactions to determine whether the capital requirements accord with the risk profile (e.g. substitution clauses). The Central Bank will also review the manner in which banks have addressed the issue of maturity mismatch in relation to retained positions in their economic capital calculations. In particular, they will be vigilant in monitoring for the structuring of maturity mismatches in transactions to artificially reduce capital requirements. Additionally, the Central Bank will review the bank’s economic capital assessment of actual correlation between assets in the pool and how they have reflected that in the calculation. Where the Central Bank considers that a bank’s approach is not adequate, they will take appropriate action. Such action might include denying or reducing capital relief in the case of originated assets, or increasing the capital required against securitisation exposures acquired.

138.Securitisation transactions may be carried out for purposes other than credit risk transfer (e.g. funding). Where this is the case, there might still be a limited transfer of credit risk. However, for an originating bank to achieve reductions in capital requirements, the risk transfer arising from a securitisation has to be deemed significant by the Central Bank. If the risk transfer is considered insufficient or non-existent, the Central Bank will require the application of a higher capital requirement than prescribed under Pillar 1 or, alternatively, may deny a bank from obtaining any capital relief from the securitisations. Therefore, the capital relief that can be achieved will correspond to the amount of credit risk that is effectively transferred. The following includes a set of examples where the Central Bank will have concerns about the degree of risk transfer, such as retaining or repurchasing significant amounts of risk or “cherry picking” the exposures to be transferred via a securitisation.

139.Retaining or repurchasing significant securitisation exposures, depending on the proportion of risk held by the originator, might undermine the intent of a securitisation to transfer credit risk. Specifically, the Central Bank might expect that a significant portion of the credit risk and of the nominal value of the pool be transferred to at least one independent third party at inception and on an ongoing basis. Where banks repurchase risk for market making purposes, the Central Bank could find it appropriate for an originator to buy part of a transaction but not, for example, to repurchase a whole tranche. The Central Bank will expect that where positions have been bought for market making purposes, these positions must be resold within an appropriate period, thereby remaining true to the initial intention to transfer risk.

140.Another implication of realising only a non-significant risk transfer, especially if related to good quality unrated exposures, is that both the poorer quality unrated assets and most of the credit risk embedded in the exposures underlying the securitised transaction are likely to remain with the originator. Accordingly, and depending on the outcome of the supervisory review process, the Central Bank will increase the capital requirement for particular exposures or even increase the overall level of capital the bank is required to hold.

141.As the minimum capital requirements for securitisation may not be able to address all potential issues, the Central Bank will consider new features of securitisation transactions as they arise. Such assessments would include reviewing the impact new features may have on credit risk transfer and, where appropriate, the Central Bank will be expected to take appropriate action under Pillar 2. A Pillar 1 response may be formulated to take account of market innovations. Such a response may take the form of a set of operational requirements and/or a specific capital treatment.

142.A bank must conduct analyses of the underlying risks when investing in the structured products and must not solely rely on the external credit ratings assigned to securitisation exposures by the credit rating agencies. A bank must be aware that external ratings are a useful starting point for credit analysis, but are no substitute for full and proper understanding of the underlying risk, especially where ratings for certain asset classes have a short history or have been shown to be volatile. Moreover, a bank also must conduct credit analysis of the securitisation exposure at acquisition and on an ongoing basis. It must also have in place the necessary quantitative tools, valuation models and stress tests of sufficient sophistication to reliably assess all relevant risks.

143.When assessing securitisation exposures, a bank must ensure that it fully understands the credit quality and risk characteristics of the underlying exposures in structured credit transactions, including any risk concentrations. In addition, a bank must review the maturity of the exposures underlying structured credit transactions relative to the issued liabilities in order to assess potential maturity mismatches.

144.A bank must track credit risk in securitisation exposures at the transaction level and across securitisations exposures within each business line and across business lines. It must produce reliable measures of aggregate risk. A bank also must track all meaningful concentrations in securitisation exposures, such as name, product or sector concentrations, and feed this information to firm-wide risk aggregation systems that track, for example, credit exposure to a particular obligor.

145.A bank’s own assessment of risk needs to be based on a comprehensive understanding of the structure of the securitisation transaction. It must identify the various types of triggers, credit events and other legal provisions that may affect the performance of its on- and off-balance sheet exposures and integrate these triggers and provisions into its funding/liquidity, credit and balance sheet management. The impact of the events or triggers on a bank’s liquidity and capital position must also be considered.

146.Banks either underestimated or did not anticipate that a market-wide disruption could prevent them from securitising warehoused or pipeline exposures and did not anticipate the effect this could have on liquidity, earnings and capital adequacy. As part of its risk management processes, a bank must consider and, where appropriate, mark-to-market warehoused positions, as well as those in the pipeline, regardless of the probability of securitising the exposures. It must consider scenarios that may prevent it from securitising its assets as part of its stress testing and identify the potential effect of such exposures on its liquidity, earnings and capital adequacy.

147.A bank must develop prudent contingency plans specifying how it would respond to funding, capital and other pressures that arise when access to securitisation markets is reduced. The contingency plans must also address how the bank would address valuation challenges for potentially illiquid positions held for sale or for trading. The risk measures, stress testing results and contingency plans must be incorporated into the bank’s risk management processes and its ICAAP, and must result in an appropriate level of capital under Pillar 2 in excess of the minimum requirements.

148.A bank that employs risk mitigation techniques must fully understand the risks to be mitigated, the potential effects of that mitigation and whether or not the mitigation is fully effective. This is to help ensure that the bank does not understate the true risk in its assessment of capital. In particular, it must consider whether it would provide support to the securitisation structures in stressed scenarios due to the reliance on securitisation as a funding tool.

149.Support to a transaction, whether contractual (i.e. credit enhancements provided at the inception of a securitised transaction) or non-contractual (implicit support) can take numerous forms. For instance, contractual support can include over collateralisation, credit derivatives, spread accounts, contractual recourse obligations, subordinated notes, credit risk mitigants provided to a specific tranche, the subordination of fee or interest income or the deferral of margin income, and clean-up calls that exceed 10 percent of the initial issuance. Examples of implicit support include the purchase of deteriorating credit risk exposures from the underlying pool, the sale of discounted credit risk exposures into the pool of securitized credit risk exposures, the purchase of underlying exposures at above market price or an increase in the first loss position according to the deterioration of the underlying exposures.

150.The provision of implicit (or non-contractual) support, as opposed to contractual credit support (i.e. credit enhancements), raises significant supervisory concerns. For traditional securitisation structures the provision of implicit support undermines the clean break criteria, which when satisfied would allow banks to exclude the securitised assets from regulatory capital calculations. For synthetic securitisation structures, it negates the significance of risk transference. By providing implicit support, banks signal to the market that the risk is still with the bank and has not in effect been transferred. The bank’s capital calculation therefore understates the true risk. Accordingly, the Central Bank will take appropriate action when a banking organisation provides implicit support.

151.When a bank has been found to provide implicit support to a securitisation, it will be required to hold capital against all of the underlying exposures associated with the structure as if they had not been securitised. It will also be required to disclose publicly that it was found to have provided non-contractual support, as well as the resulting increase in the capital charge (as noted above). The aim is to require banks to hold capital against exposures for which they assume the credit risk, and to discourage them from providing non-contractual support.

152.If a bank is found to have provided implicit support on more than one occasion, the bank is required to disclose its transgression publicly and the Central Bank will take appropriate action that may include, but is not limited to, one or more of the following:

1. i.The bank may be prevented from gaining favourable capital treatment on securitised assets for a period of time to be determined by the Central Bank;
2. ii.The bank may be required to hold capital against all securitised assets as though the bank had created a commitment to them, by applying a conversion factor to the risk weight of the underlying assets;
3. iii.For purposes of capital calculations, the bank may be required to treat all securitised assets as if they remained on the balance sheet;
4. iv.The bank must be required by the Central Bank to hold regulatory capital in excess of the minimum risk-based capital ratios.

153.The Central Bank will be vigilant in determining implicit support and will take appropriate supervisory action to mitigate the effects. Pending any investigation, the bank may be prohibited from any capital relief for planned securitisation transactions (moratorium). The Central Bank’s response will be aimed at changing the bank’s behaviour with regard to the provision of implicit support, and to correct market perception as to the willingness of the bank to provide future recourse beyond contractual obligations.

154.As with credit risk mitigation techniques more generally, the Central Bank will review the appropriateness of banks’ approaches to the recognition of credit protection. In particular, with regard to securitisations, the Central Bank will review the appropriateness of protection recognised against first loss credit enhancements. On these positions, expected loss is less likely to be a significant element of the risk and is likely to be retained by the protection buyer through the pricing. Therefore, the Central Bank will expect banks’ policies to take account of this in determining their economic capital. If the Central Bank does not consider the approach to protection recognised as adequate, action will be taken. Such action may include increasing the capital requirement against a particular transaction or class of transactions.

155.The Central Bank expects a bank not to make use of clauses that entitles it to call the securitisation transaction or the coverage of credit protection prematurely if this would increase the bank’s exposure to losses or deterioration in the credit quality of the underlying exposures.

156.Besides the general principle stated above, the Central Bank expects banks to only execute clean-up calls for economic business purposes, such as when the cost of servicing the outstanding credit exposures exceeds the benefits of servicing the underlying credit exposures.

157.Subject to national discretion, the Central Bank will require a review prior to the bank exercising a call which can be expected to include consideration of:

1. i.The rationale for the bank’s decision to exercise the call; and
2. ii.The impact of the exercise of the call on the bank’s regulatory capital ratio.

158.The Central Bank will also require the bank to enter into a follow-up transaction, if necessary, depending on the bank’s overall risk profile, and existing market conditions.

159.Date related calls must be set at a date no earlier than the duration or the weighted average life of the underlying securitisation exposures. Accordingly, supervisory authorities may require a minimum period to elapse before the first possible call date can be set, given, for instance, the existence of up-front sunk costs of a capital market securitisation transaction.

160.The Central Bank will review how banks internally measure, monitor, and manage risks associated with securitisations of revolving credit facilities, including an assessment of the risk and likelihood of early amortisation of such transactions. At a minimum, the Central Bank will ensure that banks have implemented reasonable methods for allocating economic capital against the economic substance of the credit risk arising from revolving securitisations and must expect banks to have adequate capital and liquidity contingency plans that evaluate the probability of an early amortisation occurring and address the implications of both scheduled and early amortisation. In addition, the capital contingency plan must address the possibility that the bank will face higher levels of required capital under the early amortisation Pillar 1 capital requirement.

161.Because most early amortisation triggers are tied to excess spread levels, the factors affecting these levels must be well understood, monitored, and managed, to the extent possible by the originating bank. For example, the following factors affecting excess spread must generally be considered:

1. i.Interest payments made by borrowers on the underlying receivable balances;
2. ii.Other fees and charges to be paid by the underlying obligors (e.g. late-payment fees, cash advance fees, over-limit fees);
3. iii.Gross charge-offs;
4. iv.Principal payments;
5. v.Recoveries on charged-off loans;
6. vi.Interchange income;
7. vii.Interest paid on investors’ certificates;
8. viii.Macroeconomic factors such as bankruptcy rates, interest rate movements, unemployment rates; etc.

162.Banks must consider the effects that changes in portfolio management or business strategies may have on the levels of excess spread and on the likelihood of an early amortisation event. For example, marketing strategies or underwriting changes that result in lower finance charges or higher charge-offs, might also lower excess spread levels and increase the likelihood of an early amortisation event.

163.Banks must use techniques such as static pool cash collections analyses and stress tests to better understand pool performance. These techniques can highlight adverse trends or potential adverse impacts. Banks must have policies in place to respond promptly to adverse or unanticipated changes. The Central Bank will take appropriate action where they do not consider these policies adequate. Such action may include, but is not limited to, directing a bank to obtain a dedicated liquidity line or raising the early amortisation credit conversion factor, thus, increasing the bank’s capital requirements.

164.While the early amortisation capital charge described in Pillar 1 is meant to address potential supervisory concerns associated with an early amortisation event, such as the inability of excess spread to cover potential losses, the policies and monitoring described in this section recognise that a given level of excess spread is not, by itself, a perfect proxy for credit performance of the underlying pool of exposures. In some circumstances, for example, excess spread levels may decline so rapidly as to not provide a timely indicator of underlying credit deterioration. Further, excess spread levels may reside far above trigger levels, but still exhibit a high degree of volatility, which could warrant supervisory attention. In addition, excess spread levels can fluctuate for reasons unrelated to underlying credit risk, such as a mismatch in the rate at which finance charges reprice relative to investor certificate rates. Routine fluctuations of excess spread might not generate supervisory concerns, even when they result in different capital requirements. This is particularly the case as a bank moves in or out of the first step of the early amortisation credit conversion factors. On the other hand, existing excess spread levels may be maintained by adding (or designating) an increasing number of new accounts to the master trust, an action that would tend to mask potential deterioration in a portfolio. For all of these reasons, supervisors will place particular emphasis on internal management, controls, and risk monitoring activities with respect to securitisations with early amortisation features.

165.The Central Bank expects that the sophistication of a bank’s system in monitoring the likelihood and risks of an early amortisation event will be commensurate with the size and complexity of the bank’s securitisation activities that involve early amortisation provisions.

166.For controlled amortisations specifically, the Central Bank will also review the process by which a bank determines the minimum amortisation period required to pay down 90% of the outstanding balance at the point of early amortisation. Where the Central Bank does not consider this adequate, it will take appropriate action, such as increasing the conversion factor associated with a particular transaction or class of transactions.