Fitch report explores concentration risk in Basel II proposals

Rating agency findings suggest unintended Basel II concentration risks

LONDON/NEW YORK - A new report published by Fitch Ratings explores the issue of concentration risk on recent Basel II proposals responding to the financial crisis. The report, Basel II's Proposed Enhancements: Focus on Concentration Risk, says that although the overall Basel II proposals provide meaningful enhancements that will further strengthen the effectiveness and rigour of the Basel II capital framework, Fitch's analysis indicates that specific aspects could have unintended effects on the risk sensitivity of capital requirements for structured finance (SF) exposures.

Fitch notes potential overlap between Fitch's tightened SF CDO rating criteria and proposed increases in Basel II risk- weights on 're-securitisation' exposures held by banks, which could result in the 'double-counting' of risks within SF CDO capital charges.

Addressing concentrations is an important element of measuring and managing risks within securitisation transactions, particularly re-securitisations such as SF CDOs, or collateralised debt obligations backed by an underlying pool of structured finance securities. Fitch recently developed revised rating criteria for SF CDOs that apply a rigorous and robust treatment of potential risk concentrations within these structures. As a result, the enhancement levels needed to achieve investment-grade ratings have increased considerably, particularly for collateral pools characterised by risk concentrations and thinner tranches. However, as part of the proposed Basel II enhancements under Pillar 1, which address minimum regulatory capital requirements for banks, the risk weights for 're-securitisations' such as SF CDOs will be increased relative to the risk weights on other forms of securitisation exposure.

"One of the main factors driving recent SF CDO credit deterioration has been risk concentrations within the underlying pool of structured finance collateral to the same asset classes, geographic areas, and, importantly, vintages, since assets originated within the same time period are exposed to similar underwriting risk factors," said John Olert, group managing director, Fitch Structured Finance group. "With both Fitch tightening its SF CDO rating criteria and Basel II increasing the associated capital charges on re-securitisations, it appears there is a potential overlap in these efforts, especially if other agencies make similar changes to their criteria."

"In concept, similar risk exposures should face similar capital charges, irrespective of the form the exposure takes. When layering the higher proposed Basel II re-securitisation charges onto the additional conservatism of Fitch's SF CDO criteria, our analysis indicates that the Basel II capital charges on the full SF CDO capital structure could be several multiples higher than the Basel II charges on the entire underlying pool of structured finance collateral, even though the risk exposure is essentially the same," said Ian Linnell, group managing director, Fitch Structured Finance group.

The Basel II capital framework, currently being implemented globally, is a significant regulation that Fitch believes will promote stronger risk management practices and more informative measures of risk-based capital within the banking industry. The proposed enhancements address each of the 'Pillars' of Basel II, including Pillar 1, minimum regulatory capital requirements; Pillar 2, banks' internal risk and capital assessments and the supervisory review process; and Pillar 3, risk-based disclosure to promote market discipline. As emphasised by the Basel Committee in releasing the proposals, Basel II is intended to be a 'living framework' that continues to adapt to evolution in financial markets and the financial services industry, which Fitch notes will help to support its relevance going forward.

The report 'Basel II's Proposed Enhancements: Focus on Concentration Risk' is available on Fitch's website at www.fitchratings.com.