The regulatory framework for securitisation by banks in New Zealand
This paper describes the role of the Reserve Bank in regulating securitisation by banks in New Zealand. To place in context the particular requirements applied to banks, the paper begins by providing an overview of the approach taken by the Reserve Bank to supervising banks. It then goes on to describe the securitisation process, our perspective of the benefits and risks involved in securitisation and the actual supervisory requirements. It concludes by commenting on recent and possible future developments in the regulating of banks involvement in securitisation.
The approach to banking supervision in New Zealand
The Reserve Bank is responsible for the maintenance of the financial system's soundness and efficiency, with our attention focused on the banking sector (where any systemic problems, if they were to occur, would arise).
There has been a strong presumption in economic policy development in New Zealand over the last decade or so that market forces generally produce better outcomes than those arising from bureaucratic rules and regulations. Our approach to banking supervision reflects this.
We start with the presumption that financial markets contain powerful and flexible disciplinary mechanisms for rewarding good bank performance and penalising imprudent bank behaviour. While we do not argue that market forces alone will do the job, we do see the disciplines of the market as being the dominant and most effective means for promoting a robust financial system. There are a number of key elements in our market-based approach to banking supervision.
- The first is to ensure that the marketplace has sufficient and reliable information on banks on which to base financial assessments and decisions. This is achieved through a public disclosure regime which requires banks to publish a comprehensive range of financial, corporate and risk-related information for the bank and its banking group at quarterly intervals.
- The second key element has been to strengthen the incentives for the directors and management of banks to manage their banks' affairs in a sound and responsible manner. An important aspect of this is a requirement for the directors of banks to attest to the accuracy of the information in the quarterly disclosure statements, to the fact that their banks have satisfactory risk management policies and to the fact that these are being properly applied.
- The third key element is to avoid imposing excessive administrative burdens or unnecessarily constrain banks from pursuing commercial objectives.
- The fourth key element is to minimise the perception that the Government underwrites the prudential soundness of individual banks. Should a bank fail, the Reserve Bank has statutory powers to help prevent widespread disruption to the financial system. The Reserve Bank's responsibility is not to provide a "safety net" for insolvent institutions, nor to shelter depositors from losses.
While harnessing market forces and using improved internal governance lie at the heart of our approach to supervising banks, we have also retained a number of direct prudential policy instruments. This recognises that, for the time being at least, systemic stability is best served by a combination of market disciplines and some external regulation (albeit relatively light compared to other jurisdictions). The direct prudential policy instruments that are currently in place are:
- We continue to have responsibility for registering new banks.
- Banks continue to be subject to minimum capital requirements (in line with the Basle Capital Accord) and a limit on lending to connected parties.
- We continue to monitor banks on a quarterly basis. However, monitoring is now conducted principally using banks' public disclosure statements, in contrast to the former system of monitoring on the basis of information provided privately to the Reserve Bank. In most respects, banks' disclosure statements contain information which is more comprehensive and more reliable than the information previously provided privately to the Reserve Bank.
- We continue to consult with the senior management of banks.
- And, importantly, we have retained a wide-ranging capacity to respond to financial distress or bank failure where a bank's financial condition poses a serious threat to the stability of the banking system.
Although it is far too early to make conclusive assessments of the success or otherwise of our new supervisory approach (which has now been in operation for just over two years), we are satisfied that it is encouraging prudent behaviour by banks in New Zealand, and thereby is reducing the likelihood of financial system instability in the future. Moreover, we are confident that it is doing this at lower efficiency, compliance and taxpayer costs than other supervisory options might be expected to achieve.
The principles underlying our approach to banking supervision are reflected in the stance that we take in the supervision of banks' activities in securitisation. I will outline these specific requirements soon. Before doing that I will describe the securitisation process, and the benefits and risks of securitisation as we see them at the Reserve Bank.
The securitisation process
Securitisation is a process whereby a pool of similar loans (eg residential mortgages) or other financial assets are packaged and sold in the form of marketable securities. This has the effect of transforming long-term illiquid assets into tradeable liquid assets.
Typically much of a bank's business relates to the borrowing and lending of money. Banks take deposits, and lend the proceeds to customers at a higher interest rate, thereby making a profit. In most cases the bulk of a bank's borrowing will be in the form of short-term deposits, while its loans (eg residential mortgages) will be for relatively long terms. Interest rates on some products will be floating, ie able to be adjusted at any time. On other products the rates will only be able to be adjusted after a specified period.
Banks face a number of risks from this type of business. These include credit risk (the risk that borrowers will not repay the money they have borrowed), interest rate risk (the risk that the relationship between the interest rates on lending and borrowing will shift because asset and liability repricing dates differ) and funding risk (the risk that deposits cannot be replaced as they mature or are withdrawn, leaving the bank with insufficient funds to finance long term loans).
Banks in other countries (eg the United States and Australia) have increasingly looked to reduce their involvement in traditional "on-balance sheet" borrowing and lending in favour of securitisation. This has allowed them to reduce the risks which arise from traditional bank borrowing and lending activities and enables them to concentrate on activities such as loan origination.
Banks in the United States have now expanded their securitisation activities well beyond the mortgage programmes of the 1970s and 1980s to include almost all asset types including corporate loans. Banks in Australia are quickly catching up, playing a major part in the rapidly growing securitisation market in that country. In New Zealand, a number of securitisations involving banks have taken place, although in most cases banks have not securitised their own assets. Their involvement has been related to assisting third parties to securitise assets. From our perspective at the Reserve Bank, interest by New Zealand banks in securitisation has increased markedly over the past year, and if overseas trends are followed we can expect securitisation to become increasingly important in the future.
There is no standard method of securitisation and new techniques are being developed all the time. However, most securitisations involve the following steps:
- Selection of a pool of loans
The first stage of the process is the selection of a homogeneous pool of loans, eg credit card receivables or residential mortgages. It is essential that the pool contains a large number of loans and that the loans are as similar to one another as possible. This allows statistical predictions about future behaviour to be made. In particular, it enables reasonably accurate predictions of default rates to be made. This allows the securities to be structured in a way which largely insulates investors from credit risk.
Banks can securitise their own loans, or they may securitise loans purchased from a third party, in which case the third party would be the originator rather than the bank.
- Sale to a special purpose vehicle
The pool of loans is sold to a special purpose vehicle which is usually either a trust or a company.
- Issuing of securities
The special purpose vehicle issues securities to fund the purchase of the loans from the bank. The securities are structured so that interest and principal payments are supported by cashflows from the underlying pool of loans. However, typically the interest rate on the securities will be linked to wholesale interest rates rather than to the interest rate on the underlying assets. Where wholesale interest rates are lower than retail rates, funding costs can be reduced.
- Provision of credit enhancement
To make the securities issued by the special purpose vehicle attractive to investors and to enable funding to be obtained at favourable interest rates, it is necessary to ensure that there is little risk of investors losing money. Usually this is achieved by provision of one or more credit enhancements. A credit enhancement is simply an arrangement which provides protection against credit risk (ie the risk that borrowers will not repay the funds borrowed). Normally credit enhancements will cover losses up to a level which is several times the level recorded historically, so that the likelihood of any loss for investors is very low. Commonly used credit enhancements include the following:
- third party insurance;
- over-collateralisation - this occurs when the face value of the loans held by the special purpose vehicle exceeds the value of the securities it has issued;
- issuing subordinated securities - holders of the subordinated securities take most or all of the credit risk on the loans because they receive payment only after other security holders have been paid;
- a guarantee from a third party;
- the bank being obliged to take back non-performing loans;
- a one-off gift to the special purpose vehicle to provide a buffer against which losses can be written off.
- Liquidity support
Some form of liquidity support (eg an overdraft facility) is usually arranged so that security holders receive interest payments on time even if some borrowers are a little late in making payments.
- Protection against basis risk
Unless returns for investors are linked to the rate of interest on the underlying assets, there is a risk that the relationship between the rate paid on the underlying assets and that paid on the securities will differ over time. Normally a swap will be arranged to protect against this risk.
- Servicing of loans
Someone will be appointed to service the loans in return for a fee. This involves administration of the loans including the collection of interest and principal payments from the borrowers and the instigation of action to realise security where necessary. In most cases the bank which originated the loans will carry out the servicing role. This means that the customer's relationship with the originating bank remains undisturbed and customers will be unaware that their loans have been securitised.
Benefits of securitisation
Securitisation can bring a number of benefits to banks.
- Access to a wider investor base and cheaper sources of funding - Securities issued by a special purpose vehicle will normally have a good credit rating. Consequently the cost of obtaining funding can be lower than it would be if the bank raised funds directly by taking deposits. Also, the securities are likely to be attractive to investors who would not wish to invest in bank deposits.
- Freeing up of capital and improvement in return on capital - Securitisation removes assets from the originating bank's balance sheet so it frees up capital for other uses. It may also improve the return on capital as the bank will continue to earn fee income on the securitised assets.
- Assistance in management of asset/liability mismatches - With traditional on-balance sheet borrowing and lending, the maturity of assets tends to be much longer than that of liabilities. Securitisation effectively makes bank assets more liquid providing scope to more flexibly manage maturity mismatches.
- Reduction of credit risk, interest rate and liquidity risk - Where a securitisation is structured appropriately the originating bank can transfer credit, interest rate and liquidity risks to third parties.
- Generation of fee income - By securitising its assets but retaining responsibility for servicing them, a bank can earn fee income. This can provide an income stream which is unaffected by shifts in interest rates.
- Economies of scale - A bank which does not have the capacity to increase its loan book may nevertheless be able to take advantage of economies of scale in its loan origination and servicing operations if it can increase throughput by securitising assets, while continuing to service them in return for fee income.
Disadvantages and risks
Securitisation can also give rise to disadvantages and risks.
- Retention of credit risk - Third party credit enhancements can be expensive. Thus banks will often provide credit enhancements themselves. In some cases this may leave the bank with as much credit risk as it would have had if it had retained the loans itself. This is because only a certain proportion of borrowers can be expected to default on their loans. If, say, 3 percent of borrowers normally default and the originating bank guarantees losses up to say 10 percent of the portfolio, the bank's credit risk has not been reduced. It will be obliged to make good all expected losses. Only if losses rise well above historical levels will the bank be better off than it would have been if it had retained the loans itself.
- Provision of services on other than arm's length terms - Banks which have securitised loans often provide various administration and banking services to the special purpose vehicle which holds the loans. Where such services are provided on more favourable terms and conditions than those which would apply to an unrelated party, the bank may be effectively absorbing credit losses on the loans without explicitly recognising that this is what is happening.
- Implicit risk - If a securitised pool of loans does not behave as expected and losses rise to a level where security holders could lose money, the bank may feel morally obliged to bail out the special purpose vehicle or to make good investors' losses even though it is not legally obliged to do so. This can occur because the bank wants to protect its good name and its relationships with customers.
- Reduction in asset quality - There is a risk that banks will securitise all of their best assets, thereby lowering the overall quality of assets on the balance sheet, since the better quality assets are more likely to be suitable for securitisation. The issue for supervisors here is not only whether capital requirements on a bank's residual risk in securitised assets are appropriate. They also need to be concerned with the sufficiency of regulatory capital requirements on the riskier assets remaining in the book.
- Costs - securitisation schemes can be expensive to set up and operate, particularly where the volume of assets to be securitised is not large. In practice this can make securitisation uneconomic.
- Limits operational flexibility - Procedures for managing the loans and dealing with arrears must be agreed in advance. This limits the bank's flexibility in managing customer relationships and carrying out administrative procedures.
- Complexity - Securitisation schemes can be extremely complex. This can make it difficult for banks to ensure that all risks arising from securitisation are recognised and appropriately managed.
As outlined, the Reserve Bank has a supervisory approach that aims to encourage banks to monitor and manage their own risks appropriately. Our view is that this is likely to be more effective than more traditional methods of supervision which rely primarily on detailed rules. New Zealand has, however, retained the Basle capital adequacy rules. Although we believe that disclosure alone would ensure that banks would maintain capital at least equivalent to the 8% minimum, we considered that retention of the minimum capital requirements reinforces the international credibility of the new supervisory framework, at no additional cost to banks.
In line with this philosophy, supervisory requirements relating to securitisation have two main strands:
- disclosure of information about securitisation activities;
- ensuring that credit risk arising from securitisation activities is taken into account in the measurement of banks' capital adequacy ratios.
The first main strand is disclosure where banks are required to disclose the following information about their securitisation activities:
- the nature and amount of the bank's involvement in the origination of securitised assets, and in the marketing or servicing of securitisation schemes;
- information about arrangements made to ensure that difficulties arising from securitisation activities would not impact adversely on the bank or other companies in the banking group;
- a statement as to whether financial services provided to special purpose vehicles are being provided on arm's length terms and conditions and at fair value;
- a statement as to whether any assets purchased from special purpose vehicles have been purchased on arm's length terms and conditions and at fair value;
- information about any funding provided to special purpose vehicles.
Lying behind these disclosure requirements is an internal governance discipline whereby directors of banks must attest to the accuracy of the information in the quarterly disclosure statements, to the fact that their banks have satisfactory risk management policies and to the fact that these are being properly applied. Directors potentially face serious criminal and civil penalties (including a three year jail term, fines and personal liability for depositors' losses) where a disclosure statement is found to be false or misleading.
These requirements are aimed at ensuring that information about the risks which may arise from banks' involvement in securitisation are made available to customers and potential customers, and that the risks associated with the management of complex activities like securitisation get the attention of those best equipped to do that job - namely directors and management.
More detail on the specific disclosures that are required to be made can be found in the Registered Bank Disclosure Orders in Council which were issued in the New Zealand Gazette in November 1995.
The other main area where a regulatory requirement might be imposed on a bank is in the measurement of its capital adequacy.
The Reserve Bank's capital adequacy framework requires registered banks to maintain a minimum ratio of capital to risk weighted credit exposures. This framework requires banks to take into account off-balance sheet credit exposures (eg guarantees and commitments) as well as credit risk arising from loans and other on-balance sheet exposures. It requires banks to hold capital against the assets of associated securitisation activities in certain circumstances.
Such circumstances exist where there is insufficient separation between a bank and associated securitisation activities, where a bank has provided some form of credit enhancement to an associated scheme, or where a bank retains funding risk as a result of its involvement in a securitisation. I will now comment on each of these cases in more detail.
Banks can be associated with securitisation through originating or supplying assets to special purpose vehicles, by marketing securitisation products through their branch network, by acting as a servicing agent or fund manager, or by sponsoring or establishing such arrangements. As a result of these types of association with securitisation activities, banks can be exposed to various risks. Some of these risks arise from implicit or "moral" obligations rather than formal legal obligations. For example, a bank may feel an obligation to provide support to special purpose vehicles set up to conduct securitisation activities because it considers that its own reputation and/or customer base will suffer if support is not provided.
The Reserve Banks capital adequacy rules provide guidance on what represents adequate separation or insulation from these implicit risks for regulatory purposes. Separation is deemed to have occurred if all of the following criteria are met:
- Prospectuses and brochures for securitisation products must include clear disclosures that the securities do not represent deposits or other liabilities of the bank, that the securities are subject to investment risk including possible loss of income and principal invested, and that the bank does not guarantee (either partially or fully) the capital value or performance of the securities. (It should be noted that these requirements do not override or replace any of the issuer's obligations under the Securities Act and Regulations.)
- Unless the bank is treating financial services provided to a special purpose vehicle as a credit enhancement, the bank's disclosure statements must include a statement that financial services (including funding and liquidity support) provided by the bank (and any of its subsidiaries) are on arm's length terms and conditions and at fair value. Where the bank or its subsidiaries have purchased securities issued by a special purpose vehicle or assets from a special purpose vehicle, the bank's disclosure statements must include a statement that these were purchased at fair value and on arm's length terms and conditions.
- When securities are initially issued, investors must be required to sign an explicit acknowledgement that the securities do not constitute bank deposits or liabilities and that the bank does not stand behind the capital value and performance of the securities.
- There must either be an independent trustee or there must be clear, prominent disclosure in all prospectuses, brochures and application forms relating to the scheme as to whether or not there is a trustee, and, where applicable, that the trustee is not independent of the bank.
- Where the bank or its subsidiaries provide funding or liquidity support to an associated special purpose vehicle, or purchase securities issued by an associated special purpose vehicle, the following conditions must apply:
- Such transactions take place on arm's length terms and conditions at fair value.
- Funding (including funding provided by purchase of securities issued by the special purpose vehicle) does not exceed 5 percent of the value of securities issued by the special purpose vehicle.
- Aggregate funding (including funding provided by purchase of securities issued by the special purpose vehicle) to all associated special purpose vehicles does not exceed 10 percent of the bank's tier one capital.
If these criteria are not met then a bank will be required to fully consolidate the assets of an associated special purpose vehicle for capital adequacy purposes.
Banks may face a more explicit form of risk where they provide credit enhancements to special purpose vehicles. This may mean that the bank's credit risk remains much the same as it was prior to the securitisation. Examples of credit enhancements include:
- holding a subordinated class of securities issued by the special purpose vehicle;
- provision of financial services (eg interest rate swaps) on other than arm's length terms and conditions;
- provision of risk insurance;
- provision of guarantees;
- repurchase or replacement of non-performing loans.
Banks can also face a funding risk as a result of involvement in securitisation schemes. This can occur if associated special purpose vehicles issue securities with maturities which are shorter than those of the underlying assets. In such cases there is a risk that the bank will be required to fund some, or all, of the underlying assets when the securities mature.
Where a bank has provided some form of credit enhancement to an associated scheme, or where the bank retains a funding risk as a result of its involvement in a securitisation, the bank will be required to hold capital against the assets of the scheme (ie full consolidation of the assets of an associated special purpose vehicle will be required in the measurement of capital adequacy).
These requirements are aimed at ensuring that, where securitisation does not result in risk being fully transferred from a bank to a special purpose vehicle, the bank holds an appropriate capital "buffer" for any adverse developments that may arise from this risk.
More detail on these capital adequacy regulatory requirements can be found in the document titled Capital Adequacy Framework which was issued by the Reserve Bank in January 1996.
Recent and future developments in supervising securitisation
Our current supervisory approach to securitisation was put in place in January 1996. Given the increasing interest as well as experience in securitisation since that time, we recently approached banks to seek feedback on some changes that we were proposing to make to the capital adequacy rules as applied to securitisation. The changes proposed were not major in nature. Feedback from banks ranged from contentment with the status quo to a suggestion for a more fundamental reassessment of the rules. We are currently assessing the submissions and are in the process of determining whether a refinement or more substantive revision of the rules is warranted.
Another recent development has been a change in emphasis in the Reserve Bank's approach to verifying banks' compliance with prudential regulations. From time to time, situations have arisen where banks have not found it is easy to determine whether particular transactions that they are contemplating comply with our regulatory requirements. We have decided to give written opinions on proposals relative to existing rules, and in order to keep the rules topical we will review them at more frequent intervals, probably annually. In an attempt to avoid being the party of "first resort", and to keep our costs down, before seeking a written opinion from us banks will be required to obtain opinions from their own professional legal and/or accounting advisers and submit these with the request for a Reserve Bank opinion. With respect to complex transactions, like those involving securitisation, we hope that this will go some way to providing additional certainty to banks on regulatory compliance.
There is a broader issue about the future direction of capital regulation. It now seems to be widely recognised internationally that the Basle capital adequacy framework in its present form is past its "best-by" date, and much thought is being given internationally to what might replace it. Certainly the current "one size fits all" approach to defining regulatory capital adequacy makes little sense. One possible direction would be to let banks establish their own capital requirements in the light of their business activities and their risk profiles and provide full disclosure of these. Another possible direction may be to link regulatory capital requirements to banks own internal capital allocation models. It is too early to say whether full development of such concepts might be practicable, or whether they would attract the international consensus that would be necessary. This means that the existing Basle capital adequacy framework as currently applied to New Zealand banks will not be replaced in the foreseeable future.
Until a robust alternative emerges, it would be our intention to apply the capital adequacy framework in a manner broadly consistent with the approach of other major countries, subject of course to the particular constraints that may arise from the New Zealand supervisory approach. In other words, we would not want to have regulatory requirements on securitisation applied to banks in New Zealand that materially disadvantaged them relative to their international competitors.
Finally, an emphasis on high quality disclosure of banks involvement in securitisation will continue to be a key element of the Reserve Banks supervisory approach.
Banks in New Zealand have only been involved in a relatively small number of securitisations to date. If overseas trends are followed in New Zealand, it is likely that securitisation will become increasingly popular in the future. Indeed, from our perspective at the Reserve Bank, interest by New Zealand banks in securitisation schemes has markedly picked up over the past year.
Securitisation clearly has the potential to reduce banks' credit, interest rate and liquidity risks as well as increasing the return on capital. It also creates an attractive low-risk investment product which is likely to appeal to a wide range of investors. However, securitisation also involves risks, some of which are explicit and some implicit. The Reserve Bank's supervisory requirements are aimed at encouraging banks to recognise those risks and to manage and disclose them appropriately.