The Basel Capital Accords and International Mortgage Markets: A Survey of the Literature Linda Allen Professor of Finance

Baruch College, CUNY

December 2003

Abstract This paper surveys the literature on the impacts of the Basel Capital Accords on banking market profitability, competitiveness, structure and risk-taking. Special emphasis is applied to the evolution of mortgage markets throughout the world over almost two decades of international bank regulatory policies.

This paper has received generous financial support from the Canada Housing and Mortgage Corporation (CMHC).

1 The Basel Capital Accords and International Mortgage Markets: A Survey of the Literature 1. Introduction

The 1988 Basel Capital Accord (Basel I) was revolutionary in that it sought to develop a single risk-adjusted capital standard that would be applied throughout the major banking countries of the world. This level playing field would cause best practices to be adopted by banks throughout the world, thereby enhancing the efficiency, productivity, safety and soundness of the global financial system. The Basel process produced many successes, but also several important failures and unintended consequences. Loopholes in the regulations were exploited by banks through a process known as regulatory capital arbitrage. For example, the exclusion of market risk from the capital requirements induced banks to shift their risk exposure from priced credit risk to unpriced market risk. This loophole was filled by the Market Risk Amendment of 1996, which imposed a capital charge for market risk exposure. Section 1.1 offers a detailed description of the capital requirements against market risk exposure. Compromises in Basel I made it necessary in 2001 to propose new regulations (referred to as Basel II) to address the original regulations unintended consequences. For example, the failure to differentiate between high quality and low quality commercial credits contributed to a steady increase, over the past decade, in the credit risk of bank loan portfolios. Basel II proposes to stem this deterioration in bank credit quality by imposing rigorous new credit risk measurement techniques on the Basel I framework. Thus, banks will hold capital as a cushion against credit risk exposure, as measured by either credit ratings provided by external credit rating agencies or by internal value at risk models designed to accurately measure credit exposure. This paper provides a comprehensive literature review focusing on the impact of Basel I and projected impact of Basel II on a series of general market and mortgage market issues of interest. I summarize a voluminous and growing literature on the impact of bank regulations on market competitiveness, efficiency and economic activity. The wide variety of papers on this topic indicates a broad consensus that regulation matters. That is, regulation in general and the Basel Capital Accords in particular have had a major impact on general financial market conditions as well as on the mortgage market. The main source of contention appears to be in determining just how much and in precisely what ways does regulation impact financial markets and institutions. The first question addressed relates to the existence (or non-existence) of a credit crunch induced by the adoption of Basel I. This topic is of importance in answering the questions posed with regard to general market issues. Section 2.1 describes the numerous empirical and theoretical studies that examine the relationship between credit creation and capital requirements in many countries throughout the world. A consensus appears to be that capital regulations were a contributing factor, although fluctuations in

2 economic activity and structural effects also played a role in the contraction of credit experienced during the early 1990s. The Basel Capital Accord was first introduced as a mechanism to control bank risk taking. Section 2.2 surveys studies that test whether the regulations have accomplished this fundamental objective. It seems clear that banks have exploited loopholes in capital regulations, increasing their exposures to under-priced or unpriced risks and decreasing their exposures to priced or over-priced risks. In part, Basel II is designed to close some of these loopholes. However, critiques of the Basel II proposals suggest that the New Accord will present new loopholes that will impact bank behavior in the future.1 Security design and asset securitization are important tools of regulatory capital arbitrage that impact the competitiveness of the industry, its profitability, efficiency and the structure of the playing field. Section 2.3 documents some of the financial products designed, in part, to exploit regulatory loopholes. Some forms of asset securitization have been accorded harsh treatment in bank capital regulations, thereby discouraging their development, even if they play important risk management roles. Moreover, costly and circuitous forms of Special Purpose Vehicles (SPV) have been developed to circumvent capital regulations, with the unintended consequence of impeding financial market disclosure. Section 2.4 surveys concerns about procyclicality in bank capital regulations. A consensus has emerged that banking is a procyclical business and that capital requirements exacerbate that tendency. However, it is unclear whether regulators can do anything about that other than adjust their monetary policy objectives accordingly. Since the financing of home ownership is predominately a local activity, Section 2.5 surveys mortgage markets in several countries throughout the world. In some countries (e.g., Canada, the EU) mortgages are primarily financed through deposit creation. In others (e.g., the US), mortgages are financed through capital market activity. Differences in the source of financing result in differences in mortgage market structure across countries. Section 2.6 examines the impact of Basel capital requirements on mortgage lending throughout the world. Since Basel I was not sufficiently risk sensitive, banks had incentives to pursue riskier mortgage lending opportunities. In several countries, prudential supervision limited this tendency by augmenting capital requirements with other forms of regulatory intervention. A review of the literature regarding Basel I impacts is particularly timely now, as the process of revision for Basel II proposals draws to a close. The current ongoing process of review, revision and testing that has spanned almost three years is a testament to the Basel Committee on Banking Supervisions diligence in addressing public
1

For example, see Chapter 6 of Allen, Boudoukh and Saunders (2004).

3 criticism and integrating recommendations. This survey should help us all become more effective participants as that process of revision, and ultimate implementation, continues. 2. Survey of the Literature

Before assessing the future, we must examine the past. In this paper, I discuss the literature describing and assessing Basel I and II, as well as other bank regulations and market forces affecting the banking industry. I focus on the regulatory impact on credit creation, bank risk taking incentives, securitization and regulatory arbitrage and procyclicality. I conclude with a section on the characteristics of various mortgage markets around the world and a discussion of the literature assessing the potential impact of Basel II on mortgage lending throughout the world. 2.1 The Basel Impact on Credit Creation

Capital requirements may impact the banking systems ability to extend credit. If regulatory capital requirements are set too high (i.e., above economic capital requirements), then the risk-adjusted market return on bank loans will be insufficient to cover this artificially high cost of capital, thereby reducing bank lending activity. This so-called credit crunch will affect the aggregate level of economic activity. In this section, I review the large and somewhat inconclusive literature regarding this topic. In particular, much of the work centers on the existence (or lack thereof) of a credit crunch in the wake of the adoption of Basel I that may have contributed to the severity of the 1990-1991 recession in the US. In this section, I also review international studies, as well as a survey of studies evaluating the potential impact of Basel II on aggregate bank capital creation. Jackson et al (1999) summarize their literature review by stating their view of a consensus on the topic of a relationship between a credit crunch and adoption of Basel I. During the 1980s and 1990s banks tended to raise their capital levels, although this may have been a response to increased supervisory or market discipline, higher required levels of economic capital or a response to more stringent Basel I regulatory capital requirements. Jackson et al (1999) find that the average ratio of capital to risk-weighted assets of major banks in the G-10 rose from 9.3% in 1988 to 11.2% in 1996. They conclude that, although the cause of this overall increase in bank capitalization is ambiguous, Basel I appears to have been the impetus that induced weakly capitalized banks to increase their capital positions either through mergers or capital issuance. Theoretical studies are found that can either support or refute the credit crunch hypothesis. Capital requirements may induce a credit crunch at certain points of the business cycle. Jackson et al (1999) state that banks tend to meet regulatory capital requirements using the least cost approach. During cyclical downturns and financial crises, the cost of issuing additional capital may become prohibitive; thus, banks meet their capital requirements by restricting lending. However, during upturns, the opposite is true and banks may expand both lending and capital positions. Thus, explicit capital

4 requirements (both Basel I and II) promote procyclicality in banking (see Section 2.4 for a survey of the literature on procyclicality). Furthermore, Chami and Cosimano (2001) find the existence of a bank capital financial accelerator that transmits monetary policy to the banking sectors level of credit creation. For example, a tight monetary policy tends to reduce the banks net interest margin, thereby reducing the value of capital in preserving the banks charter value. Under those circumstances, the bank would be likely to hold less capital, thereby restricting the supply of loans to the economy as regulatory capital requirements become binding. Furthermore, Thakor and Wilson (1995) use a theoretical model to show that the demand for bank loans will decrease as increased regulatory capital requirements both increase the cost of loans and make it less likely that banks will renegotiate to restructure troubled loans. However, Thakor (1996) finds that a tight money supply could either increase or decrease bank lending, depending on the effect of monetary policy on the term structure. If a decrease in the money supply increases short-term rates more than long-term rates, then the spread between short-term deposits and long-term government securities declines. Thus, investing in government securities is relatively less profitable and the bank will try to enhance profitability by increasing its lending activity. As the probability of credit approval by banks increases, aggregate lending in the banking sector increases. In contrast, if long-term rates increase by more than short-term rates, then investing in long-term government securities financed with short-term deposits becomes more profitable for banks, thereby resulting in a decrease in aggregate bank lending. Hall (1993) contends that Basel I encouraged US banks to shift away from loans into government securities, thereby decreasing total loans extended by US commercial banks by $150 billion in the years of Basel I implementation. However, the question of whether this entire shift was indicative of a Basel-induced credit crunch is largely an empirical one. Proponents of the view that Basel I capital requirements induced a credit crunch during the 1990-1991 recession in the US include Bernanke and Lown (1991), Shrieves and Dahl (1992), Hancock and Wilcox (1993, 1995), Berger and Udell (1994), Peek and Rosengren (1995a, 1995b), and Lown and Peristiani (1996). In contrast, opponents (such as Sharpe (1995)) argue that observed decreases in lending during capital-constrained downturns in economic activity may be the result of reduced loan demand rather than limitations in credit supply. Johnson (1991) finds that the contraction of bank credit in 1990 was not homogenous, but was instead determined by local economic conditions and bank financial condition. In particular, banks with the lowest lending growth in 1990 had greater exposure to bad real estate loans, lower S&P credit ratings and lower capital ratios. Thus, Johnson (1991) finds that compliance with Basel I capital requirements was only one factor limiting the supply of bank credit in the US during the 1990 recession. This view is supported when comparing the 1990-1991 recession to the 2000-2001 recession in the US. Stiroh and Metli (2003) find that the impact on the quality of bank loan portfolios, as well as the availability of credit, was much milder in the 2000-2001 recession as compared to the 1990-1991 recession. Moreover, the impact in 2000-20001 was localized in certain troubled industries, particularly the telecommunications industry. Stiroh and Metli (2003) attribute the absence of a significant 2000-2001 credit crunch to the strong financial position of the banking system at the start of the economic downturn, rather than to any regulatory policy changes.

Brinkmann and Horvitz (1995) examine the availability of loan supply in the wake of the implementation of Basel I without distinguishing between required capital and discretionary capital. That is, banks may choose to hold a cushion to meet regulatory capital requirements. Thus, the imposition of Basel I may have an impact on loan supply even if all banks met the higher regulatory minimum capital levels, if banks restrict loan supply in order to build a desired capital cushion level. Brinkmann and Horvitz (1995) find that banks with larger capital surpluses under Basel I increased their lending at twice the rate of banks with smaller surpluses or deficient capital levels, suggesting that the Basel I capital requirements may have been binding due to their impact on discretionary capital levels. Bugie, et al (2003) suggest that the greater volatility inherent in the more complex Basel II proposals will exacerbate this tendency toward capital surpluses. Hancock and Wilcox (1994a) test bank convergence between regulatory capital requirements and long run equilibrium, bank-specific economic capital levels. They find US banks resold single-family home mortgages into the secondary mortgage backed securities market, but increased their holding of commercial mortgages. Moreover, well capitalized banks increased their mortgage lending more than poorly capitalized banks decreased their lending. Hancock and Wilcoxs (1994b) results also do not find evidence of a shift out of high risk-weighted loans to low risk-weighted securities, as would be the case if implementation of Basel I had induced regulatory capital arbitrage. Thus, their results are not consistent with a Basel-induced credit crunch. Instead, Hancock and Wilcox (1994a) explain the shifts in lending as responses to increases in real estate delinquency rates that led to higher economic capital requirements during the 1990-1991 period in the US. Thus, they conclude that Basel capital regulations do not constrain bank lending behavior as much as the economic capital targets self-imposed by the banks. Hancock and Wilcox (1997) further examine the impact of Basel I on the real estate market in the US. However, in this paper, they find significant effects of the capital crunch on real estate market activity. There was a pronounced drop in commercial real estate loans in the US during the period following adoption of Basel I. Moreover, the volume of new single-family real estate loans leveled off during that period. Using national data, Hancock and Wilcox (1997) find a significant decrease in real estate lending by capital-constrained banks. However, non-bank financial intermediaries, such as government-sponsored enterprises, could have filled the gap left by the banks because they were unaffected by changes in capital regulations, but they did not. Hancock and Wilcox (1997) conclude that real economic activity in the real estate sector was affected by a combination of local economic and banking conditions. Thus, Hancock and Wilcox (1997) contend that banking sector retrenchment during the implementation of Basel I had a real impact on economic activity in the real estate sector and may have contributed to a credit crunch. Peek and Rosengren (1992) document the reverse effect of the Hancock and Wilcox (1997) impact of banking sector retrenchment on real estate market activity. They find that the upheaval in the real estate market, following the collapse of the New England real estate bubble and the economic slowdown in New England, seriously impacted the

6 condition of the regions banks, rather than the reverse causality.2 New England banks experienced a substantial decline in bank capital due to loan losses emanating from the real estate sector. This led poorly capitalized banks to reduce their lending more rapidly than well-capitalized banks. This suggests that regional banks had excessive exposure to local economic and market conditions during 1990-1991. Thus, Peek and Rosengren (1992) contend that it was loan losses, rather than increased Basel I capital requirements that eroded bank capital levels, thereby inducing a credit crunch. Studies using international data demonstrate a similar inconsistency in empirical results. Chiuri et al (2001, 2002) use data from 15 emerging countries (Argentina, Brazil, Chile, Hungary, India, Korea, Malaysia, Mexico, Morocco, Paraguay, Poland, Slovenia, Thailand, Turkey, and Venezuela) to test whether the introduction of Basel I caused credit to contract.3 Their answer is affirmative, with the aggregate credit contraction exacerbated in countries that either strictly enforced the Basel I capital requirements or concurrently experienced currency or financial crises. Retrenchment in the supply of bank loans may have had detrimental impacts on the aggregate level of real economic activity in emerging markets. This credit crunch effect was exacerbated in emerging countries by underdeveloped alternative sources of financing. This restriction in the supply of credit is larger for undercapitalized than for well-capitalized banks.4 Chiuri et al (2002) find, however, that some of the reduced lending may have been ill-advised and thus the credit contraction was not necessarily detrimental to the economy. Moreover, the severity of the credit crunch was reduced somewhat for foreign banks, suggesting that globalization of the banking industry may mitigate the contractionary impact of Basel capital requirements. However, Chiuri et al (2001, 2002) conclude that the credit contraction implications of Basel I are the result of increases in aggregate capital levels. To the extent that Basel II does not raise overall capital requirements, there may not be the same retrenchment in capital supply. In contrast, Bikker and Hu (2002) find no support for the credit crunch hypothesis using an international sample of banks from 26 developed and developing countries. Since banks typically hold capital in excess of regulatory minimums, they conclude that capital requirements do not appear to be binding constraints on loan supply. There are several studies examining the relationship between capital regulation and bank credit creation in Japan. Japan implemented new guidelines on bank capital in May 1986
Duebel (2002) shows that credit loss realizations in the US commercial mortgages peaked at 250 basis points in 1993 after more than 15 years averaging only 50 basis points. However, Duebel (2002) argues that it was the homogenous behavior of financial institutions rather than the intrinsic character of property markets that led to this decline in real estate values. Some examples of this homogenous behavior are the firesale prices received by the Resolution Trust Corporation for the sale of thrift assets and the sale of low risk mortgage loans by banks eager to meet Basel I capital requirements. 3 Using a simultaneous equation model, Chiuri et al (2001, 2002) follow Peek and Rosengren (1995a, 1995b) in attempting to disentangle the supply and demand effects of the reduction in credit following the introduction of Basel I. That is, higher capital requirements may have reduced bank supply of credit, but recession and financial crisis may have reduced the demand for credit. 4 Kang and Stulz (2000) find that strong reliance on bank financing and the lack of alternative sources of funds in Japan contributed to the decline in firm value displayed by the loss of more than half of equity value for the typical firm on the Tokyo Stock Exchange during 1990 to 1993.
2

7 in preparation for increased competition from foreign banks association with the liberalization of the Japanese financial sector. At that time, banks without foreign branches were required to increase their capital ratios to 4% by March 1991. Those banks with overseas branches had to increase their capital to 6% by March 1998.5 Basel I was adopted in Japan in December of 1988, with the eventual deadline of compliance with the 8% rule required as of March 1993. One of the goals of Basel I was to level the playing field and lift Japanese banks capital levels from their comparatively low levels in the pre-Basel period. Table 2.1.1 shows capital to assets ratio for the large banks in seven countries in 1987 pre-Basel I. Japanese banks had the lowest ratios, averaging 2.11%, with all 10 banks in the sample below the Tier 1 minimum of 4%; see Wagster (1996). Only Canadian and Swiss large banks were fully compliant with Tier 1 Basel I capital requirements in 1987 (see Table 2.1.1). Furthermore, Eysell and Arshadi (1990) find that most US commercial banks with asset size exceeding $10 billion did not meet the 8% Basel capital requirements in 1987, whereas a majority of smaller banks exceeded the 8% Tier 1 plus Tier 2 risk-based capital requirements. INSERT TABLE 2.1.1 AROUND HERE Honda (2002) examines Japanese bank credit creation during the period of 1967-1994 and finds that the introduction of Basel I reduced aggregate bank credit significantly.6 Moreover, Ito and Sasaki (2002) examine 87 major Japanese banks and find that they reduced lending in the post Basel I period, as well as issued additional subordinated debt.7 Kim and Moreno (1994) trace the reduction in bank lending during the mid-1980s to mid-1990s to the impact of falling stock prices on Japanese bank capital levels. Since capital requirements were becoming more stringent during this period, the reduction in bank capital levels became a binding constraint on lending activities for Japanese banks.8 A possible resolution of these conflicting empirical results is that the credit crunch literature suffers from an identification problem in that there are several possible supply and demand effects that may explain the apparent decline in lending that coincided with

International banks were permitted to include up to 70% of unrealized gains on equity security holdings (hidden reserves) into their capital in order to meet the new capital requirements instituted in May 1986 in Japan. After the adoption of Basel I, this was decreased to allow only 45% of hidden reserves to be included into Tier 2 bank capital; see Honda (2002). Table 2.1.1 shows that the average capital to asset ratios for Japanese banks in 1987 was 12.35% if hidden reserves are fully included. 6 Evans, et al (1999) find that Japanese banks focused almost exclusively on market share maximization during the pre-Basel I period, thereby neglecting possible risk management and profit maximization policies. The pursuit of growth at all costs set the stage for the chronic bad loans and undercapitalized state of the Japanese banking system during the 1990s. In contrast, Evans, et al (1999) examine European banks and find that while they also experienced asset growth at the same time as did the Japanese banks, their risk levels were lower and their capital levels were higher than those of Japanese banks. 7 Japanese banks issued subordinated debt in order to raise Tier 2 capital because Tier 1 capital (equity) was too expensive given the dramatic fall in Japanese equity prices after 1989. 8 Japanese banks typically hold significant equity positions and therefore reductions in stock prices erode bank capital levels, thereby constraining the supply of bank loans. However, Kim and Moreno (1994) also note that falling equity prices in Japan may reflect deteriorating economic conditions that would reduce the demand for bank loans.

8 the introduction of Basel I.9 Furfine (2001) incorporates the following four explanations into a theoretical model that is confronted with actual US bank data in order to simulate bank reactions to changes in capital requirements. Aggregate lending in the US decreased in the early 1990s as a result of: (1) higher capital requirements mandated by Basel I, (2) lower loan demand due to the economic recession, (3) greater regulatory scrutiny,10 and (4) a secular shift in banking away from on-balance sheet to more lucrative off-balance sheet activities. After controlling for these factors, Furfine (2001) finds that some form of regulatory involvement, either raising capital requirements or increasing regulatory monitoring, was a necessary contributor to the credit crunch. That is, the observed portfolio adjustment undertaken in the early 1990s could not have been simply the result of changing economic conditions or secular change. (Furfine (2001), p. 36.) Furthermore, Furfine (2001) uses the simulation to examine the likely impact of the early Basel II proposals. Since Basel II proposes leaving aggregate capital requirements unchanged, Furfine (2001) finds that a Basel II-induced credit crunch is unlikely.11 Indeed, the simulation results suggest that banks would shift their portfolios toward safer loans if Basel II regulations were adopted. However, Bugie et al (2003) state that the data and model requirements of the IRB approaches in Basel II may induce sectoral credit crunches, such that banks ration credit to small and informationally opaque businesses. Moreover, the Quantitative Impact Studies undertaken by the Basel Committee suggest that Basel II will slightly reduce overall capital requirements for retail-oriented banks using the IRB Approach, but increase overall capital requirements for large corporate banks. The effect of Basel II on universal banks with balanced retail/business mixes, therefore, is expected to be neutral. Kupiec (2001) highlights a fundamental inconsistency between Basel I and Basel II that may affect the banking systems role in the crucial capital formation function. Basel I follows a hold-to-maturity ideology in keeping with the banks role as liquidity provider to the economy. That is, as in Diamond (1984), the bank intermediates between longterm, illiquid, risky investment opportunities (loans) and short-term liabilities (deposits). Under normal circumstances, the bank is expected to bridge the liquidity gap by holding assets until maturity, thereby avoiding the realization of short-term valuation changes that would result if the banks assets were marked to market (MTM). Kupiec (2001) shows that the standardized approach in Basel II follows this hold-to-maturity (HTM) methodology, since credit ratings implicitly set the investment time horizon equal to the time to maturity. However, the IRB models obtain their inputs using one year, MTM credit risk measurement models (such as CreditMetrics). Thus, there is a fundamental
Hancock, et al. (1995) attempt to disentangle the loan supply effect (due to shifts in regulatory capital requirements) from the loan demand effect (due to an economic contraction that reduced loan demand) using a vector-autoregression model and find that banks adjust their capital positions much more quickly than they adjust their loan positions. Moreover, credit-constrained banks reduced their lending by greater amounts than well-capitalized banks, suggesting that some, but not all, of the explanation for the credit crunch can be traced to regulatory restrictions. 10 Bizer (1993) finds that banking supervisors assigned lower CAMEL ratings to banks during the credit crunch period. Moreover, Peek and Rosengren (1995a, 1995b) find that regulatory actions, such as cease and desist orders, had a significant impact on bank lending activity. 11 Allen (2001) presents the regulatory view that Basel II should preserve the aggregate capital level, but better distribute capital across banks in a more risk sensitive manner.
9

9 inconsistency that may make IRB-adopting (i.e., more sophisticated) banks reluctant to act as residual liquidity providers to the economy, thereby potentially hampering efficient capital allocation and inducing a credit crunch. Kupiec (2001) shows that the differences in capital requirements under the MTM and HTM approaches may be non-trivial. The problem is exacerbated for long-term, high quality credits.12 Thus, Basel II may impact aggregate bank credit creation even if aggregate capital levels are left unchanged. 2.2 The Basel Impact on Bank Risk Exposure

The introduction of risk-based Basel capital requirements was intended to offer banks a loophole to avoid onerous regulation. If banks reduce their risk exposure (as measured by the regulations), then they can reduce their holdings of expensive capital sources of funds. Thus, a primary goal of Basel capital requirements is to control bank risk taking. This section examines the literature studying whether this goal has been (will be) achieved under Basel I (II). Keeton (1989) documents the motivation behind the adoption of Basel I as increasing regulatory control over bank risk exposure and enhancing the safety and soundness of the banking system by encouraging safe banks to grow faster and risky banks to grow slower. Avery and Berger (1991) compare Basel I to the leverage requirements in place in the US during the 1980s. They conclude that the introduction of risk-based capital requirements would increase capital standards for large banks more than for small banks, holding portfolio composition constant, but that the aggregate capital level in the banking industry would only increase slightly. Moreover, they find that the banks with the highest levels of risk-weighted assets tend to have the poorest performance, suggesting that the market return for risk-taking was inadequate. However, overall, Avery and Berger (1991) find an inverse relationship between risk-based capital requirements and bank risk taking. In contrast, Furlong and Keeley (1989), Keeley (1990), Keeley and Furlong (1990) and Gennotte and Pyle (1991) show that capital regulations can increase bank risk by encouraging banks to seek out more risky activities.13 Rochet (1992) finds that capital regulations can limit bank risk taking for risk averse (as opposed to risk neutral) banks only. Moreover, Thakor (1996) finds that increases in bank capital requirements raise the risk exposure of the banking sector. However, Flannery (1989) uses an option-theoretic model to show that risk-based capital requirements (such as Basel I and the selective marking-to-market of problem loans in the context of a bank examination) encourage the bank to invest in less risky individual assets, but riskier portfolios.14
12

Basel IIs treatment of time to maturity may create perverse incentives when dealing with loans with maturities greater than 3 years such that the loan adjustment factor decreases the loans risk weight as the loan quality (credit rating) deteriorates. See Allen (2002). 13 Lam and Chen (1985) show that the relationship between bank risk and capital requirements is made more complex when interest rates are stochastic. 14 This apparent contradiction arises because bank capital regulations do not adequately incorporate correlations. Thus, banks can reduce their capital requirements if they invest in highly correlated, relatively

10

Blum (1999) uses a dynamic model to show that capital regulations like Basel I may reduce bank profitability, thereby inducing the bank to increase its risk exposure, particularly for undercapitalized banks that have to raise equity in the future. That is, increasing the banks risk exposure may reduce the cost of issuing equity for undercapitalized banks. Krainer (2003) shows that banks increase the risk of their portfolios (and hold relatively more loans) when stock prices increase, signaling a reduction in the risk aversion of stockholders. That is, when banks increase the proportion of risky loans in their portfolios, they choose to increase their levels of equity capital. In contrast, when stock prices fall, there is a flight to safety and a shift out of risky loans into lower risk securities and cash. Examining data on US banks over 19561999, Krainer (2003) finds evidence of these cyclical shifts. Moreover, bank capital responsiveness to risk taking predates the introduction of formal risk-based capital requirements. Thus, capital regulations are not binding constraints on the banks optimal risk-related economic capital policies. Capital requirements are only one of the tools used by bank regulators to control bank risk taking. Even pre-Basel minimum capital-asset ratios (leverage restrictions) may induce banks to limit the risks of their portfolios. Morgan and Smith (1987) show how a pre-Basel (non-risk-adjusted) capital requirement may either increase or decrease the incentive to use forward contracts to hedge the banks risk exposure depending on the banks profitability (spread), the forward rates, risk preferences and the banks initial capital position. Moyer (1990) shows that US banks undertake accounting changes in order to bring the bank into compliance with leverage restrictions. Moreover, Beatty et al (1995) find evidence of capital ratio management before the introduction of Basel I. However, Allen and Saunders (1992) find banks engaging in window dressing activities, that artificially increase bank size, thereby making compliance with pre-Basel I capital requirements more costly. Ford and Weston (2003) examine the performance of banks in Belgium, Denmark, Germany, Ireland, Italy, the Netherlands, Scandinavia, Switzerland and the UK over the 1980-1996 period. They find that following the introduction of Basel I, the volatility of bank equity returns decreased across most European countries, except Belgium and Scandinavia. Prior to the implementation of Basel I, banks in Belgium and Scandinavia had the highest risk-adjusted returns, suggesting that these banks were undercapitalized relative to their risk exposure in the pre-Basel period. Despite the standardized capital requirements of Basel I, however, Ford and Weston (2003) find considerable differences in the risk/return performance across countries. They claim that capital levels appear to be driven by assessments of economic risk, rather than by capital regulations. Moreover, country-to-country differences in accounting practices, stringency of provisioning for loan losses and recognition of non-performing loans undermines the goal of providing a level international bank regulatory playing field.

low risk individual assets. This reduces the risk of the individual assets comprising the banks portfolio, thereby lowering capital requirements, but increases the overall portfolio risk exposure.

11 Empirically, Allen and Jagtiani (1997) find that US banks increased their exposure to systematic market risk after the passage of Basel I, although they limited their interest rate risk exposure. Bikker and Hu (2002), using an international sample of banks in 26 developed and developing countries, find that the profit margin on high risk loans is relatively small, suggesting that the additional costs and losses of these risky loans are not covered sufficiently by higher credit spreads. Rime (2000) finds that Basel I induced Swiss banks to increase their capital levels over the 1989-1995 period, but not to decrease their risk exposure. This is attributed to the rigidity of the Swiss market in providing risk-sharing opportunities, as well as the relatively illiquid market for small banks stock in Switzerland. Ediz, et al (1998) use confidential supervisory data for UK banks and find that Basel I capital requirements were binding constraints, inducing British banks to increase their capital positions. However, they find little evidence of a BIS policyinduced shift away from high risk-weighted loans in the UK. Wall and Peterson (1995) empirically test banks responses to the introduction of Basel I. They find that banks considered themselves well capitalized in 1989, but were required to increase their capital levels above their private targets by capital regulations. This was particularly pronounced for banks subject to regulatory orders. Hancock and Wilcox (1994b) document the sharp rise in US bank capital levels during the early 1990s, from a post-WWII average ranging from 6%-8% to over 10%. They estimate a long run target equilibrium capital level that is specific to each bank. The more volatile the banks local economy, the higher its capital target ratio. Thus, banks tended to build capital as a cushion against external market risk and regulatory intervention (triggered by bank examiner CAMEL ratings of 4 or 5 denoting inadequate bank management).15 Stolz (2002) summarizes the empirical findings and finds that flat (pre-Basel) capital requirements limit bank risk taking, despite some examples of outlier banks that take excessive risk in order to exploit the government safety net. Moreover, managerial risk aversion and strict prudential supervision by bank regulators appear to control bank risk taking incentives. The banking systems response to risk-based capital requirements depends on the cost of recapitalization. That is, the introduction of Basel I required either an increase in capital or a decrease in risk exposure. US banks tended to respond by decreasing risk, whereas Swiss banks did not. Stolz (2002) argues that this differential response may be obtained because portfolio adjustments (in terms of shifting the risk of the banks portfolio) are more costly in the less liquid Swiss markets than in the US. Hovakimian and Kane (2000) also find evidence that capital regulation over the period 1985 to 1994 did not deter banks from shifting risk onto the public safety net.16 Banks were found to exploit a deposit insurance subsidy that exposes the FDIC to increased risk of loss. Hovakimian and Kane (2000) use an option-theoretic empirical model to show
15

Wall (1989) and Wall and Peterson (1987) find that the introduction of explicit (non-risk-based) capital requirements in 1981 also induced some banks (large bank holding companies in the US) to increase their capital levels. Thus, regulatory scrutiny may induce banks to enhance their capital positions, independent of the form (i.e., risk-based or flat rate) of the regulations. 16 Berger, Herring and Szego (1995) document the long-term decline in equity to asset ratios for US banks as the government safety net expanded over the late 19th-early 20th centuries.

12 that regulatory policies relying on accounting measures of risk and capital are not sufficient to eliminate risk shifting behavior by US banks. Hancock and Wilcox (1994b) present evidence that economic capital requirements in the US increased in the post-Basel I period; therefore, the Basel I capital constraints were not binding. In contrast, Hall (1993), Lavin, Griswold and Karels (1996) and Thakor (1996) all find that the introduction of the Basel I capital requirements induced US banks to reduce the risks of their portfolios.17 Moreover, Haubrich and Wachtel (1993) use US bank call reports to empirically verify that bank asset portfolios became less risky in the wake of the introduction of Basel I as banks increased their holdings of government securities and decreased their holdings of loans. In contrast, Laderman (1994) finds evidence that the increased cost of raising capital generated the shift in US bank portfolios during the period following the implementation of Basel I. That is, the increased cost of issuing bank equity limited a capital-constrained banks ability to comply with the new higher capital requirements, thereby inducing the bank to increase its capital ratio by decreasing the size of the loan portfolio and shifting into lower risk government securities with lower capital requirements. Thus, the impact of capital constraints was both to reduce the risk of the banking sector and to stunt the creation of credit in the US economy (see section 2.1 on the credit crunch). In contrast, Hancock and Wilcox (1994c) found that capital-deficient banks shifted their portfolios toward high risk assets. However, Jacques and Nigro (1997) use a three-stage least squares approach and verify the earlier findings that the introduction of Basel I increased capital ratios and reduced the risk of the banking sector in the US. However, their results are somewhat sensitive to the degree of capital deficiency for each bank. These disparate results can be resolved by Calem and Rob (1996) who find that the relationship between bank risk and capital requirements is a U-shaped function of the initial capital position of the bank. Severely undercapitalized banks maximize risk in order to improve the banks capital position (i.e., maximize the banks equity call option value), thereby engendering concerns about moral hazard. As the banks position becomes only slightly undercapitalized, the incentives are to reduce risk so as to avoid insolvency. Finally, adequately or well capitalized banks respond to more stringent capital requirements by taking on more risk to increase the value of equity. Stolz (2002) reviews the conflicting theoretical results in this literature, noting the difference between flat capital regulation (e.g., a leverage limitation) and risk-based capital regulation. Banks can circumvent the intent behind flat capital regulation by increasing the risk of their portfolios, thereby increasing the probability of bank insolvency. However, determining the correct risk weights for risk-based capital requirements is very difficult, particularly since banks information advantages make it difficult for outsiders (such as regulators and the market) to correctly evaluate the risk and market valuation of bank assets.18 Thus, perverse risk-taking incentives can be
17

In a survey of 205 banks, Lavin, Griswold and Karels (1996) find that 37% increased their capital-asset ratio over the 1989-1994 period, with 46% of that increase attributed to the Basel I capital requirements. 18 However, increased asset securitization has obviated this critique somewhat; see Rochet (1992).

13 encouraged by inaccurate risk weights in risk-based capital regulations. Boyd and Gertler (1993) note with regard to instituting regulatory policies that induced price risktaking behavior is preferable to micro-managing banks portfolio choices. Supporting the findings of the perverse risk-taking incentives in Basel I, Allen, Jagtiani and Landskroner (1996) show that the implementation of Basel I encouraged banks to switch from priced credit risk exposure to unpriced interest rate risk exposure. Therefore, it is unclear whether Basel I increased or decreased the overall risk of the US banking sector since, although credit risk declined over the pre to post-Basel I period, interest rate risk increased (during the period prior to the introduction of the market risk amendment to Basel I that added a capital charge for interest rate risk exposure). Furthermore, Greenspan (1998) notes that Basel I has been successful in raising bank capital levels, but not necessarily in controlling bank insolvency risk. This is because Basel I regulations are not tied to any chosen insolvency probability standard. Moreover, except for trading account activities, Basel I does not adjust capital standards to reflect hedging, diversification and risk management techniques. Krainer (2002) links the risk-based capital requirements of Basel I to the resolution of an agency conflict between risk averse depositors and less risk averse bank shareholders. Thus, if the bank increases its risk exposure, the resulting increase in capital requirements prevents the shifting of wealth to shareholders from depositors and other bank creditors. However, Krainer (2002) argues that Basel I is insufficient to accomplish this goal because of the regulations crude assessment of risk, which is easily subverted through capital regulation arbitrage. If Basel II is more sensitive to the banks risk exposure, it may act as a more effective mechanism to maintain the balance between stockholders and risk averse depositors. Kim and Kross (1998) find evidence of strategic accounting behavior with regard to loan loss provisions and write-offs around the implementation of Basel I. Undercapitalized banks reduce their loan loss provisions and increase their write-offs in order to meet the new capital requirements. Well-capitalized banks exhibited no such behavior with regard to loan loss provisions, although they exploit the new capital requirements to increase their loan write-offs. Moreover, Rajan (1994) finds that banks under-reported real estate loan losses during the 1988-1989 recession in New England and that loan loss provisions/charge-offs during the 1986-1992 period are correlated across banks. This suggests that banks strategically manage their loss reserves over time. Allen and Rai (1996) note that bank capital requirements are only one component of the regulatory/market banking environment. They examine an international sample of banks to distinguish between the impact of capital requirements (Basel I adopted across all countries in the sample) and individual country-specific factors (such as the generosity of deposit insurance and the extensiveness of the safety net). Examining banks in Canada, Germany, Spain, France, Italy, Japan, the UK and the US over 1991-1993, Allen and Rai (1996) find two opposing effects on capital levels: (1) a moral hazard effect (implying a positive relationship between bank risk and capital levels) and (2) a market rents effect (implying a negative relationship between bank risk and capital levels). They find that

14 the moral hazard effect dominates for banks in countries with strong safety nets; i.e., bank risk increases as banks reduce capital levels to maximize the put option value of the government safety net (too big to fail, deposit insurance, etc.).19 However, in countries with more limited safety nets, the market rents effect dominates; i.e., banks increase their capital levels, thereby reducing risk, in order to maximize bank charter value. Mpuga (2002) examines the impact of the introduction of limited risk-based capital requirements on banks in developing countries. He uses the example of Ugandas adoption in 1993 of formal minimum capital levels that required a minimum paid up capital of 500 million Uganda shillings for domestic banks and 1 billion Uganda shillings for foreign-owned banks. Moreover, there was some attempt at the time to relate different proportions of minimum capital to different risk categories of assets. The new capital requirements had a positive impact on deposit and asset growth rates, bank capital levels and profitability for the Ugandan banking industry overall. However, locallyowned banks appeared to have increased their risk exposure and experienced declines in earnings and capital in the wake of the 1998-1999 crisis in Uganda. In contrast, foreignowned banks posted strong gains (in asset size, capital levels and reductions in risk) in the years following the introduction of capital requirements. Mpuga (2002) attributes this differential to the superior managerial and supervisory skills of foreign-owned banks as compared to the under-developed domestic banking institutions. Similarly, Caprio and Honohan (1999) describe the difficulty in fine-tuning bank capital requirements in developing countries that are subject of periodic political crises and regime changes. Moreover, they describe managerial deficiencies in estimating losses in an environment subject to sudden economic shocks that result in discrete shifts in the banks risk exposure. Furthermore, Sundarajan, et al (2001) assert that Basel I and IMF codes of good practices on transparency and disclosure have had an insignificant impact on credit risk and bank safety and soundness. However, regulatory policy has been effective to the extent that regulatory policy has revealed bank responses to exogenous macroeconomic or market specific economic factors. Boyd and Graham (1991) discuss the trend toward consolidation in the US banking industry that gained momentum in the 1990s. They note that although over the past two decades there has been a considerable decrease in the number of banks in the US, the remaining banks are larger. This growth in average bank size is not related to cost efficiencies or reductions in risk according to Boyd and Graham (1991). Rather, it appears to be driven by the too big to fail government safety net that induces banks to build up market share, thereby protecting incumbent management from the takeover and control market. In their comprehensive study, Berger, Demsetz and Strahan (1999) find similar results; consolidation increases bank market power, increases systemic risk and possibly expands the financial safety net. However, they find some evidence of improvements in profit efficiency and risk diversification. Moreover, Bos and Kolari (2003) find that geographic expansion and consolidation of large European and US banks yield potential efficiency gains stemming from differentials in cost and profit efficiency levels across countries. In particular, since US banks have greater cost and profit
19

Boyd and Gertler (1993) attribute exploitation of the generous government safety net as the explanation for excessive risk taking by US banks and thrifts that led to their poor performance during the 1980s.

15 efficiency than European banks, Bos and Kolari (2003) conclude that there is an economic motivation for cross-Atlantic bank mergers. Berger, et al (2000) examine the impact of global diversification on banking efficiency. Using data from banks based in France, Germany, Spain, Canada, Italy, Japan, the Netherlands, South Korea, Switzerland, the UK and the US, they examine foreign bank mergers and acquisitions. They find that domestic banks tend to have higher cost and profit efficiency than foreign banks on average. However, they claim that foreign-owned banks are more efficient than domestic banks under the conditions that the foreign banks are efficient institutions that are headquartered in a limited number of countries with favorable market, regulatory or supervisory conditions. In particular, US banks were able to utilize their efficiency advantages to compete more effectively when acquiring banks in other countries. Whether these advantages were due to well-developed US securities markets, geographic mobility, prudential supervisory activity or domestic operational efficiencies could not be ascertained.20 One of the concerns associated with the liberalization of banking powers in the GrammLeach-Bliley Act of 1999 (that removed Glass Steagall restrictions on commercial banking in the US) was that regulatory oversight would be diluted by the overlap of functions within a given corporate entity. This could spill over into systemic risk if the universal banks were empowered to take on excessive levels of risk, thereby extending the coverage of the government safety net beyond commercial banking. Boyd, Graham and Hewitt (1993) simulate mergers between banks and nonbanking financial intermediaries and find that mergers of banks with insurance companies reduce risk, whereas mergers between banks and securities firms increase risk. Allen and Jagtiani (2000) find that diversification reduces overall risk, but increases the synthetic universal banks systematic market risk. Moreover, Allen and Jagtiani (1997) show that securities firms had the highest levels of market risk exposure across all US financial intermediaries during the 1974-1994 period. Thus, newly created financial holding companies (FHC) can exploit their universal banking powers to increase risk exposure despite the introduction of more stringent risk-based capital requirements. As noted in several studies, capital requirements are just one of an array of banking regulations designed to monitor, manage and maintain the safety and soundness of the banking system. Deposit insurance protection is part of that array. To the extent that the pricing of the deposit insurance premium is insensitive to bank risk exposure, the introduction of deposit insurance protection will undermine market discipline and may induce moral hazard risk shifting by banks. In 1967, deposit insurance protection was introduced in Canada; deposits receive government insurance up until an amount of C$60,000. The deposit insurance premium levied by the Canada Deposit Insurance Corporation (CDIC) was flat-rate until 1998.21 Gueyie and Lai (2003) examine the Canadian banking system from 1959 to 1982 in order to assess the impact of the
20

Rajan (2000), in commenting on Berger, et al (2000) noted that the results do not control for bank risk taking across borders. 21 The premium rate was 3.33 basis points per insured deposits from 1967 to 1985, 10 basis points from 1986 to 1992, 12.5 basis points in 1993, and 16.67 basis points from 1994 to 1998.

16 introduction of deposit insurance on bank risk taking. They find that Canadian banks significantly increased their risk exposure after the introduction of deposit insurance. However, they do not attribute the increased risk to a moral hazard response to the introduction of deposit insurance, but instead to increased volatility in Canadian financial markets, especially the financial services industry. Gueyie and Lai (2003) confirm results by Saunders and Wilson (1995) that find, for the US, a positive and significant correlation between bank risk taking and capital ratios. Thus, Gueyie and Lai (2003) conclude that the riskiest banks in Canada tended to have the highest capital positions, thereby demonstrating self-discipline and the absence of moral hazard risk shifting to the CDIC. The financial condition of the Canadian banking system prior to the introduction of deposit insurance in 1967 is the source of some controversy. Carr et al (1995) claim that the stability of Canadian banks from 1890 to 1966 (no bank failures) was due to the prudent policies of bank management in the absence of an explicit deposit insurance system, as well as due to active monitoring of bank risk taking by both depositors and bank regulators. Kryzanowski and Roberts (1993, 1999) disagree and claim that Canadian banks were technically insolvent in the 1930s. In their view, only an implicit 100% guarantee from the Canadian government kept Canadian banks from failing. Indeed, Gueyie and Lai (2003) claim that concern about the loss of this implicit government guarantee could be one of the reasons that the Canadian Bankers Association so vigorously opposed the introduction of an explicit deposit insurance program in Canada. In a different context, Dionne and Harchaoui (2003) find conflicting results. Although they find that the riskiest Canadian banks are those that are most actively engaged in asset securitization, these risky banks are found to have the lowest capital levels. This contradicts the self-discipline hypothesis of Gueyie and Lai (2003) and suggests that Canadian banks have engaged in moral hazard risk shifting in response to onerous capital requirements that force diversified banks to hold excessive capital levels. A primary shortcoming of Basel I was its failure to differentiate levels of credit risk within particular asset classes, e.g., commercial and industrial loans. Basel II proposes to correct that by increasing the sensitivity to credit risk exposure of the risk classification process.22 Kupiec (2001) describes how the three part evolutionary structure of Basel II can create perverse incentives. For example, capital requirements for low quality, high risk (below BBB) instruments are significantly lower under the standardized approach than under the IRB foundation approach. Thus, less sophisticated banks using the standardized approach have an incentive to specialize in high risk credits, thereby increasing the risk of the overall banking system as the least capable banks assume the most risk. However, using a large sample of loans to small- and medium-Spanish firms, Saurina and Trucharte (2003) find that banks that manage credit risk well have an
22

Altman and Saunders (2001a) state that the Basel I flat capital requirement is not corrected for the unrated category under the standardized approach of Basel II. Moreover, they find that the risk weights are insufficiently convex so that low risk loans have a capital charge that is set too high and high risk and unrated loans have a capital charge that is set too low.

17 incentive to evolve from the standardized to the IRB approaches of Basel II. Moreover, Dietsch and Petey (2002) use a portfolio of 220,000 French small and medium sized enterprise loans to show that the IRB risk weights are set too high for all risk levels.23 In contrast, Frerichs and Wahrenberg (2003) use data from Deutsche Bundesbank to show that capital requirements are set too low if based on historical rating class default rates (as in the standardized approach of Basel II). However, they find that both the pooling data across institutions and the continuous validation of internal rating systems over time improve the accuracy of credit risk measurement models. Herring (1999) argues that existing risk measurement models perform poorly when it comes to extremely low probability, extreme tail catastrophic risk events. Because they have no personal historical experience to draw upon, most risk managers will have only limited understanding of the risk of ruinous risk events; i.e., firms do not live to learn the lessons of extreme risk events. This underestimation of the risk of ruin results in disaster myopia. Basel II may address some of these criticisms to the extent that the advanced operational risk models attempt to model these potentially disastrous shocks. However, prudential supervision and capital requirements are ill equipped to address a bank that this is currently solvent (and perhaps even in good financial condition), but vulnerable to extreme risk events. Herring (1999) notes that market discipline might be a more effective way of addressing this quandary, particularly for banks with subordinated debt.24 Moreover, encouraging diversification across activities and across geographic areas for well-capitalized banks may reduce their catastrophic risk exposure. Hawke (2002) stresses the importance of independence and freedom from political pressures in fostering the efficacy of prudential supervision in maintaining the safety and soundness of the banking system. He traces the source of financial decline in country after country (e.g., Argentina, Japan, South Korea, and Turkey) to a politicized banking system, cronyism and a captive regulatory agency subject to outside pressures. Thus, the impact of regulatory supervision on bank safety and soundness may be somewhat independent of the regulatory details themselves; rather, the important factor is the evenhanded and transparent application of general prudential supervisory policies.25 Bugie et al (2003) are concerned about the omission of any treatment in Pillar I of the proposals of interest rate risk in the banking book, business and reputation risk, and concentration risk. Moreover, given the complexity of the Pillar I rules, Bugie et al (2003) contend that banks will be preoccupied with assessing the covered risks, thereby neglecting these important omitted risk exposures. Benink and Wihlborg (2002) state that there is no way to design Basel II (or any other regulation) that will eliminate all
23

Using Moodys data on US firms, Carpenter, Whitesell and Zakrajsek (2001) estimate that the introduction of Basel II would lower capital requirements. 24 In the wake of the Mexican debt crisis, the SEC required the revelation of any concentration of country risk exposure that exceeded 0.75%. However, this might reveal confidential information and undermine confidence, thereby becoming a self-fulfilling prophesy of disaster. 25 Aggarwal and Jacques (2001) use a three stage least squares model to examine the impact of prompt correct action and early intervention on bank capital levels. They find that US banks substantially increased their capital levels without increasing their credit risk exposure in the wake of the passage of the FDICIA that mandated stricter enforcement of bank capital supervisory policies.

18 possibilities to game the system with perverse results on bank risk taking. Instead, they point to the importance of the third pillar, market discipline, as an important element of Basel II. To strengthen market discipline, Benink and Wihlborg (2001) call for the mandatory issuance of subordinated debt by large banks.26 2.3 Securitization and Regulatory Capital Arbitrage

Jones (2000) outlines regulatory capital arbitrage mechanisms used by banks to circumvent the intent of Basel I to increase capital requirements as risk exposure increases.27 Some common techniques include the use of securitization to concentrate and transfer credit, the creation of remote special purpose vehicles (SPV) to transfer ownership, and the use of indirect credit enhancements. For example, by unbundling and repackaging a loan portfolios cash flows, an asset-backed security (ABS) can be sold by the bank as an investment grade vehicle. As long as any potential recourse to the bank is kept to less than 8% of the pool, there is no capital charge to the bank under Basel I. If the SPV originates the underlying securitized assets and bank recourse is replaced by a direct credit substitute issued by the SPV, then the capital charge under Basel I can be reduced from 100% to 8%. Moreover, by restructuring financial guarantees as indirect credit enhancements, the bank can avoid capital charges under Basel I. Jones (2000) notes that as of March 1998, outstanding non-mortgage bank securitization programs (a mechanism often used to arbitrage capital regulations) exceeded $200 billion or more than 25% of the total risk-weighted loans in banks in the US. Thus, the potential impact of regulatory capital arbitrage is quite extensive. Greenspan (1998) notes, however, that regulatory arbitrage may not be undesirable if it permits banks to correct excess capital requirements. If banks could not avoid these excessive capital regulations through regulatory capital arbitrage, they would have no choice but to exit relatively low-risk businesses, thereby increasing the overall risk level of the banking system. Securitization, particularly of high quality assets, can dramatically reduce the banks regulatory capital requirement. This occurs if the securitization is with partial recourse. If the required economic capital is much lower than the regulatory capital requirement, the bank can insure the credit quality of the ABS and still reduce its regulatory capital levels. Jackson et al (1999) provide a series of examples illustrating the use of securitization in regulatory capital arbitrage under Basel I. The base case is a $200 portfolio of on-balance sheet (100% risk-weighted) loans less the loan loss reserve (equal to the portfolios expected loss) of $2, funded with $22 of equity and $176 of deposits.

There has been a great deal of controversy regarding the practicality of subordinated debt requirements in fostering market discipline. For a discussion of the pros and cons, see the special issue of the Journal of Financial Services Research, vol. 20, no. 2/3, 2001, edited by Mark Flannery. 27 Similar arbitrage incentives exist for regulations other than capital requirements. McCauley and Seth (1992) show how US reserve requirements induced banks to book their loans to US businesses off shore. During the latter half of the 1980s, foreign bank lending to US companies increased to around a 45% market share, until the reserve requirement was removed in 1990. Baer and Pavel (1988) document a shift during the 1980s away from US bank regulators reliance on reserve requirements toward capital restrictions as tools of prudential bank supervision.

26

19 The total (Tier I) regulatory capital ratio is 12% (11%).28 Now consider a securitization without recourse of $40 of the loan portfolio, thereby reducing funding through deposits to $136. The new total (Tier I) capital ratio is 15% (13.8%). Next, Jackson et al (1999) consider securitization of term loans with recourse. To enhance the credit of the ABS, the originating bank transfers $42 of on-balance sheet loans into the SPV, but only sells $40 of ABS. The remaining $2 represents the credit enhancement provided to the SPV by the originating bank. If payments on the underlying loan pool are sufficient to repay all obligations on the ABS, then any additional payments (called excess servicing) will be made to satisfy a $2 subordinated bank loan to the originating bank (actually, an equity position in the SPV). However, if there are losses, the originating bank absorbs them, to a maximum value of $2. Thus, the bank retains a first loss provision of $2 in this example. If the loans in the underlying pool are of high credit quality, there is little likelihood that this first loss provision will be breached. Moreover, the ABS investors are exposed to very small amounts of risk. The $2 subordinated loan to the SPV is treated as recourse under Basel I and subject to a 100% capital requirement. Despite this, the banks regulatory capital levels increase (to 12.8% for Tier I and 13.9% for total as compared to the 11% and 12% base case ratios) because the amount of recourse per dollar of securitized assets is less than 8%.29 Jackson et al (1999) state that securitization of revolving credits is one of the fastest forms of regulatory capital arbitrage. The bank designates certain lines of credit to be transferred to the SPV. That is, if and when the lines are drawn down, these amounts are sold to the SPV. The SPV funds these purchases by selling ABS for a certain amount and issuing a para passu sellers interest (equity stake) for the residual (credit enhancement) amount. Using the example provided by Jackson et al (1999), securitization of revolvers increases the banks regulatory capital ratios under Basel I to 12.8% (Tier I) and 13.9% (total risk-based capital requirement). Finally, the bank can increase its capital ratios even further by using remote origination vehicles such as loanbacked Asset Backed Commercial Paper (ABCP). In this securitization structure, the credit enhancements provided by the originating bank are treated as direct credit substitutes rather than recourse, thereby reducing the Basel I capital requirements from 100% (for recourse) to 8% of the credit enhancements Maximum Potential Credit Loss. This is achieved by having the SPV, rather than the sponsoring bank, originate the loans; a process known as remote origination. Since the loans have not been owned or sold by the bank, they are eligible for treatment as direct credit substitutes rather than recourse. Under this structure, the hypothetical bank in Jacksons et al (1999) example can increase Tier I (total) capital ratios to 13.8% (15%) from the base ratios of 11% (12%). Jackson et al (1999) estimate that most non-mortgage related ABS and ABCP that are issued by the ten largest US bank holding companies tend to be motivated by regulatory capital arbitrage. As an estimate of the amount of arbitrage undertaken in response to Basel I, Jackson et al (1999) note that as of March 1998, outstanding non-mortgage ABS and ABCP issued by the top ten US bank holding companies exceed $200 billion or more
28

The total regulatory capital ratio under Basel I is computed as follows: (Equity $22 + Reserves $2)/(Risk Weighted Assets $200) = 12%. Tier I capital ratios are: $22/$200 = 11% 29 Jackson et al (1999) use the low-level recourse rule to calculate the Basel I capital ratios in this example.

20 than 12% on average of their total risk-weighted assets and over 25% on average of their total risk-weighted loans. Jackson et al (1999) conclude that significant amounts of regulatory capital arbitrage are undertaken by US banks, as well as by Canadian, European and Japanese banks, particularly through collateralized loan obligations (CLO) and ABCPs. This has fueled much of the rapid development in the securitization market in Europe, according to Jackson et al (1999). Basel II proposes fairly strict tests to ascertain whether a clean break has been made before the assets can be removed from the originating banks balance sheet for the purposes of capital regulations. A clean break has occurred if: 1. 2. 3. the transferred assets have been legally separated from the originating bank so that they are beyond the reach of the banks creditors in the event of the banks bankruptcy; and the assets underlying the ABS are placed into a special-purpose vehicle; and the originating bank has neither direct nor indirect control over the assets transferred into the special-purpose vehicle.

Even when the conditions for a clean break are met, the originating bank may still be required to hold capital against the assets in the ABS pool if regulators believe that the bank is subject to reputational risk. That is, to prevent damage to the originating banks reputation, the bank might offer implicit recourse, which may take the form of the following possible responses to credit deterioration in the asset pool underlying the ABS: the bank may repurchase or substitute credit-impaired assets in the pool, loans may be made to the special-purpose vehicle, or fee income associated with the ABS structure may be deferred. Under such circumstances, regulators may force the bank to hold capital against all assets in all ABS issued, even those for which implicit recourse was not granted, as if all assets in all ABS pools remained on the banks balance sheet. Thus, the finding of the provision of implicit recourse engenders punitive regulatory action that is made public by bank regulators. Originating banks not satisfying conditions for a clean break (e.g., by providing credit enhancements for ABS or servicing the loan cash flows in the underlying pool of assets) may still be allowed to limit the risk of the assets for capital regulatory purposes if all credit enhancements are provided up front at the issuance of the ABS. In general, however, the value of any credit enhancements must be deducted from the banks capital using the full risk-based capital charge. Moreover, if the ABS has any provisions that may force an early wind-down of the securitization program if the credit quality of the underlying loans in the asset pool deteriorates beyond a certain point, then the originating bank must apply a minimum 10 percent conversion factor to the notional value of all offbalance sheet assets in the pool underlying the ABS in order to calculate the capital charge. Under Basel II proposals, banks that invest in ABS, as opposed to originating banks, must hold capital charges according to the following risk weights:

21

External Credit Assessment

AAA to AA20%

A+ to A50%

BBB+ to BBB100%

BB+ to BB150%

B+ and Below or Unrated Deduction from capital: RW=1250%

This schedule conforms with the risk weights under the Standardized Approach of Basel II, except for the lowest quality ABS (B+ and below or unrated) where there is in effect a one-to-one capital charge if a bank invests in these bonds. Indeed, the stringency of this capital charge is to offset the type of regulatory arbitrage apparent under Basel I. For example,30 under Basel I, a bank with $100 million of BBB loans on the balance sheet paid a capital charge of $8 million. Suppose these loans were placed in a SPV and two tranches of bonds were issued. The first tranche of $80 million were rated AA because they were structured to absorb default losses only after the first 3 percent of losses on the entire $100 million loan portfolio (corresponding to the historical default rate of bonds with a BBB rating) were borne by the second tranche of $20 million. Because of the low quality of the second tranche they were rated B. Suppose that the high quality tranche was sold to outside investors, but the bank or its subsidiaries (as commonly happens) ended up owning (buying) the second B rated tranche. Because Basel I treated all commercial credit risks with equal weight, the capital requirement on the $20 million of purchased bonds (that have virtually the same credit risk as the original $100 million BBB portfolio) would be subject to a capital charge of only $20 million x 8 percent = $1.6 million. That is, the bank has arbitraged a capital savings of $8 million minus $1.6 million = $6.4 million through the securitization. Under the proposed Basel II, the capital charge on the $20 million tranche would be $20 million, thereby eliminating arbitrage incentives. For those investing banks that use the IRB approaches instead, the probability of default can be measured for each tranche of each ABS. However, the Basel II proposals assume a LGD (loss given default) of 100 percent for ABS, in contrast to the 50 percent assumed under the Foundations Approach for unsecuritized loans. Banks can also sponsor special-purpose vehicles that purchase assets from non-banks that then issue ABS; i.e., remote origination. Although sponsoring banks are neither the loan originators nor servicers, they may provide credit enhancements, which must be deducted from capital.31 However, if sponsoring banks sell any of their own assets to the sponsored special-purpose vehicle, they are treated as if they were originating banks and subject to the regulations for ABS originators.

This example is taken from Saunders and Allen (2002), chapter 15. First-loss credit enhancements are deducted from capital, whereas a capital charge is levied against subordinated second-loss credit enhancement using risk weights determined by the assets in the ABS.
31

30

22 Despite their apparent value as credit risk management tools, credit derivatives have not been well treated under the BIS I capital requirements.32 According to Wall and Shrikhande (1998), the present U.S. approach is to treat credit derivatives as a loan guarantee, provided the payoff from the credit derivative is sufficiently highly correlated with the loan. If the counterparty is neither a bank nor a government entity, the risk weight is 100 percent; no risk reduction is recognized. If the counterparty is a bank, the risk weight on the loan for the buyer of the guarantee is 20 percent; however, for the bank that issues the guarantee to the counterparty, the risk weight of the guarantee is 100 percent (i.e., it is as if the counterparty has been extended a loan). Thus, in aggregate, the combined-risk-based capital requirements of the two banks could increase as a result of using the derivative. (Under certain conditions, however, this capital burden may be reduced.)33,34 Basel II proposes a harmonization of treatment of credit derivatives (see Saunders and Allen (2002), chapter 15) under the supervisory pillar. Despite these incentives to engage in regulatory capital arbitrage, Donahoo and Shaffer (1991) show that the primary incentive leading to asset securitization is profitability, i.e., a comparative advantage in loan origination and servicing creates the incentive to turnover the asset portfolio. Moreover, Jagtiani, Saunders and Udell (1995) show that the changes in bank capital requirements did not consistently impact the speed of adoption of off-balance sheet activities by banks. However, capital regulations can have a marginal effect. Donahoo and Shaffer (1991) show that the impact of the introduction of Basel I was to increase the relative return to securitization by increasing the relative cost of holding assets on the balance sheet. To the extent that Basel II further increases this relative cost, for at least some classes of assets, the introduction of Basel II can be expected to further encourage banks to engage in asset securitization. However, Donahoo and Shaffer (1991) note that non-bank financial institutions, such as captive finance companies, that engage in asset securitization are not impacted by shifts in bank capital requirements at all. Thus, Donahoo and Shaffer (1991) contend that the incentives to securitize are relatively inelastic with respect to bank capital requirements. This conclusion is contradicted by Pavel (1986) and Simons (1993). They find that the adoption of Basel I induced banks to seek out ways to remove capital-intensive loans
This may account for the observation that only the largest US banks use credit derivatives at all. Moreover, total credit derivatives exposure at US banks as of March 31, 2001 comprised less than 1 percent of US banks notional derivative exposures and 64 percent of the total credit derivatives exposure was held by JP Morgan Chase. See Rule (2001). 33 Wall and Shrikhande (1998) note that the combined regulatory capital requirements may be reduced if three conditions are met: (1) the bank selling the credit risk is bound by the risk-based guidelines, (2) the counterparty's (the buyer of the credit risk) required capital under the leverage standard exceeds its required capital under the risk-based standard, and (3) the counterparty does not already have such a high level of off-balance-sheet commitments that the regulators impose a judgmental increase in its leverage requirement. In this case, the bank holding the loan and selling its risk would reduce its capital requirement for the loan to one-fifth the original level (moving from a 100 percent weighting to a 20 percent weighting). Further, the counterparty may not experience any increase in its capital requirements since the credit derivative would not be included in the calculation of its leverage ratio (p. 10). 34 Since July 1998, banks in the U.K. have been permitted to include credit derivatives in their trading book, provided that they can be hedged and that market makers exist. Under this treatment, the bank holds capital against the underlying asset only, thereby avoiding a capital charge on both the underlying and the derivative.
32

23 from their books. However, Pavel and Phllis (1987) and Carlstrom and Samolyk (1995) find that the impact of capital constraints was less important than the banks comparative information advantage in originating and servicing loans. Karaoglu (2003) finds support for the use of loan securitizations to meet capital requirements, as well as to manage the flow of accounting information. Banks securitize loans when they can book fair valuation gains. Using a sample of US banks, Karaoglu (2003) finds evidence that banks securitize loans when they can book gains in quarters in which they have incentives to increase either regulatory capital or earnings. Chami and Cosimano (2001) examine the connection between bank capital requirements and market structure. They find that the existence of capital requirements (such as the introduction of Basel I) enhances collusive behavior among banks, thereby reducing market competitiveness. This result is obtained whenever capital requirements reduce expected profits to banks that renege on collusive agreements. Thus, Basel I was anticompetitive to the extent that Basel I increased the overall minimum capital requirements for the banking industry. Since Basel II is designed to be neutral with respect to the overall, aggregate capital level, the Chami and Cosimano (2001) model would predict that Basel II would have no impact on the level of competition among banks. Introduction of Basel I had negative announcement affects according to the empirical results of Cooper, Kolari and Wagster (1991). They find significantly negative abnormal returns for bank stocks upon announcement of the Basel I proposals and adoption. US bank stocks exhibited the largest negative reaction. Madura and Zarruk (1993) find a similar negative stock market reaction for large US money center banks, but find no impact on the share prices of US super-regional banks, perhaps because of their higher, pre-Basel I capital levels. Wagster (1996) tests the announcement effects on bank stock prices of 18 events taking place between September 11, 1985 to March 28, 1990 that led to the approval of Basel I. Examining banks from Canada, Germany, Japan, the Netherlands, Switzerland, the UK and US, he finds that only Japanese bank equity returns showed a significant and large cumulative wealth gain of 31.63% associated with the introduction of Basel I.35 Examining US banks, Eyssell and Arshadi (1990) find no significant wealth effects upon announcement of Basel I. Kupiec (2001) shows that the IRB approaches in Basel II may discourage banks from accurate and timely loan loss provisioning and may discourage their investment in fairly valued distressed credits. This may reduce liquidity in the secondary market for leveraged loans and other non-investment grade instruments. Furfine (2002) examines the impact of the Russian default and the near-default of Long Term Capital Management during the summer of 1998 and finds that the interbank federal funds market performed well, providing liquidity to the banking sector (particularly to less risky banks), without increases in risk premiums.
35

Using the same 18 events, Kang and Stulz (2000) find that the Basel Accord had a significant impact on both Japanese banks and Japanese firms dependent on bank loans for financing.

24 2.4 Procyclicality and the Basel Accord

One of the primary reasons for the delay in adoption and implementation of the Basel II proposals has been the international controversy regarding their potentially procyclical impact. Banking is a procyclical business. That is, banks tend to contract their lending activity when business turns down because of their concern about loan quality and repayment probability. This exacerbates the economic downturn as credit constrained businesses and individuals cut back on their real investment activity. In contrast, banks expand their lending activity during boom periods, thereby contributing to a possible overheating of the economy that may transform an economic expansion into an inflationary spiral. However, increased risk sensitivity in bank capital requirements may exacerbate these procyclical tendencies. If banks are constrained by risk sensitive (as measured by internal models) capital allocations and regulatory requirements, they may be unable to lend during low points in the business cycle and overly encouraged to lend during boom periods.36 This is because risk sensitive capital requirements increase (decrease) when estimates of default risk increase (decrease).37 Thus, if credit risk models overstate (understate) default risk in bad (good) times, then internal bank capital requirements will be too high (low) in bad (good) times, thereby forcing capitalconstrained banks to retrench on lending during recessions and expand lending during booms.38 There is very little agreement on whether risk-based capital requirements are procyclical in nature. Indeed, the question itself has been posed with some ambiguity. Allen and Saunders (2002) attempt to clarify the question (and provide a literature review regarding the answer) by distinguishing between ex ante and ex post procyclical shifts. It is almost axiomatic that defaults and credit problems would multiply in times of distressed macroeconomic conditions. Moreover, good economic times provide the rising tide that lifts even the shakiest of financial boats. Thus, ex post realizations of credit problems display clear procyclical patterns increasing during recessions and decreasing during expansions. However, these patterns may be consistent with fixed portfolio loss distributions that have no systematic ex ante risk factors affecting expected credit risk exposure. That is, we must distinguish between ex post realizations of credit losses (that may increase during recessions, but do not reflect increased risk in the future) and ex ante shifts in the entire loss distribution that reflect future expected changes in risk exposure. Unfortunately, most empirical studies do not distinguish between ex ante and ex post procyclicality. Therefore, their results are difficult to interpret. Carpenter et al (2001)
To the extent that external credit ratings provide through the cycle estimates of default risk smoothed across the entire business cycle, it is the IRB approaches of Basel II that is most likely to exacerbate the procylical tendencies of banking. However, if credit ratings behave procyclically [as shown by Ferri, Liu and Majnoni (2000), Monfort and Mulder (2000) and Reisen (2000)], then even the proposed standardized approach in Basel II will exhibit cyclical fluctuations in capital requirements. 37 Most studies examine procyclicality in capital requirements. However, Ayuso, Perez and Saurina (2002) use data on Spanish banks to show that capital buffers in excess of requirements display significant procyclical tendencies, such that a 1% growth in GDP might reduce capital buffers by as much as 17%. 38 Borio, Furfine and Lowe (2001) demonstrate that assessed risk falls during economic booms and rises during economic busts, although bank capital cushions lag the business cycle.
36

25 find no evidence of procyclicality using a sample of changes in US borrowers credit ratings since 1970. Moreover, Carosio (2001) states that Basel Is procyclical impact might be dampened in Basel II. That is, since there is a flat capital charge for all commercial and industrial loans under Basel I, there is no impediment to banks pursuing tough lending policies during recessions or lowering credit standards during expansions. Under Basel II, banks would find that their capital requirements are sensitive to changes in their lending policies. In contrast, Blum and Hellwig (1995) find that Basel I increased procyclicality by increasing the size of the aggregate demand multipliers. Bikker and Hu (2002) also find strong evidence of procyclicality in bank profitability and provisions for loan losses for an international sample of banks in 26 countries over the period 1979-1999. The evidence of procyclicality (increase in profitability and decreases in provisions for loan losses during economic upturns and vice versa) is more pronounced during the post-Basel I period than during the pre-Basel I period. Thus, introduction of risk-based capital requirements appears to have exacerbated procyclical tendencies in banking. Moreover, Monfort and Mulder (2000) find strong evidence of procyclicality in credit ratings for 20 emerging market economies. Their simulations show that capital requirements under the Basel II standardized approach would increase dramatically during times of economic or financial crisis, thereby possibly exacerbating the detrimental real economic effects. Part of the question of the impact of procyclicality on bank capital regulation is the issue of financial market integration and globalization. Peek and Rosengren (1997, 1999) argue that Basel I contributed to the migration of Japanese economic problems to commercial lending downturns in the US. Jacques (2003) conjectures that Basel II may exacerbate the contagion effect, thereby increasing global integration of financial and banking markets. Merton (1995) argues that regulatory policy should utilize derivatives markets in order to achieve well-defined policy objectives. Indeed, perhaps unintentionally, they have already done so. Merton (1995) uses the example of a ten year German government bond issued sold in 1990 with a put-option provision. The impact of this was to commit the German government to a stabilization monetary policy. That is, the put option transfers interest rate risk from the bondholders to the German government. Thus, if interest rates rise, the puts are more and more in the money, thereby obligating the German government to, in effect, repurchase equivalent bonds without an embedded option. Similarly, the German government sells bonds when interest rates fall (bond prices rise). The put option acts as an automatic open market operation stabilizer selling bonds when prices rise (interest rates fall) and buying bonds when prices fall (interest rates rise), thereby countering procyclical effects. Historically, bank regulators have handled risk diversification poorly. The focus of prudential regulation has been each individual entry in the individual banks portfolio. Overall capital levels either for the entire bank or the entire banking system are obtained by simply aggregating across the individual requirements. Basel II has made some attempt to introduce correlations into the Internal Ratings-Based models. Szego (1995)

26 notes that one of the first bank regulations to introduce correlation into the regulators credit risk calculation was the EC Directive 92/121 of December 1992 on Large Loans. This directive limits loan concentration to a single borrower, as well as to multiple borrowers subject to the same risk. Thus, the regulations are contingent on estimates of correlation across loans, although the directive is not explicit on how these correlations are to be measured. McDonough (2002) gave a speech when he was President of the Federal Reserve Bank of New York and Chairman of the Basel Committee on Banking Supervision that regulatory policy should be market-based and adaptive. Crises must be addressed on a case-bycase basis and market forces should be harnessed to accomplish regulatory goals of safety and soundness of the banking system. Borio, Furfine and Lowe (2001) find evidence of procyclicality in Basel II capital requirements, resulting in a destabilizing impact on the banking system. They are concerned with mismeasurement of risk due to short time horizons that are unduly effected by correlations across firms and cyclical macroeconomic factors. They recommend the use of forward-looking provisioning that can stabilize the system by requiring more capital during good times and reducing capital requirements during economic downturns.39 Borio, Furfine and Lowe (2001) claim that this approach would both track risk better and act as a built-in stabilizer, so that banks are required to raise capital when the cost is relatively low (during economic booms and bull markets), but can economize on their capital when the cost of capital is prohibitively high (during recession and financial market crises). Using international data, Purhonen (2002) finds evidence that there is considerable procyclicality in the IRB foundation approach of Basel II. Using KMV empirical EDFs as a measure of internal ratings, he examines minimum capital requirements over the period November 1996June 2001 using both the January 2001 and November 2001 IRB calibrations. He finds considerable cyclical effects across all regional portfolios: US, EU, Asia-Pacific and Latin America. In particular, during the Russian debt and the LTCM crises in the summer of 1998, the US banking system would have needed either significant infusions of capital or would have had to significantly reduce lending and sell assets, thereby exacerbating the cyclical downturn. Similar procyclical patterns were found for the EU and Latin American portfolios during the summer of 1998. In contrast, the Asian portfolio experienced considerable increases in credit risk exposure in late 1996, then again during the second half of 1998, and again during 2001. Thus, the increased capital requirements implied by the procyclical IRB approach could have exacerbated the Japanese economic crisis.
Carosio (2001) also advocates provisioning based on expected loan losses, not actual past losses. In the US, reserves for loan losses are set equal to expected future loan charge-offs. In practice, however, accounting rules differ from country to country so that oftentimes the loan loss reserve is a measure of current or incurred losses, rather than expected future losses. See Wall and Koch (2000) and Flood (2001). Indeed, Cavallo and Majnoni (2001) show that distorted loan loss provisions may have a pro-cyclical effect that exacerbates systemic risk. In particular, many Latin American countries require large provisions for loan losses (averaging 8 percent of gross financing), raising the possibility of excessive capital requirements in these countries due to double counting of credit risk [see Powell (2001)].
39

27

Altman and Saunders (2001a) are concerned that the use of agency ratings under the standardized approach of Basel II could produce cyclically lagging rather than leading capital requirements. Catarineu-Rabell, Jackson and Tsomocos (2003) find that the procyclicality of Basel II will depend on the type of credit ratings that are adopted by the banking system. If stable, through-the-cycle credit ratings (such as those published by Moodys and Standard & Poors) are utilized, then the procyclical effect will be much less than if banks use point-in-time ratings that analyze the credit risk using real time structural models. In their model, banks maximize profits by choosing a counter-cyclical credit rating policy; that is, they reduce risk weights during recession (thereby encouraging more borrowing than would result if the banks used a cyclically neutral credit policy) and increase risk weights during expansions (thereby discouraging borrowing).40 However, since this runs counter to the aim of Basel II to make capital requirements more sensitive to credit risk exposure, then the second best solution is for banks to pursue a procyclical policy that exacerbates macroeconomic fluctuations. Concern about excessive procyclicality in Basel II is misplaced according to Jordan, Peek and Rosengren (2002). They find evidence of procyclical changes in capital requirements even in the current regulatory regimes. They find that even in Basel Is less risk sensitive environment, banks often experience declines (increases) in regulatory capital requirements during economic upturns (downturns), thereby exacerbating cyclical swings as capital-constrained banks cut down on lending during recessions and capitalrich banks increase lending during expansions. The current regulatory mechanism for these fluctuations is through mandated changes in provisioning for loan loss reserves. Rather than the automatic and continuous credit risk capital adjustment envisioned in Basel II, currently credit risk adjustments to loan loss reserves often occur at discrete intervals, most often after a bank examination takes place. Jordan, Peek and Rosengren (2002) document abrupt losses of bank capital during recessions that occur around the time of bank examinations.41 For example, during the 1990 recession, banks experienced declines in their capital ratios of over 4% within a one-year period. Thus, greater credit risk sensitivity in the proposed new capital requirements may not change the inherent procyclicality in bank capital regulations, but merely the timing of the realization of the procyclical effects.42 Table 2.4.1 presents a summary of the Allen and Saunders (2002) procyclicality literature survey. There is some consensus about the existence of procyclical, systematic effects in empirical measures of default probability (PD) and loss severity (LGD) rates, but (as is obvious from the brief review in this section) there is no agreement on what the impact will be for bank capital regulations.
40

This counterintuitive result obtains from their choice of parameters and their assumption that rents obtained from relationship lending will offset any cyclical impact on credit risk exposure. 41 Chiuri, Ferri and Majnoni (2002) find evidence of significant contractions in credit supply in emerging economies when regulatory capital requirements are more strictly enforced, although Saunders (2002) argues that risk-shifting could actually induce increases in the supply of credit. 42 Estrella (2001) finds that optimal capital levels lag credit risk exposure (as measured by VAR) by about one quarter of a business cycle. Using data on US banks for 19841999, he finds procyclical patterns in external capital levels.

28 INSERT TABLE 2.4.1 AROUND HERE 2.5 An International Survey of Mortgage Markets43

Mortgage lending is one of the primary engines of a free market economy. As of the end of 1999, the 25 largest banks in the US held $436.38 billion worth of residential (1-4 family properties) mortgages, accounting for 26% of their domestic loan portfolios. This represented the second largest category of loans on US bank balance sheets, surpassed in size only by commercial and industrial loans (totaling $524.14 billion or 28.9% of the aggregate domestic loan portfolio of the top 25 US banks).44 Moreover, mortgagebacked securities (MBS) represent the largest category of debt securities on bank balance sheets. Table 2.5.1 shows that the total amount of MBS held by the top 25 US banks as of the end of 1999 was $269.6 billion, or 43.88% of the aggregate debt security investment portfolio. Generally, the credit risk of the mortgages underlying MBS is transferred either to the Federal Housing Association (FHA) for GNMA-issued securities, or to private mortgage insurers. However, MBS issuers generally take a first-loss position that requires them to absorb losses up to a certain limit. Moreover, loans sold by banks into MBS with recourse can result in off-balance sheet risk. As of year-end 1999, Calem and LaCour-Little (2002) estimate that total recourse exposure on mortgages at the 25 largest banks in the US was $9.8 billion, or about 20% of the outstanding balances of the sold mortgages. This amounted to about one third of these banks total recourse exposure on all sold loans. Campbell and Dietrich (1983) show that the determinants of default on insured conventional residential mortgage loans in the US are: age of the mortgage, LTV upon mortgage origination, contemporaneous LTV, contemporaneous payment to income ratio and unemployment rates. INSERT TABLE 2.5.1 AROUND HERE Clauretie and Herzog (1990) investigate the impact of state foreclosure laws on mortgage loan losses in the US.45 The first major difference in state-to-state foreclosure processes is the power-of-sale procedure. Some states allow the lender to quickly liquidate the property through a trustee with little legal expense. However, others require a judicial procedure that entails court action and significant transaction costs. Clauretie and Herzog (1990) estimate that the risk to the FHA is 60% greater for mortgages insured in states with a judicial procedure requirement (i.e., without a power-of-sale procedure).

43

Common abbreviations and acronyms used in this section are: GSE=government-sponsored enterprises such as Fannie Mae and Freddie Mac. GNMA=Government National Mortgage Association that issues securities backed by Federal Housing Association (FHA) government insurance for residential mortgages. MBS=mortgage-backed securities. ABS=asset-backed securities. LTV=loan-to-value ratio. See the appendix for a list of abbreviations. 44 As of year-end 1999, consumer loans at the top 25 US banks totaled $278.88 billion, or 15.4% of the aggregate domestic loan portfolio. Commercial mortgages totaled $164.08 billion, or 9% of the aggregate domestic loan portfolio for the top 25 US banks at the end of 1999. 45 Deng et al (2000) use an options-theoretic approach to document the impact of regional variations in economic conditions on mortgage prepayment and default.

29 The second major difference in foreclosure procedures is the statutory right of redemption. This is a period (generally ranging from 75 days to 18 months following the foreclosure) granted to the mortgagor to redeem the property for the amount of the delinquent payments and foreclosure expenses. Clauretie and Herzog (1990) find that the length of the statutory right of redemption is positively related to foreclosure losses. Moreover, Clauretie and Herzog (1990) find that foreclosure losses are reduced when there is a coinsurance contract that shares the losses between the lender and the mortgage insurance agency. In addition, foreclosure losses are reduced by the presence of a deficiency judgment procedure in state foreclosure laws (permitting the attachment of the mortgagors personal assets to recover the difference between the unpaid loan balance and the propertys liquidation value). In the US, access to mortgage credit has been significantly affected by the Home Mortgage Disclosure Act (HMDA) of 1975, the Fair Housing and Fair Lending Legislation (of 1968 and 1974) and the Community Reinvestment Act (CRA) of 1977. These laws expand the opportunities of minorities and lower income households (earning less than 80% of the area median income) to obtain mortgage loans. Apgar and Duda (2003) document that CRA-eligible lending to blacks (Hispanics) is 20% (16%) higher for CRA-regulated lenders than for independent mortgage companies and non-banks that are not subject to the legislation. However, the relative importance of CRA-regulated lenders has declined so that as of 2003 less than 30% of all home purchase loans are subject to CRA review. This is the result of shifts in the mortgage market, as well as increased geographic diversification of bank lenders. Apgar and Duda (2003) report that in 1993, 36.1% of all home purchase loans were made by CRA-regulated institutions in their assessment (local) areas, whereas that percentage had fallen to 29.5% in 2003. Moreover, consolidation in the banking industry has undermined the effectiveness of mortgage allocation legislation as larger, more geographically diverse bank portfolios find it easy to comply with legislative minimum levels of CRA-eligible lending.46 At the end of 2001, the total volume of outstanding mortgage loans in the EU was more than 3.9 trillion euros, totaling around 40% of bank lending in Europe and 40% of EU gross domestic product. Out of this, residential mortgage loans accounted for 3.4 trillion euros. More than 95% of these mortgages were retained on the banks balance sheets, in contrast to the US in which the majority of mortgage loans are securitized and held off the balance sheet. Therefore, as a result of these features of the European mortgage market, the design of capital requirements on mortgage loans is of critical importance to European lenders. Manning (2002) estimates that if European banks incorporate the IRB approaches of Basel II (utilizing the low historic loss rates in the mortgage markets), risk weights for residential mortgages might be halved, resulting in capital savings estimated at 68 billion euros for European mortgage lenders. European mortgage lending is a low risk and therefore a low margin business according to Manning (2002). Real estate portfolios are regionally diversified and residential mortgages are highly standardized. Thus, the lower capital requirements would not result
However, Dahl, Evanoff and Spivey (2003) find that the CRA standards are objectively based on the banks lending level, asset size and affiliation with a bank holding company.
46

30 in additional risk for the banking system. From 1975 to 1999, the losses on mortgage loans extended by Danish commercial and savings banks averaged between 0.22% to 1.15%. Over the subperiod 1994-1998, the losses of mortgage banks in Denmark on commercial real estate loans averaged 0.254% compared with losses on all lending by Danish banks averaging 0.7%. (See Manning (2002).) Licensed mortgage bankers in Germany are called Hypothekenbanken. Residential (commercial) mortgage lending in Germany over the period 1988-1998 had an average loss rate of 0.03% (0.05%) for loans with LTV less than 60% and 0.15% (0.18%) for LTV greater than 60%. Loss rates on consumer loans over the 1988-1998 period average 0.26%. In the UK over the period 1989-1998, the provisions for bad and doubtful debts charged by UK building societies in their income and expenditure accounts each year ranged from 0.08% of loans outstanding in 1989 to 0.95% in 1992. For a major French mortgage credit provider, Manning (2002) states that losses on residential lending from 1993-2000 ranged from 0% to 0.135%, averaging 0.024% over the period. In Sweden, losses on residential mortgages are less than 0.1% of the book value of loans per year. In Norway, unsecured loans to private retail customers have an expected LGD that is 4 to 7 times as high as for an average residential mortgage; see Manning (2002). Similar low risk characteristics of European mortgage markets are found in Germany, Belgium, Italy, the Netherlands, Portugal and Austria according to a 1995 survey conducted by the Royal Institute of Chartered Surveyors. Manning (2002) offers these statistics as evidence demonstrating the prudence behind the reduction of risk weights for mortgage loans in Basel II proposals. At the end of 1998, Manning (2002) reports that the European Mortgage Federation estimated several sources of financing for the residential mortgage lending outstanding in the EU as follows: 62% was funded using retail deposits; 19% using mortgage bonds (i.e., debt securities issued by mortgage credit institutions and covered by mortgage loans which remain on the balance sheet of the issuer);47 1% using MBS. Mortgage lending in Canada is also primarily funded using deposits. However, Manning (2002) claims that the level of securitization has increased in recent years as a result of incentives for mortgage lenders to transfer their risks and diversify their sources of funding. Securitization is relatively costly and capital intensive in Europe, thereby explaining the preference of European mortgage banks for on-balance sheet sources of funding (e.g., covered and uncovered mortgage bonds). There are no government-sponsored entities in Europe as in the US to standardize contracts and facilitate the sale of loans to capital market investors. Articles 87 and 88 of the consolidated version of the Treaty on European Union outlaw state aid in the form of guarantees in order to avoid any unfair

47

Mortgage bonds include both covered and uncovered bonds. Covered bonds are secured against public sector entities; see discussion of German HPBs in this section. Manning (2002) states that mortgage bonds represent 18% of the European capital market; at the end of 2000 total volume was approximately 616 billion euros. Under current EU rules, mortgage bonds receive a 10% risk weight.

31 competition. This may explain the absence of national mortgage agencies similar to the US government-sponsored entities.48 Government-sponsored entities (GSE), such as Freddie Mac and Fannie Mae, are the primary mortgage market agencies in the US. They have been regulated by the Office of Federal Housing Enterprise Oversight (OFHEO) since 1992, although they were established after WW II in order to facilitate home mortgage financing. GSE must comply with capital charges for credit risk, prepayment risk and interest rate risk under catastrophic, worst loss assumptions. There is also a flat 30% charge for operational risk. Capital is designed to cover potential losses over a ten year period of prolonged, severe economic stress. However, the total of all GSE capital requirements is 2.5% of onbalance sheet and 0.45% of off-balance sheet exposures, significantly below BASEL I requirements. The 2002 test of OFHEO regulatory measures to measure and manage insolvency risk found that risk-based capital requirements for both Fannie Mae and Freddie Mac were lower than the minimum capital levels.49 Moreover, risk-based capital for Freddie Mac was only a third of that of Fannie Mae because of greater internal risk controls; see Duebel (2002).50 Roll (2003) claims that at $5 trillion in outstanding debt, the US mortgage market is the envy of every other country. (page 29) This represents a rapid increase from $2.7 trillion in the first quarter of 1990 to $5.2 trillion at the end of 1999.51 The Federal government has played a role in developing the US mortgage market through tax deductions for mortgage interest payments, deposit insurance for banks that increases funds available to finance real-estate loans (among other lending activities), and credit enhancements in the form of long-term federal guarantees (from GNMA, FHA and VA) protecting holders of MBS against default. The active secondary mortgage market (either for MBS or whole loans) can be attributed to the homogenous credit quality assigned by the level of credit guarantees. Moreover, Fannie Mae and Freddie Mac absorb the unpredictable and idiosyncratic prepayment risk in home mortgages. In the US, Fannie Mae and Freddie Mac MBS account for almost 25% of all mortgage debt in the US. In addition, both GSEs retain portfolios of directly purchased whole loans and MBS that amount to an additional 16% of total US mortgage lending; see Roll (2003).52 Thus, Fannie Mae and Freddie Mac are instrumental in the extension of over 40% of all mortgage debt obligations in the US. Over the 1990-1998 time period, the
48

Howeer, some EU member states (such as Germany) have centralized issuing institutions that pool mortgages and sell shares to private stockholders. 49 The capital requirements for GSE are determined using a 2002 credit risk model by OFHEO. See www.ofheo.gov. 50 However, there have been recent scandals with regard to excessive exposure to interest rate risk at Fannie Mae (e.g., a negative duration gap of more than 11 months exposing Fannie Mae to declining interest rate shifts) and lack of transparency in accounting (e.g., earnings management that took the form of underreporting net income at Freddie Mac). 51 Roll (2003) notes that as a matter of comparison, the total US national debt in August 2000 was $5.7 trillion. 52 Since 1994, the relative importance of these retained portfolios has increased from around 6% to 16% of total mortgage lending, as compared to the proportion of MBS which fell slightly from 26% in 1994 to less than 25% at the end of 1999.

32 portion of MBS held by non-US entities increased from around 4% to almost 13% of the MBS total plus holdings comprising about one third of Freddie Macs outstanding debt issues; see Roll (2003).53 Roll (2003) contends that the existence of GSEs has significantly reduced the cost of mortgage borrowing for US home buyers. Gonzalez-Rivera (200) shows that Fannie Mae and Freddie Mac purchase MBS when MBS yields are high relative to US Treasury yields, thereby reducing both secondary market MBS yields and primary market mortgage rates. Moreover, Cotterman and Pearce (1996) find that mortgages conforming to Fannie Mae and Freddie Mac standards have mortgage rates that are about 25-40 basis points lower than non-conforming jumbo mortgages. As of 2000, the original amount of a conforming mortgage cannot exceed $252,700.54 The importance of the GSEs in encouraging mortgage lending is demonstrated by the clustering of mortgages around the conforming standards. In contrast, White (2003) stresses the contingent liability created by the implicit guarantee offered by the federal government to Fannie Mae and Freddie Mac. Since Fannie Mae and Freddie Mac borrow funds at lower cost, their existence increases home ownership in the US, thereby engendering the economic and social positive externalities associated with owners as compared to renters. Although White (2003) agrees that the cost of conforming mortgages has been reduced by around 25 basis points, he claims that the social welfare goals of expanding home ownership are imperfectly met through indirect means such as GSE subsidies. He claims that the impact is not concentrated on the areas that would yield the greatest return in terms of social welfare, i.e., the lower and middle income levels. Instead, the conforming mortgage level is typically set above the median sales price for homes ($168,500 for new homes and $139,000 for existing homes in 2000). Thus, much of the GSE subsidy is distributed to higher income households in areas that would be well served by the private market. In 1992, HUD set housing policies that would be geared toward (1) less than median income households, (2) geographically under-served areas, and (3) special subsidies for very low income households living in very low income areas. However, White (2003) claims that these goals were not binding constraints on GSE lending policy. Indeed, he proposes privatizing Fannie Mae and Freddie Mac, thereby eliminating the potential federal government exposure to a large contingent liability consisting of considerable credit risk, interest rate risk and operational risk. Moreover, White (2003) forecasts that once privatized, these firms would continue to operate and innovate, albeit without the benefit of open-ended federal guarantees. Once free from the implicit subsidy, the federal government could directly subsidize selected home buyers with targeted programs deemed to be socially beneficial.
53

The high credit quality of debt issued by US GSEs is reflected in their ability to borrow at an average yield spread of 19 basis points below LIBOR over the 1994-2000 period. Roll (2003) predicts that non-US investors will become an ever more important source of funding to the US mortgage market through investments in high credit quality Fannie Mae and Freddie Mac securities. 54 Non-conforming jumbo mortgages generally have lower LTV ratios on average, borrowers with higher incomes and better credit standing, and more valuable real estate as collateral. Since the credit risk of jumbos is generally lower than for conforming mortgages, Cotterman and Pearces (1996) finding of a 2540 basis point differential in mortgage rates is an underestimate of the importance of the GSEs in lowering mortgage rates for conforming loans.

33

Duebel (2002) contrasts the Anglo-Saxon with the Continental European mortgage markets, although the two approaches are gradually converging. Anglo-Saxon countries, such as Australia, the UK and the US, typically fund mortgages using bank deposits.55 In contrast, Continental European countries, such as France and Germany, utilize bank bond issues as the primary funding source.56 Moreover, Anglo-Saxon-style mortgage markets are more likely to insist on the use of insurance to control mortgage credit risk, particularly for high LTV mortgages.57 Duebel (2002) describes the Australian mortgage insurance market. Insurers must comply with a minimum capital requirement on each loan in which the mortgage LTV exceeds 67%. This capital requirement is set equal to 2% of the mortgage loan in excess of an LTV of 67%. Moreover, an unearned premium reserve must be set up to cover the term structure of default risk over the life of the mortgage.58 A claims equalization reserve of 25% of earned premiums must be retained for 10 years to protect against catastrophic risk. In the US, the analogous contingency reserve is fixed at 50% of earned premiums. Asset securitization is undertaken for several reasons: (1) economic risk transfer (to use capital markets to transfer credit risk); (2) reduced funding costs (by pooling the loans, the ABS can obtain an investment grade credit rating and be sold at a higher price/lower credit spread); (3) market arbitrage (regulatory restrictions may prohibit direct lending and securitization offers market access); (4) regulatory arbitrage (transfer of loans without recourse reduces capital requirements); (5) meeting capital requirements (transferring loans from the balance sheet reduces the banks capital requirements); and (6) diversification of funding sources. Jobst (2003) claims that asset securitization has successfully achieved the following goals: (1) curtailed balance sheet growth and reduce regulatory capital costs, and (2) reduced the economic cost of capital by using risk transfer to minimize the required credit risk premium. Traditional (off-balance sheet) securitization involves the transfer of assets into a special purpose vehicle (SPV) incorporated for the purposes of the creation of the ABS. The originator continues to service the loan in exchange for receipt of a servicing fee. Synthetic (on-balance sheet) securitization occurs if the originator does not actually transfer the asset pool to a SPV. Instead, the loans are segregated on the balance sheet
However, Craig and Thomson (2003) note that community banks can use home mortgages as collateral backing subsidized loans from Federal Home Loan Banks. The Gramm-Leach-Bliley Act of 1999 expanded this to include loans to small businesses and small farmers by community banks. 56 As counter examples to these broad classifications of the two mortgage markets, the German Bausparkasse were modeled after the US savings and loans, thereby funding mortgages using savings deposits and US agencies, such as Freddie Mac and Fannie Mae, issue debt to finance their mortgage holdings. 57 During the 1980s, British building societies were required to have mortgage indemnity guarantees for high LTV real estate loan. Thus, these banks were protected by insurers from catastrophic risk during the period of falling house prices in the early 1990s in the UK. 58 That is, excess cash flows are required in the early years when default probabilities are high relative to lower conditional default probabilities as the mortgage approaches maturity.
55

34 and the originator buys credit protection (e.g., credit default swaps; see discussion in section 2.3) to protect the purchasers of the ABS from any credit risk exposure emanating from the originators non-pool assets. Although Basel I levies a 50% risk weight on all loans fully secured by mortgages on owner-occupied or owner-rented property, German bank regulators decided to apply the 50% risk weight to residential mortgage loans secured on the first 60% of the propertys lending value called Realkredite (usually lower than the propertys market value because of a liquidity discount). In practice, Realkredite is usually fully secured since the principal amount does not exceed 50% of market values. German mortgage banks typically fund Realkredite by issuing secured mortgage bonds known as HypothekenPfandbriefe (HPBs) that are high quality mortgage-backed securities. Because of the low risk of HPBs, there has never been a publicly known default since their introduction in 1769; see Odenbach (2002).59 The portion of the original mortgage in excess of the Realkredite is 100% risk weighted and funded using deposits, interbank credit and unsecured bonds.60 Only banks and insurance companies can originate mortgages in Germany. However, all mortgage originators must comply with Basel capital requirements.61 Since traditional asset securitizations have high transaction costs, potential tax implications and may destroy customer relationships, Odenbach (2002) states that German mortgage originators that can fund ABS using HPBs or low rate deposits tend to use synthetic securitization. Indeed, traditional securitizations have all but been discontinued in Germany according to Odenbach (2002). However, since only a portion of the mortgage loan can be financed using Hypotheken-Pfandbriefe (HPBs), the originating banks risk rating is important in determining the cost of subordinated debt sources of residual financing. For those high risk, high cost German originators, there is the Provide Program, i.e., a mortgage securitization vehicle sponsored by a governmentsponsored entity, Kreditanstalt fur Wiederaufbau (KfW). Odenbach (2002) explains that the mortgage lender enters into a credit default swap with Provide at the junior, mezzanine and senior tranche levels. Provide issues MBS and collateralizes them with 0% risk weight KfW debt instruments. This is the least cost method of financing the loan portfolio because it converts mortgage financing into public sector financing. Traditional (off-balance sheet) securitizations require the transfer of title to the assets from the originator to the special purpose vehicle (SPV) that has any chosen risk profile, independent from the parent institution. This risk profile is achieved by engineering the collateral level and the payment priorities to adjust the ABSs risk exposure. Payment priorities and loss tolerance levels are differentiated by tranche so that each tranche has a distinct risk/return profile. One of the features used to enhance the credit rating of ABS
Manning (2002) states that HPB mortgage bondholders were expropriated by German currency reforms in 1924 and 1948, although the real collateral underlying the bonds held its value through both world wars. The resulting capital gains were taxed away by the government through a debt revaluation tax. 60 German mortgage banks typically issue two types of liabilities: HPBs and subordinated debt. Realkredite mortgages that back HPBs can be secured separately in a SPV. See Odenbach (2002). 61 In other countries, such as the UK and the US, non-regulated mortgage originators can engage in asset securitization without complying with bank capital regulations.
59

35 is the first loss provision. The first loss provision allocates a certain amount of losses to a party other than the ABS holder, who bears residual risk if losses exceed the first loss provision levels. Losses covered under first loss provisions emanate from internal sources (the underlying assets) or external sources of credit enhancements (e.g., deductibles on third-party guarantees, letters of credit, reserve funds and cash collateral accounts). Jobst (2003) distinguishes between mandatory first loss provisions, necessary to achieve a given credit rating, and excessive first loss provisions, in terms of foregone securitization or excessive levels of credit enhancement. Jobst (2003) shows how excessive first loss provisions can be used as a signal to differentiate high quality from low quality issuers of ABS. One, although not the only, motivation behind asset securitization has been capital arbitrage (see section 2.3). If there is a gap between economic and regulatory capital, banks can use securitization to adjust their risk/regulatory capital positions, such that if regulatory capital requirements are perceived to be onerous, the bank will raise its risk profile in ways that do not trigger additional capital requirements. Jackson et al (1999) note that the volume of securitization is substantial. As of March 1998, the volume of outstanding non-mortgage securitizations by the ten largest US bank holding companies totaled $200 billion (on average more than 25% of the banks risk-weighted loans). Moreover, they note that bank and non-bank structured finance in Europe increased from $8.5 billion in 1995 to $41 billion in 1997. In 1988, the total value of collateralized mortgage obligations (CMOs) issued in the U.S. was $20 billion. In 1992 (the year of full implementation of the Basel Capital Accord in both the U.S. and Canada), the issuance of CMOs exceeded $80 billion.62 An important incentive contributing to this fourfold increase in new issues was the capital constraints imposed by the Basel Capital Accord. To economize on their capital costs, banks sought new ways to remove loans from their balance sheets. For US banks, securitization proved to be a popular response to the Basel Capital Accord. Until recently, the growth of traditional (off-balance sheet) loan securitization (as in the case of loan sales and trading) had been hampered by concerns about negative customer relationship effects if loans were removed from the balance sheet and packaged and sold as CLOs (collateralized lending obligations) to outside investors. In response, a variety of synthetic (on-balance sheet) securitization products has emerged, but the differences among them relate to the way in which credit risk is transferred from the loan-originating bank to the note investor. The Basel II proposals treat traditional and synthetic securitization the same, focusing on the fundamental risk of the banks exposure; see Bugie et al (2003). INSERT FIGURE 2.1 AROUND HERE Saunders and Allen (2002) show an example of the fast-growing market for synthetic securitizations.63 In 1997, JP Morgan introduced a structure known as BISTRO (Broad Index Secured Trust Offering), illustrated in Figure 2.1. In this structure, the originating
62 63

See Allen (1997), p. 719. Fitch reported in February 2001 that more than 50 percent of all CDOs were synthetic CDOs.

36 bank purchases credit protection from the intermediary bank (e.g., JP Morgan Chase) via a credit default swap subject to a threshold. That is, the swap will not pay off unless credit losses on the reference loan portfolio exceed a certain level, 1.50 percent in this example.64 The intermediary buys credit protection on the same portfolio from a SPV. The BISTRO SPV is collateralized with government securities that it funds by issuing credit-tranched notes (CLN) to capital market investors. However, the BISTRO collateral is substantially smaller than the notional value of the portfolio. In the example shown in Figure 2.1, only $700 million of collateral backs a $10 billion loan portfolio (7 percent collateralization).65 This is possible because the portfolio is structured to have enough investment grade loans and diversification that make it unlikely that losses on the loan portfolio would exceed $850 million ($700 million in BISTRO collateral plus the banks absorption of the first $150 million in possible losses, i.e., 1.5 percent of the portfolios notional value.) This structure significantly reduces the legal, systems, personnel, and client relationship costs associated with a traditional ABS. It permits much greater diversity in the portfolio underlying the BISTRO than is possible for a CLO or CLN. Moreover, since the BISTRO is unrelated in any way to the originating bank, there should be no reputational risk effects and no recourse, thereby further reducing capital charges. In Canada, mortgage securitization proceeded quite differently than in the US. In December 1986, under the provisions of the National Housing Act (NHA), Canada introduced a mortgage-backed securities program based on federal insurance, similar to the US GNMA and FNMA programs.66 The first NHA mortgage-backed securities were issued in January 1987. However, Dionne and Harchai (2003) show (in their Chart 3) that the volume of activity in this market did not really accelerate until the implementation of the Basel Capital Accord in 1991-1992. Moreover, there was a downturn in the issuance of NHA-insured mortgage-backed securities, but increased issuance of alternative forms of asset-backed securities during the second half of the 1990s. There are two classes of ABS in Canada: (1) NHA-insured MBS and (2) securities backed by other (domestic) assets.67 NHA-insured MBS are actually insured by the federal government through the Canada Mortgage and Housing Corporation (CMHC) under the provisions of the National Housing Act, which had the goal of increasing the availability and decreasing the cost of financing for residential housing.68 Qualifying
This threshold can be viewed as equivalent to the credit enhancement offered by the originating bank in a CLO or CLN (credit-linked note). 65 Typically, BISTRO collateralization ranges from 5-15 percent of the notional value of the loan portfolio. 66 Current information on NHA MBS can be obtained at the following websites: http://www.cmhcschl.gc.ca/en/moinin/inmobase/index.cfm and http://www.cmhc-schl.gc.ca/en/moinin/morbabo/index.cfm. 67 Domestic receivables are used in Canadian ABS because the use of foreign assets has been hampered by technical complications, such as withholding taxes associated with cross-border transfers of property, currency risk and international differences in issue and rating expenses. 68 The CMHC issues Canadian Mortgage Bonds (CMB) that finance the CMHCs purchases of NHA-MBS from the banks. Banks can also sell NHA-MBS directly into the market. However, the issuance of CMB enhanced the liquidity of the NHA-MBS because the CMB are bullet bonds with annual cash flows, whereas the NHA-MBS are amortizing, monthly coupon instruments with an unpredictable prepayment option. See http://www.cmhc-schl.gc.ca/en/moinin/morbabo/index.cfm.
64

37 lenders (banks, life insurance companies, credit unions, caisse populaire, trust or mortgage loan companies) must register with the CMHC in order to qualify for NHA mortgage insurance.69 Qualifying mortgages for NHA insurance must be residential (any combination of exclusive-homeowner, multifamily, or social housing).70 NHA-MBS are sold in denominations of $5,000 with terms ranging from six months to 25 years.71 The Central Payor and Transfer Agent (CPTA) receives monthly mortgage payments and transfers them (net of a servicing fee) to the holders of the MBS.72 Dionne and Harchaoui (2003) cite a study by Nesbitt Burns that shows that most of the 1997 NHAMBS were either retained by the issuing company or sold to institutional investors. However, there is a liquid, over-the-counter secondary market in NHA-MBS. Securitization of assets other than mortgage loans was initiated in Canada in 1989. However, the markets size was restrained until the mid-1990s. Dionne and Harchaoui (2003) point to limitations on the participation of insurance companies in the market and restrictive quantitative tests applied to underlying institutions as explanations for this stunted market growth in Canadian ABS. Moreover, accounting guidelines and regulatory arrangements generated uncertainty about the treatment of securitized receivables, thereby restricting growth in the market for ABS in Canada. The market is structured as off-balance sheet traditional securitizations, with legal transfer of the loans and any recourse from the originators balance sheets to a SPV. The SPV can be designated as a single-seller SPV that securitizes the receivables of the parent institution only or as a multi-seller SPV that securitized loans issued by other companies in exchange for a fee. Most Canadian ABS are rated by a national bondratings agency, such as the Canadian Bond Rating Service and the Dominion Bond Rating Service. According to Dionne and Harchaoui (2003), most Canadian ABS are highly rated. To accomplish this, credit enhancements are often attached to the ABS in the form of: (1) reserve accounts (offering cash or short term securities as collateral backing the loan pool); (2) lines of credit; (3) over-collateralization (the balance of the securitized loans exceeds the principal of the issued ABS); and (4) spread accounts (the SPV retains some of the proceeds of the issue as additional collateral). Dionne and Harchaoui (2003) show that outstanding securitized assets in Canada increased from under C$500 million to over C$63 billion by the end of 1998. They delineate four development phases of the market. The first initiation phase lasted from 1987-1989, with the introduction of NHA-MBS. During the second phase from 19891994, the NHA-MBS market grew and other ABS were introduced, with a slight acceleration in market growth in 1992, according to Dionne and Harchaoui (2003). As of the end of 1994, the outstanding amount of NHA-MBS was C$17.5 billion, representing around two thirds of the total volume of securitized assets in Canada. The third phase,
69

As of 1998, there were 65 approved issuers, including a wide range of credit unions and life insurance companies; see Dionne and Harchaoui (2003). 70 Social housing includes co-operatives, seniors residences and nursing homes. 71 The maturity of the ABS is determined by the maturities of the loans in the underlying pool. However, for revolving contract ABS, the maturities of the underlying pool of loans may be shorter than the selected maturity of the ABS issue; therefore, groups of assets are purchased by the SPV on a periodic basis to bridge the gap in maturities. 72 The CPTA is managed by a major trust company in Canada under contract by the CMHC.

38 1994-1996, showed a decline in the issuance of NHA-MBS of approximately 20%, but an offsetting growth in issuance of other, non-insured ABS. Thus, total market volume was fairly stable during the third phase. A boom in volume in the securitized assets market in Canada was experienced during the fourth phase, 1997-1998, led mostly by the introduction of securitization of credit card receivables, mortgages and other loans, as well as a slight recovery in issuance of NHA-MBS. As of the end of 1998, the value of outstanding NHA-MBA was C$19.1 billion, but that only represented 30% of the total market for securitized assets in Canada. The volume of other ABS outstanding in Canada was almost C$44 billion as of the end of 1998. The breakdown of securitized assets in Canada, as of 1998, is as follows: NHA-MBS (30.1% of the total), credit card receivables and automobile loans (25.3%), commercial loans and lease receivables (22.4%), other mortgages (22.1%) and miscellaneous loans (0.1%); see Dionne and Harchaoui (2003). Jones et al (2002) consider the Canadian mortgage market to be relatively illiquid because of the low level of securitization of residential mortgages in Canada and the limited size of the NHA-MBS market. They apply a 72% liquidity discount (haircut) to Canadian residential mortgages, suggesting that the cash value available to the bank from pledging residential mortgages is only 28% of their face value.73 This haircut is not a firesale liquidation price decrease, but the estimated cash value obtainable in the normal course of a business relationship. The evolution of the Canadian securitization market had one feature in common with the process in the US - the securitized assets market moved from mortgage pass-throughs to collateralized mortgage obligations that permitted more variety in risk shifting opportunities (see Allen (1997), chapter 21). This shift is reflected in the change in maturities as the market developed. In the early years of asset securitization, most MBS had long maturities driven by the maturities of the mortgages underlying the pass-through asset pool. As the market for CMOs developed (allowing for engineering of market maturities and payment flows that deviate from the simply pro rata pass-through), the maturities shortened so that by year-end 1998, short-term ABS in Canada totaled C$39.3 billion, almost one-and-a-half times the volume of the long-term ABS. Dionne and Harchaoui (2003) note that another factor contributing to the shift in maturities is regulatory capital arbitrage, since the conversion factor for off-balance sheet items with less than one year original maturity is zero. Thus, capital requirements have impacted the development of the Canadian mortgage and MBS markets. Jones et al (2002) claim that the Canadian residential mortgage market (estimated at approximately C$400 billion in December 2002) is quite lucrative for Canadian banks. The origination and servicing fees are generous and mortgage banking relationships often lead to other lucrative banking transactions. For example, the contractual term of residential mortgages in Canada is normally five years, with an average life of 2.5 years, suggesting considerable amounts of refinancings and repeat business for the originating bank. Given the attractiveness of this market, the low level of securitization of Canadian residential mortgages is quite puzzling. Jones et al (2002) estimate that approximately five percent of Canadian residential mortgages are financed through the federally
73

Jones et al (2002) assume only a 2% haircut for Canadian NHA-MBS.

39 guaranteed Canadian Mortgage Bond program initiated by the CMHC. An additional 15% is financed through asset-backed commercial paper issues. The remaining 80% is funded through short term deposits or internal bank funds.74 The illiquidity of Canadian banks residential mortgages coupled with the low level of deposit insurance protection in Canada (the ceiling is set at C$60,000) create a net liquidity shortfall that ranges between 47% to 74% of uninsured deposits for the major Canadian banks. However, perceptions of too big to fail (TBTF) implicit government guarantees have prevented insolvencies among the large Canadian banks. 2.6 The Basel Impact on Mortgage Markets

Basel I risk weights for residential mortgages are generally set at 50% since performing mortgages are considered as prudently underwritten. In practice, the 50% risk weight has been applied to mortgages that are both insured (backed by private mortgage insurance) and uninsured (as long as the LTV ratio does not exceed 90% and the borrower is not considered subprime). All residential mortgages not meeting these criteria are assigned a 100% risk weight. Basel I proceeded on the assumption that all residential mortgage lending was low risk, or as the English saying goes, as safe as houses. (See Klopfer (2002).) Basel II (particularly the IRB approaches) recognizes that all mortgage loans do not have the same credit risk exposure. Even before formal adoption of Basel II, however, some countries had augmented Basel I regulations to include LTV as an indicator of relative risk (i.e., low LTV, low risk). Thus, to be eligible for the 50% Basel I risk weight, the mortgage must not exceed certain LTV restrictions: 60% in Germany and Luxembourg, 75% in the Netherlands, 80% in Spain and Italy and 90% in the US. Moreover, France, Switzerland, Germany, Spain, Luxembourg and Sweden limit the LTV of mortgages that back up the mortgage bond issues. In Canada, mortgages with LTV greater than 75% must have mortgage insurance. Similarly, in Japan, all mortgages with LTV greater than 70% are required to have a good guarantee. The Government Housing Loan Corporation in Japan does not purchase mortgages with LTV exceeding 80%. In the UK, mortgage rates carry a risk premium tied to the LTV, so that the lower the LTV, the lower the rate, resulting in mortgage best buys. (See Klopfer (2002).) Basel I did not adequately measure credit risk in the mortgage market. There is no adjustment in risk weight for the LTV or the existence of mortgage insurance. Thus, Basel I created a disincentive for banks to purchase mortgage insurance and instead encouraged the issuance of high LTV, uninsured mortgages. This may explain the growth of the jumbo mortgage market in the post Basel I years. However, several European countries adopted mortgage limitations that were more restrictive than Basel I.
74

Jones et al (2002) allocate 10% of the funding for residential mortgages as coming from global capital market initiatives that have not yet been developed. Jones et al (2002) example of a global initiative is the securitization of Canadian residential mortgages by a US securities trust special purpose vehicle. Currently, this is extremely expensive because of the cost of setting up the SPV and hedging the US dollar/Canadian dollar currency risk.

40 For example, in 1900, Germany instituted the Mortgage Bank Act that limits the size of the mortgage loan to a sustainable mortgageable value of the property, Duebel (2002).75 In contrast, Anglo-Saxon countries, such as Australia, the UK and the US, utilize market value appraisals to determine the mortgages LTV. These lending limitations have been effective in preventing losses during cyclical downturns in real estate values. Basel I does not specifically address asset securitization, but Odenbach (2002) describes national bank regulations that fill in this gap. In March 1997, German bank regulators (currently the Federal Authority for Financial Services Supervision known as BAFin, formerly known as BAKred) published Circular 4/97 that states the off-balance sheet treatment of asset securitizations. To be eligible for a 2% risk weight (in place of the 100% risk weight on all mortgage loans in excess of the Realkredite), the ABS must assign the assets to a SPV with no recourse to the originator. Limitations on asset transfers, capital injections and risk transfers are standard in most bank regulations regarding capital requirements for ABS. However, German bank regulators also require that the assets entered into the pool have to be selected on a random basis, so as to discourage cherry picking of the highest quality assets for placement into the SPV, thereby leaving the originator with a portfolio of loans with high levels of credit risk. For asset securitizations that meet the regulatory restrictions, capital requirements are reduced from the 8% level (with the 100% risk weight) to a 2% level. In June 1999, German bank regulators published Circular 10/99 to regulate the capital requirements of the credit derivatives used to enhance the credit of synthetic securitizations. As long as the credit risk from the underlying asset is completely transferred, Circular 10/99 provides for a 0% risk weight (e.g., credit-linked notes issued by the originating bank). However, Circular 10/99 did not mention synthetic securitizations directly. Thus, German ABS originators exploited this regulatory vacuum by aggressively engineering synthetic securitizations in 2000 and 2001. One of the innovations induced by regulatory capital arbitrage was interest sub-participations which allowed the originator to use interest collected on the underlying loans to pay for credit protection. Since the sellers of credit protection were OECD banks, the risk weight was decreased to 20% from 100% through this innovative form of financial engineering. In early 2002, German bank regulators closed this loophole by limiting the capital requirements for synthetic securitizations to follow those required of traditional (offbalance sheet) securitizations. Increases in capital requirements affect the relative profitability of mortgage lending. Duebel (2002) claims that non-bank financial intermediaries, such as finance companies, mortgage lenders and government-sponsored equities, were the beneficiaries of Basel I in that banks were forced to sell, at relatively low prices, their low risk mortgage loans in order to avoid onerous capital charges. However, Duebel (2002) also notes that the mortgage market uses economic capital in order to control risk exposure. In order to
75

German bank regulators can require mortgage banks to remove imprudently underwritten loans from the protection of the banks senior bond coverage. These riskier tranches are typically financed using subordinated debt issues.

41 achieve a AAA credit rating, mortgage LTV ratios are adjusted to offset housing price risk. Using a sample of European countries, Duebel (2002) notes that, for a given LTV, default probabilities in the Netherlands are lower than in Italy or Germany. To the extent that Basel II can differentiate between the high risk (low LTV) mortgage loans and the low risk (high LTV) mortgages, then excessive capital requirements should be eliminated, thereby reducing the incentive for banks to resell their mortgages at low prices. Thus, Basel II may actually reduce the level of securitization in the mortgage market. Manning (2002) contends that mortgage loans should have lower (as opposed to higher) Basel II risk weights than those levied on other retail lending for several reasons. First, mortgages have no cross-default clause, such that a default on a mortgage does not trigger other defaults. Second, Manning (2002) claims that lenders review the allocation of capital and the mortgages credit risk on a regular basis.76 A third justification for lower mortgage risk weights is that mortgages are backed by collateral. A fourth reason is that the European bank practice of holding mortgages until maturity promotes bank monitoring that reduces risk exposure. Finally, homeowners try to avoid foreclosure on their homes at all costs. INSERT TABLES 2.6.1 AND 2.6.2 AROUND HERE Studies indicate that LTV is an important indicator of credit risk. Table 2.6.1 (2.6.2) shows the relationship between LTV and default probabilities (loss severity) for six countries as determined by one rating agencys mortgage risk models for a BBB-rated MBS. Klopfer (2002) notes how surprising it is that the Basel II proposals do not incorporate LTV in the new proposals. The standardized approach retains a flat risk weight similar to Basel I. Klopfer (2002) claims that this lapse in the move toward greater risk sensitivity was the result of the desire to give banks the incentive to move from the standardized to the IRB approaches of Basel II.77 Quigley and Van Order (1991) agree that capital requirements should vary by LTV and geographic diversification since mortgage credit risk exposure depends on these factors. Their calculations, using a sample of 300,000 conventional mortgages originated from 1976 through 1980 in the US, estimates that the economic capital requirements on a mortgage portfolio with LTV ranging from 81% to 90% is only one third of the economic capital requirements of a mortgage portfolio with LTV ranging from 91% to 95%. Moreover, holding LTV constant, a nationally diversified mortgage portfolio needs only one third to one half as much economic capital as a mortgage portfolio that is concentrated in a given geographic region.
76

European regulations on own funds allocation to credit risk require that capital be allocated on each loan for the forthcoming year, with a review each year. 77 Klopfer (2002) describes the industry comments regarding Basel II proposals as being asymmetric in that no bank is going to argue for higher capital requirements. Moreover, he describes a series of proposals that would allow for greater risk sensitivity in Basel IIs treatment of mortgages under the standardized approach. These proposals range from establishing a high LTV/100% risk weight category to setting a risk weight schedule based on LTV (e.g., 20% risk weight for loans with LTV less than 60%, 50% risk weight for LTV between 60-80%, and 100% risk weight for LTV exceeding 80%).

42

Mortgage markets tend to be more segmented than other financial markets. Thus, portfolio diversification can eliminate some of the cyclical swings due to geographic and sectoral real estate price fluctuations. To the extent that Basel II does not incorporate adequate reductions due to portfolio risk diversification, then the new capital regulations may require excessive levels of capital for mortgage portfolios.78 Thus, capital arbitrage would be encouraged as banks divest themselves of low risk, diversified mortgage portfolios in order to avoid onerous capital requirements. To determine whether this is a likely outcome, one must assess the accuracy of the correlation assumptions implicit in the Basel II proposals, particularly in the real estate loan IRB formulations. Calem and LaCour-Little (2002) compare regulatory and economic capital for portfolios of mortgage loans. They find that economic capital levels are determined by specific loan characteristics (the LTV ratio and the borrowers credit rating) and the geographic diversification of the mortgage portfolio.79 Thus, if regulatory capital rules are not sufficiently sensitive to these elements of portfolio risk exposure, then regulatory capital requirements will diverge from economic capital levels.80 In particular, capital requirements under Basel I and the standardized approach to Basel II are found to be too high for banks with regionally diversified portfolios. Calem and LaCour-Little (2002) examine a portfolio of 30 year fixed-rate, conforming-size residential mortgage loans and use a nonparametric re-sampling approach to construct risk sensitive proposals for Basel II capital requirements. However, Greenspan (1998) is concerned about cherry picking of assets in securitizations that leave high risk assets on the balance sheet with economic capital far in excess of regulatory minimums. In the 1980s, commercial banks and thrift institutions aggressively increased their holdings of commercial real estate loans. Handorf (2001) notes that many of these loans were poorly underwritten and undercapitalized. When the real estate market experienced dramatic declines in property values (during the 1980s there was a consecutive series of crises as regional real estate values declined dramatically in Texas, California, New England, etc.); many of the lenders became insolvent. Since then, commercial real estate loans and commercial MBS must conform to stringent underwriting rules and capitalization requirements; see Handorf (2001). Thus, historic rates of default are very low and Basel II proposes a lower capital risk weight for these assets. Table 2.6.3 shows the low level of loan charge-offs over the 1996-2000 period for commercial real estate loans in the US.

78

Under the standardized approach, there is no diversification effect on capital requirements. The IRB approaches permit some reduction in capital requirements due to portfolio risk diversification effects. However, the formal granularity adjustments to capital requirements (that reduced capital requirements for well-diversified portfolios) were dropped from the Basel II proposals. 79 Even the IRB proposals under Basel II do not address geographic diversification of the loan portfolio in capital requirements, but leave that consideration to the supervisory pillar II. 80 However, Gordy (2003) shows how an add-on risk factor can adjust capital requirements to reflect various levels of portfolio diversification. If, however, portfolio returns are driven by more than one systematic risk factor, then both Basel I and II regulatory capital requirements can diverge substantially from economic capital levels.

43 INSERT TABLE 2.6.3 AROUND HERE The standardized approach of Basel II utilizes external credit ratings to set risk weights. Thus, commercial MBS with Aaa/AAA ratings will find their risk weight fall from 100% under Basel I to 20% under Basel II. Unrated commercial mortgages, however, are subject to a different treatment proposed under the Basel II standardized approach. Since historically commercial real estate loans have been excessively risky in many countries throughout the world, Basel II is reluctant to lower the risk weight below 100%. However, there is a preferential risk weight of 50% for that portion of the loan that does not exceed 50% of the propertys market value (or 60% of the mortgage lending value, see discussion of Realkredite in section 2.5). To receive such preferential treatment, banks must document that historic loss levels on the preferred commercial loans do not exceed 0.3% p.a. and that the banks losses from all commercial real estate loans do not exceed 0.5% of the outstanding loans in any given year. Table 2.6.3 suggests that, on average, commercial real estate loans originated by large US banks would qualify for the 50% preferential risk weight. Handorf (2001) estimates that the preferred risk weights under Basel II will create an increase of between 50 to 90 basis points in returns for upper medium grade and high grade (rated BBB/Baa or higher) commercial MBS issuers. Over the period 1996 through 2000, commercial real estate loans outstanding in the US increased at a rate of 9.8% p.a. from $770 billion to $1.23 trillion; see Handorf (2001).81 Over the same time period, the amount of commercial MBS outstanding increased at a rate of 37.5% p.a. Table 2.6.4 shows that the commercial MBS market in the US grew at the expense of the market shares of commercial banks and life insurance companies. Handorf (2001) expects that the proposed reduction in bank regulatory capital requirements for commercial real estate should increase the attractiveness of this market segment, thereby increasing the market share of banks in financing commercial real estate activity. INSERT TABLE 2.6.4 AROUND HERE Hagen and Holter (2002) document the low risk exposure of German commercial mortgage markets. In a study undertaken by the Association of German Mortgage Banks (VDH) in 1996, the 18 largest commercial banks and seven Landesbanken collected data on losses from loans for office and multi-purpose commercial buildings. The mean default rate was found to be 0.15%, with a loss rate for loans with a LTV ratio less than 60% of between 0.03% to 0.04%. The average LTV in the sample was 72%. In 1999, another survey of losses in real estate lending was conducted using data over the 1988 to 1998 period. Hagen and Holter (2002) show that the loss rate is a function of the LTV, with higher losses at higher LTV levels. However, the relative frequency of bad debt charges was significantly lower for commercial real estate loans taken for the purposes of office building and retail stores than for mortgages on residential or hotel properties. On average, the loss rate on commercial property loans over the entire 1988-1998 period was

81

Over the same period, the annual growth rate for debt was only 6.2% p.a. See Handorf (2001).

44 0.04% as compared to an average loss rate of 0.26% for all loans.82 Hagen and Holter (2002) assert that the low historic loss rates in the German mortgage market make it important for German mortgage banks to progress through the Basel II stages to the IRB Advanced approach that permits the use of historic estimates of PD and LGD. Hagen and Holter (2002) document the results of a VDH project to measure the impact of implementation of the advanced IRB approach of Basel II capital regulations on the capital requirements for German mortgage banks.83 They find that German mortgage banks were ill equipped to meet the stringent prerequisites for adoption of the IRB Advanced approach. Internal rating systems did not typically distinguish between PD and LGD, the ratings were not generally calibrated to the banks loss history, and historical data were often insufficient to estimate PD and LGD for each bank. Thus, the VDH pools data from all of its members in order to reduce the cost of data collection, create a standardized internal rating model, check the models calibration and improve the quality of the database. The results of the project should enable German mortgage banks to better comply with Basel II capital requirements. Hagen and Holter (2002) calculate LGD separately from PD. Defaults are divided into three groups: liquidations, settlements and cures. Hagen and Holter (2002) show that 45% of the defaults were liquidated for an average LGDL of 30%. An additional 15% of the defaulting loans were restructured and settled for an average LGDS of 12%. Finally, 40% of the defaults were cured and returned to health with a LGDC equal to 0. The average LGD for the sample mortgage portfolio can be calculated as: LGD = (Liquidation Rate x LGDL) + (Settlement Rate x LGDS) + (Cure Rate x LGDC) = (0.45 x 30%) + (0.15 x 12%) + (.40 x 0) = 15.8% The recovery rates and liquidation durations were estimated using a database consisting of 2,500 loan observations segmented by property type, location and other characteristics. Hagen and Holter (2002) report the formation of 13 distinct segments in residential property and nine in commercial real estate. Default probabilities, recovery rates and liquidation values varied across the separate segments. Liquidation durations for the residential (commercial) property sector ranged from 17 to 22 (24 to 32) months. There was a strong positive correlation between default risk and LTV ratio found in the study. Basel II proposes to deduct first loss credit enhancement tranches from capital requirements for securitizations. This is true for both traditional and synthetic securitizations. The proposals test for the possibility of implicit support due to reputational considerations that would require that the ABS be treated as if it were an onbalance sheet item requiring full capital backing (see discussion of a clean break in
Loss rates on commercial mortgages experienced a large increase in the early 1990s as a result of German reunification, although a similar jump was not observed for residential mortgages. 83 Hagen and Holter (2002) contend that this VDH-sponsored project is the only one of its kind being conducted throughout the world. Manning (2002) states that mortgage lenders in Belgium, Denmark, Germany, Spain, the Netherlands, Sweden and the UK are in the process of building databases in preparation of the IRB model requirements. However, a proposal to pool data at the European level was rejected because it was neither feasible nor of added value. (Manning (2002), p. 14.)
82

45 section 2.3). To the extent that the Basel II standardized approach does not take portfolio diversification into account in assessing capital requirements, asset securitization under Basel II may still reduce minimum required capital levels backing mortgages because the risk weight will be reduced by the securitized pools diversification effect (thereby raising the credit rating of the ABS). Klopfer (2002) criticizes the Basel II proposals for mortgages. For instance, the standardized approach is insufficiently risk sensitive. Basel II proposals initially retained the 50% risk weight for mortgages under the standardized approach, but this was changed in the July 2002 proposals to a 40% risk weight. Odenbach (2002) also notes that the July 2002 Basel II proposals called for a reduction in the risk weights for Realkredite from 50% to 40%, thereby reducing the capital requirement to 3.2% (from 4%). However, since the losses on Realkredite are far lower than even 3.2%, this may be excessive and may be reduced further in the final proposals. Klopfer (2002) argues that the IRB approaches are not well suited to mortgage credit risk assessment. In particular, the one year time horizon is not relevant for long-term mortgage loans. Klopfer (2002) shows that expected losses on mortgages peak in the 3-7 year time horizon after origination.84 Thus, limiting the time horizon to one year understates the expected losses on a mortgage portfolio. Moreover, one year is insufficient to capture economic fluctuations and other factors contributing to the mortgage portfolios long-term performance. Klopfer (2002) shows that the average ratio of ten year delinquencies is 2.21 times higher than for delinquencies over a four year from origination time horizon. In contrast, Duebel (2002) critiques the potential impact of the Basel II 2001 proposals on the mortgage market as potentially reducing capital too much, by noting that risk is endogenous. Thus, incorporation of Value at Risk (VaR) models that do not incorporate the integration between behavior in the real estate and financial markets will underestimate catastrophic risk exposure. BIS regulations focus on individual credits and then obtain the banks capital requirement by aggregating, with minor adjustments, across the portfolio. Duebel (2002) argues that portfolio risk models are more relevant, particularly for mortgages. Moreover, stress testing and consideration of extreme events must be enhanced to avoid under-capitalization. However, Duebel (2002) is encouraged by the Basel II proposals regarding market discipline, enhanced transparency of financial reporting and the flexible wielding of regulatory oversight. Klopfer (2002) criticizes the reliance on bank data for Basel II calibration purposes. Calem and LaCour-Little (2002) obtain higher economic capital requirements using data on high LTV mortgages obtained from US mortgage insurers as compared to bank mortgage data.

84

Klopfer (2002) notes that most mortgage insurers use a ten year period to capture loss experience on mortgages. He proposes altering Basel II proposals to use the highest average annual 90-plus-day delinquency rate for any given loan age for each individual LTV category over the 10 year period.

46 Credit risk mitigation by mortgage insurers has been relegated to the supervisory pillar in the Basel II proposals. Klopfer (2002) argues that mortgage insurers can be valuable allies for bank regulators. They act as an early warning system on the riskiest mortgages in the portfolio. Mortgage insurers maintain the MTM property valuation process required to monitor LTV ratios. In their roles as counterparties and guarantors, mortgage insurers demand better credit reporting and track errors in measurement. Since mortgage insurers have first loss exposure, they have an incentive to introduce new measures of credit risk measurement and management. Finally, Klopfer (2002) claims that mortgage insurers transfer credit risk outside the banking system to highly solvent third parties, thereby limiting systemic risk exposure. INSERT TABLE 2.6.5 AROUND HERE In section 2.5, I described the mortgage market as it has evolved in various countries throughout the world. In section 2.6, I discussed the Basel regulatory initiatives. It should be clear that market structure is inextricably linked to regulatory environment. Table 2.6.5 summarizes the conclusions of sections 2.5 and 2.6 by comparing the US and European mortgage markets, focusing on both market structure and prudential bank regulation. 3. Conclusion As voluminous as the literature is on this topic, there are still questions to be resolved. A definitive consensus has not yet been reached on issues such as the extent of procyclicality in credit risk measurement models, capital allocation implications of capital requirements, and the optimal structure of the mortgage market. Opportunities for future research in this area abound. Studies are needed examinng the competitiveness of the mortgage lending market to other types of lending and the impact on mortgage market structure on the terms and conditions in the housing market. Capital arbitrage between mortgage and non-mortgage lending exists, but has been inadequately studied. Finally, the literature has still not answered the question of whether the Basel Accords have achieved their initial purpose to level the international playing field in order to enhance the safety, soundness and efficiency of banking throughout the world.

47

References Acharya, V.V., A Theory of Systemic Risk and Design of Prudential Bank Regulation. NYU, Dissertation Thesis. January 2001. Aggarwal, R. and K.T. Jacques, 2001, The Impact of FDICIA and Prompt Corrective Action on Bank Capital and Risk: Estimates Using a Simultaneous Equations Model, Journal of Banking and Finance, vol. 25, 1139-1160. Allen, L., 2002, Discussion, in Ratings, Rating Agencies, and the Global Financial System, R. Levich, G. Majnoni, and C. Reinhart, editors, Boston: Kluwer Academic Press, 221-224. Allen, L., 1997, Capital Markets and Institutions: A Global View, New York: John Wiley and Sons. Allen, L., J. Boudoukh and A. Saunders, 2004, Understanding Market, Credit and Operational Risk: The Value at Risk Approach, London: Blackwell Publishing. Allen, L., J. Boudoukh, and A. Saunders, 2004, Understanding Market, Credit and Operational Risk: The Value at Risk Approach, Blackwell Publishing. Allen, L., G. De Long, and A. Saunders, 2003, Issues in the Credit Risk Modeling of Retail Markets, Journal of Banking and Finance, forthcoming. Allen, L., J. Jagtiani and Y. Landskroner, 1996, Interest Rate Risk Subsidization in International Capital Standards, Journal of Economics and Business, vol. 48, 251-267. Allen, L. and J. Jagtiani, 1997, Risk and Market Segmentation in Financial Intermediaries Returns, Journal of Financial Services Research, 12: 2/3, 159-173. Allen, L. and J. Jagtiani, 2000, The Risk Effects of Combining Banking, Securities, and Insurance Activities, Journal of Economics and Business, 52, 485-497. Allen, L. and A. Rai, 1996, Bank Charter Values and Capital Levels: An International Comparison, Journal of Economics and Business, vol. 48, 269-284. Allen, L. and A. Saunders, 2002, Cyclical Effects in Credit Risk Ratings and Default Risk, with A. Saunders, Credit Ratings: Methodologies, Rationale and Default Risk, Michael Ong, ed., London: Risk Books, 45-79. Allen, L. and A. Saunders, 1992, Bank Window Dressing: Theory and Evidence," with A. Saunders, Journal of Banking and Finance, vol. 16, 585-623.

48 Allen, T., 2001, Revisions to International Bank Solvency Standards: A UK Supervisory Perspective, Journal of Financial Regulation and Compliance, vol. 9, no. 4, 305-311. Altman, E.I., with B. Brady, Explaining Aggregate Recovery Rates on Corporate Bond Defaults, Salomon Center Working Paper, November 2001. Altman, E.I. and A. Saunders, An Analysis and Critique of the BIS Proposal on Capital Adequacy and Ratings. Journal of Banking and Finance, January 2001a, pp. 25-46. Altman, E.I. and A. Saunders, Credit Ratings and the BIS Reform Agenda. Paper presented at the Bank of England Conference on Banks and Systemic Risk, London, May 23-25, 2001b. Apgar, W. and M. Duda, 2003, The Twenty-Fifth Anniversary of the Community Reinvestment Act: Past Accomplishments and Future Regulatory Challenges, Federal Reserve Bank of New York Economic Policy Review, June, 269-191. Asarnow, E. and D. Edwards, Measuring Loss on Defaulted Bank Loans: A 24-Year Study. The Journal of Commercial Lending, March 1995, pp. 11-23. Avery, R.B. and A.N. Berger, 1991, Risk-Based Capital and Deposit Insurance Reform, Journal of Banking and Finance, vol. 15, 847-874. Ayuso, J., D. Perez and J. Saurina, Are Capital Buffers Procyclical? Banco de Espana working paper, April 2002. Baer, H.L. and C.A. Pavel, 1988, Does Regulation Drive Innovation? Federal Reserve Bank of Chicago Economic Perspectives, vol. 12, no. 2, 3-15. Bank for International Settlements, Proposal to Issue a Supplement to the Basel Accord to Cover Market Risks, Basle, April 1995. Bank for International Settlements, Standardized Model for Market Risk. Basle, Switzerland: Bank for International Settlements, 1996. Bank for International Settlements, Credit Risk Modeling: Current Practices and Applications. Basel Committee on Banking Supervision, Document No 49, April 1999a. Bank for International Settlements, Sound Practices for Loan Accounting and Disclosure. Basel Committee on Banking Supervision, Document No 55, July 1999b. Bank for International Settlements, Range of Practice in Banks Internal Ratings Systems. Basel Committee on Banking Supervision, Document No 66, January 2000. Bank for International Settlements, The New Basel Capital Accord January 2001.

49 Bank for International Settlements, Long-term Rating Scales Comparison, April 30, 2001. Bank for International Settlements, Working Paper on the Regulatory Treatment of Operational Risk, September 2001. Bank for International Settlements, Results of the Second Quantitative Study, November 5, 2001a. Bank for International Settlements, Potential Modifications to the Committees Proposals, November 5, 2001b. Bank for International Settlements, Third Basel Consultative Document, April 2003. Barnhill, T.M., Jr., and W. F. Maxwell, 2002, Modeling Correlated Interest Rate, Spread Risk, and Credit Risk for Fixed Income Portfolios. Journal of Banking and Finance, 26/2-3, February. Beatty, A., Chamberlain, S.L. and J. Magliolo, 1995, Managing Financial Reports of Commercial Banks: The Influence of Taxes, Regulatory Capital and Earnings, Journal of Accounting Research, 33, 231-262. Benink, H. and C. Wihlborg, The New Basel Capital Accord: Making It Effective with Stronger Market Discipline, European Financial Management, vol. 8, no. 1, 103-115. Berger, A.N. and G.F. Udell, 1994, Did Risk-Based Capital Allocate Bank Credit and Cause a Credit Crunch in the United States?, Journal of Money, Credit and Banking, vol 26, , pp. 585628. Berger, A.N., R.S. Demsetz and P.E. Strahan, 1999, The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future, Journal of Banking and Finance, vol. 23, 135-194. Berger, A.N., R. DeYoung, H. Genay, and G.F. Udell, 2000, Globalization of Financial Institutions: Evidence from Cross-Border Banking Performance, Brookings-Wharton Papers on Financial Services 2000, 23-158. Berger, A.N., R.J. Herring, and G.P. Szego, 1995, The Role of Capital in Financial Institutions, Journal of Banking and Finance, vol. 19, 393-430. Bernanke, B.S. and C.S. Lown, 1991,The Credit Crunch,Brookings Papers on Economic Activity, 2, , pp. 20548. Bikker, J.A. and H. Hu, 2002, Cyclical Patterns in Profits, Provisioning and Lending of Banks and Procyclicality of the New Basel Capital Requirements, BNL Quarterly Review, no. 221, June, 143-175.

50

Blum, J., 1999, Do Capital Adequacy Requirements Reduce Risks in Banking? Journal of Banking and Finance, vol. 23, 755-771. Blum, J. and M. Hellwig, 1995, The Macroeconomic Implications of Capital Adequacy for Banks, European Economic Review, vol. 39, 739-749. Bongini, P., L. Laeven, and G. Majnoni, How Good is the Market at Assessing Bank Fragility: A Horse Race Between Different Indicators. World Bank, Working Paper, January 2001. Borio, C., C. Furfine and P. Lowe, 2001, Procyclicality of the Financial System and Financial Stability: Issues and Policy Options, Bank for International Settlements Working Paper. Bos, J.W.B. and J.W. Kolari, 2003, Large Bank Efficiency in Europe and the United States: Are There Economic Motivations for Geographic Expansion in Financial Services? Working Paper. Boyd, J.H. and M. Gertler, 1993, US Commercial Banking: Trends, Cycles and Policy, NBER Working Paper No. 4404, July. Boyd, J.H., and S.L. Graham, 1991, Investigating the Banking Consolidation Trend, Federal Reserve Bank of Minneapolis Quarterly Review, Spring, 3-15. Boyd, J.H., S.L. Graham, and R.S. Hewitt, 1993, Bank Holding Company Mergers with Nonbank Financial Firms, Journal of Banking and Finance, vol. 17, 43-63. Brinkmann, E. and P.M. Horvitz, 1995, Risk-Based Capital Standards and the Credit Crunch, Journal of Money, Credit and Banking, vol. 27, no. 3, August, 848-863. Bugie, S., T. Azarchs, Y. Burger, S. Quinn, Basel II: No Turning Back for the Banking Industry, Standard & Poors Research Report, August 22, 2003. Calem, P.S. and M. LaCour-Little, 2002, Risk-Based Capital Requirements for Mortgage Loans, Board of Governors of the Federal Reserve System Working Paper, November 20, 2002. Calem, P.S. and R. Rob, 1996, The Impact of Capital-Based Regulation on Bank RiskTaking: A Dynamic Model, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series 96, no. 12, March. Campbell, T.S. and J.K. Dietrich, 1983, The Determinants of Default on Insured Conventional Residential Mortgage Loans, Journal of Finance, vol. XXXVIII, December, 1569-1581.

51 Cantor, R., Moodys Investors Service Response to the Consultative Paper Issued by the Basel Committee on Bank Supervision A New Capital Adequacy Approach. Journal of Banking and Finance, January 2001, pp. 171-186. Caprio, G. and P. Honohan, 1999, Restoring Bank Stability: Beyond Supervised Capital Requirements, Journal of Economic Perspectives, vol. 13, no. 4, Fall, 43-64. Carey, M., "Credit Risk in Private Debt Portfolios." Journal of Finance, August 1998, pp. 1363-1387. Carey, M., Dimensions of Credit Risk and Their Relationship to Economic Capital Requirements. NBER, Working Paper 7629, March 2000. Carey, M., Consistency of Internal versus External Credit Ratings and Insurance and Bank Regulatory Capital Requirements. Federal Reserve Board, Working Paper, February 2001a. Carey, M., A Policymakers Guide to Choosing Absolute Bank Capital Requirements. Federal Reserve Board Working Paper, June 3, 2001b, Presented at the Bank of England Conference on Banks and Systemic Risk, May 23-25, 2001b. Carlstrom, C.T. and K.A. Samolyk, 1995, Loan Sales as a Response to Market-Based Capital Constraints, Journal of Banking and Finance, vol. 19, 627-646. Carosio, G., 2001, The New Basel Capital Adequacy Framework, Economic Notes by Bancq Monte dei Paschi di Siena SpA, vol. 30, no. 3, 327-335. Carpenter, S.B., W. Whitesell and E. Zakrajsek, 2001, Capital Requirements, Business Loans and Business Cycles: An Empirical Analysis of the Standardized Approach in the New Basel Capital Accord, November 13, Board of Governors of the Federal Reserve System Working Paper. Carr, J., F. Mathewson and N. Quigley, 1995, Stability in the Absence of Deposit Insurance: The Canadian Banking System 1890-1966, Journal of Money, Credit and Banking, vol. 27, no. 4, 1137-1158. Carty, L.V., Bankrupt Bank Loan Recoveries. Methodology, June 1998. Moodys Investors Service Rating

Catarineu-Rabell, E., P. Jackson, and D.P. Tsomocos, 2003, Procyclicality an the New Basel Accord Banks Choice of Loan Rating Systems, Bank of England Working Paper. Cavallo, M., and G. Majnoni, Do Banks Provision for Bad Loans in Good Times? Empirical Evidence and Policy Implications. World Bank, Working Paper 2691, June 2001.

52

Chami, R. and T.F. Cosimano, 2001, Monetary Policy with a Touch of Basel, IMF Working Paper No. WP/01/151, October. Chiuri, M.C., G. Ferri, and G. Majnoni, The Macroeconomic Impact of Bank Capital Requirements in Emerging Economies: Past Evidence to Assess the Future, Journal of Banking and Finance, vol. 26, 2002, pp. 881-904. Chiuri, M., F. Giovanni, and G. Majnoni, 2002, The Macroeconomic Impact of Bank Capital Requirements in Emerging Economies: Past Evidence to Assess the Future, Journal of Banking and Finance, vol. 26, 881-904. Chiuri, M., F. Giovanni, and G. Majnoni, 2001, Enforcing the 1988 Basel Capital Requirements: Did it Curtail Bank Credit in Emerging Economies? Ecnomic Notes by Banca Monte dei Paschi di Siena SpA, vol. 30, no. 3, 399-419. Clauretie, T.M. and T. Herzog, 1990, The Effect of State Foreclosure Laws on Loan Losses: Evidence from the Mortgage Insurance Industry, Journal of Money, Credit and Banking, May, vol. 22, 221-233. Cooper, K., J. Kolari, and J. Wagster, 1991, A Note on the Stock Market Effects of the Adoption of Risk-Based Capital Requirements on International Banks in Different Countries, Journal of Banking and Finance, vol. 15, 367-381. Cotterman, R.F. and J.E. Pearce, 1996, The Effects of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation on Conventional FixedRate Mortgage Yields, Studies on Privatizing Fannie Mae and Freddie Mac, US Department of Housing and Urban Development, Office of Policy Development and Research, May, 97-168. Craig, B.R. and J.B. Thomson, 2003, Federal Home Loan Bank Lending to Community Banks: Are Targeted Subsidies Desirable? Journal of Financial Services Research, vol. 23, no. 1, 5-28. Crouhy, M., D. Galai, and R. Mark, Risk Management, McGraw-Hill, New York: 2001. Dahiya, S., M. Puri, and A. Saunders, Bank Borrowers and Loan Sales: New Evidence of the Uniqueness of Bank Loans, Department of Finance Stern School of Business NYU, Working Paper, 2001. Dahl, D., D.D. Evanoff, and M.F. Spivey, 2003, The Timing and Persistence of CRA Compliance Ratings, Journal of Financial Services Research, vol. 23, no. 2, 113-132. Das, S.R., L. Freed, G. Geng, N. Kapadia, Correlated Default Risk, September 14, 2001 Working Paper, Santa Clara University.

53 Deng, Y., J.M. Quigley, and R. Van Order, 2000, Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options, Econometrica, vol. 68, March, 275-307. Diamond, D., 1984, Financial Intermediation and Delegated Monitoring, Review of Economic Studies, vol. 51, 393-414. Dietsch, M. and J. Petey, 2002, The Credit Risk in SME Loans Portfolios: Modeling Issues, Pricing, and Capital Requirements, Journal of Banking and Finance, vol. 26, 303-322. Dionne, G. and T.M. Harchaoui, 2003, Banks Capital, Securitization and Credit Risk: An Empirical Evidence for Canada, Working Paper 03-01, January. Donahoo, K.K., and S. Shaffer, 1991, Capital Requirements and the Securitization Decision, Quarterly Review of Economics and Business, vol. 31, no. 4, Winter, 12-23. Duebel, H.J., 2002, Mortgage Credit Risk, Regulatory Standards and the Basel II Banking Supervision Reforms, Housing Finance International, vol. 17, 3-11. Ediz, T., I. Michael, and W. Perraudin, 1998, The Impact of Capital Requirements on UK Bank Behavior, Federal Reserve Bank of New York Economic Policy Review, October, 15-22. Estrella, A., The Cyclical Behavior of Optimal Bank Capital, Federal Reserve Bank of New York Working Paper, December 2001. Evans, J., J. Simpson, and AA. Mahate, 1999, The Operating and Balance Sheet Performance of Japanese International Banks in Relation to Safety Levels: A Comparison with Western European Banks, University of Wollongong Working Paper. Eyssell, T. and N. Arshadi, 1990, The Wealth Effects of the Risk-Based Capital Requirements in Banking: The Evidence from the Capital Market, Journal of Banking and Finance, vol. 14, 179-197. Falkenheim, M. and A. Powell, The Use of Credit Bureau Information in the Estimation of Appropriate Capital and Provisioning Requirements. Central Bank of Argentina, Working Paper, 2001. Ferri, G., L.G. Liu, and G. Majnoni, The Role of Rating Agency Assessments in Less Developed Countries: Impact of the Proposed Basel Guidelines. Journal of Banking and Finance , January 2001, pp. 115-148. Flannery, M., 1989, Capital Regulation and Insured Banks Choice of Individual Loan Default Risks, Journal of Monetary Economics, vol. 24, September, 235-258.

54 Flood, M., Basel Buckets and Loan Losses: Absolute and Relative Loan Underperformance at Banks and Thrifts. Office of Thrift Supervision, Working Paper, March 9, 2001. Ford, G. and R. Weston, 2003, Risk-Adjusted Performance of European Banks Under the Basel Accord, Working Paper. Freixas, X., B. Parigi, and J.C. Rochet, Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank. Journal of Money, Credit and Banking, Vol. 32, No. 3, Part II, August 2000. Frerichs, H. and M. Wahrenburg, 2003, Evaluating Internal Credit Rating Systems Depending on Bank Size, May 13, University of Frankfurt Working Paper. Furfine, C., 2001, Bank Portfolio Allocation: The Impact of Capital Requirements, Regulatory Monitoring, and Economic Conditions, Journal of Financial Services Research, vol. 20, no. 1, 33-56. Furfine, C., 2002, The Interbank Market During a Crisis, European Economic Review, 46, 809-820. Furlong, F.T. and M.C. Keeley, 1989, Capital Regulation and Bank Risk-Taking: A Note, Journal of Banking and Finance, vol. 13, 883-891. Gennotte, G. and D. Pyle, 1991, Capital Controls and Bank Risk, Journal of Banking and Finance, vol. 15, 805-824. Gonzalez-Rivera, G., 2001, Linkages Between the Secondary and Primary Markets for Mortgages: The Role of Retained Portfolio Investments of the Government-sponsored Enterprised, Journal of Fixed Income. Gordy, M.B., 2003, A Risk-Factor Foundation for Ratings-Based Bank Capital Rules, Journal of Financial Intermediation, July, 199-232. Gordy, M.B., A Comparative Anatomy of Credit Risk Models. Journal of Banking and Finance, January 2000, pp. 119-149. Greenspan, A., 1998, Wanted: Bank Regulators Who Act More Like the Market, Secondary Mortgage Markets, vol. 15, no.1/2, 6-10. Griep, C. and M. De Stefano, Standard & Poors Official Response to the Basel Committees Proposal. Journal of Banking and Finance, January 2001, pp. 149-170. Gueyie, J.P. and V.S. Lai, 2003, Bank Moral Hazard and the Introduction of Official Deposit Insurance in Canada, International Review of Economics and Finance, vol. 12, 247-273.

55

Gupton, G.M., Bank Loan Loss Given Default. Moodys Investors Service, Special Comment, November 2000. Gupton, G.M., D. Gates and L.V. Carty, Bank-Loan Loss Given Default, Moodys Investors Service, Global Credit Research, November 2000. Hagen, L. and R. Holter, 2002, Implications of Basel II for the Risk Management of German Mortgage Banks, Housing Finance International, vol. 17, no. 1, 33-42. Hall, B.J., 1993, How Has the Basel Accord Affected Bank Portfolios? Journal of the Japanese and International Economies, vol. 7, 408-440. Hammes, W. and M. Shapiro, The Implications of the New Capital Adequacy Rules for Portfolio Management of Credit Assets. Journal of Banking and Finance, January, 2001, pp.97-114. Hancock, D., A.J. Laing, J.A. Wilcox, 1995, Bank Capital Shocks: Dynamic Effects on Securities, Loans and Capital, Journal of Banking and Finance, vol. 19, 661-677. Hancock, D. and J.A. Wilcox, 1993, Was There a Capital Crunch in Banking? The Effects on Real Estate Lending of Business Conditions and Capital Shortfalls, Journal of Housing Economics, vol 3, 1, December, pp. 75105. Hancock, D. and J. Wilcox, 1994a, Bank Capital, Loan Delinquencies, and Real Estate Lending, Journal of Housing Economics, 3, 121-146. Hancock, D. and J. Wilcox, 1994b, Bank Capital and Portfolio Composition, Board of Governors of the Federal Reserve System Working Paper. Hancock, D. and J. Wilcox, 1994c, Bank Capital and the Credit Crunch: The Roles of Risk-Weighted and Unweighted Capital Regulations, Journal of American Real Estate and Urban Economics Association, vol. 22, no. 2, 59-94. Hancock, D. and J.A. Wilcox, 1995, Bank Balance Sheet Shocks: Are There Dynamic Effects on Bank Capital and Lending? Journal of Banking and Finance, vol 19, , pp. 66177. Hancock, D. and J.A. Wilcox, 1997, Bank Capital, Non-Bank Finance and Real Estate Activity, Journal of Housing Research, vol. 8, 75-105. Handorf, W.C., 2001, Commercial Real Estate Lending and the New Basel Capital Accord, Commercial Real Estate Lending, Summer, 41-49. Haubrich, J. and P. Wachtel, 1993, Capital Requirements and Shifts in Commercial Bank Portfolios, Federal Reserve Bank of Cleveland Economic Review, vol. 29, 8-15.

56

Hawke, J.D., Jr., 2002, Independent Bank Regulation is Essential for Sustained Economic Growth, Business Economics, July, 6-10. Hendricks, D. and B. Hirtle, Bank Capital Requirements for Market Risk: The Internal Models Approach, Federal Reserve Bank of New York Economic Policy Review, December 1997, pp. 1-12. Herring, R.J., 1999, Credit Risk and Financial Instability, Oxford Review of Economic Policy, vol. 15, no. 3, 63-79. Hoggarth, G., R. Reis, and V. Saporta, Costs of Banking System Instability: Some Empirical Evidence. Paper presented at the Bank of England Conference on Banks and Systemic Risk, London, May 23-25, 2001. Honda, Y., 2002, The Effects of the Basel Accord on Bank Credit: The Case of Japan, Applied Economics, July 10, v. 34, 10, 1233-1240. Hovakimian, A. and E.J. Kane, 2000, Effectiveness of Capital Regulation at US Commercial Banks, 1985 to 1994, Journal of Finance, vol. LV, no. 1, February, 451468. International Swaps and Derivatives Association (ISDA), Credit Risk and Regulatory Capital, New York/London, March 1998. Ito, T., and Y.N. Sasaki, 2002, Impacts of the Basel Capital Standard on Japanese Banks Behavior, Journal of the Japanese and Interenational Economies, vol 16, 372397. Jackson, P., with C. Furfine, H. Groenveld, D. Hancock, D. Jones, W. Perraudin, L. Radecki, and M. Yoneyama, 1999, Capital Requiremetns and Bank Behavior: The Impact of the Basel Accord, Basel Committee on Banking Supervision Working Papers, No. 1, April. Jackson, P., W. Perraudin, and V. Saporta, Setting Minimum Capital for Internationally Active Banks. Paper presented at the Bank of England Conference on Banks and Systemic Risk, London, May 23-25, 2001. Jacques, K. and P. Nigro, 1997, Risk-Based Capital, Portfolio Risk and Bank Capital: A Simultaneous Equations Approach, Journal of Economics and Business, vol. 49, 533547. Jacques, K., 2003, The Macroeconomic Implications of a Revised Basel Accord: A Comparison with the 1988 Risk-Based Capital Standards, May, Office of Financial Institutions Policy Working Paper, May.

57 Jagtiani, J., A. Saunders and G. Udell, 1995, The Effect of Bank Capital Requirements on Bank Off-Balance Sheet Financial Innovations, Journal of Banking and Finance, June, 647-658. Jobst, A., 2003, Risk Sharing in Securitization: The Function of the First Loss Provision as a Signaling Device, London School of Economics Working Paper, April 8, 2003. Johnson, R., 1991, The Bank Credit Crumble, Federal Reserve Bank of New York Quarterly Review, Summer, 40-51. Jones, D., 2000, Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues, Journal of Banking and Finance, vol. 24, 35-58. Jones, S., G.W. Bauer, A. Kriegler, 2002, Bank Liquidity: Canadian Bank Case Study, Moodys Research Report, December. Jordan, J., J. Peek, and E. Rosengren, Credit Risk Modeling and the Cyclicality of Capital, BIS conference, March 6, 2002. Kang, J.K. and R.M. Stulz, 2000, Do Banking Shocks Affect Borrowing Firm Performance? An Analysis of the Japanese Experience, Journal of Business, vol. 73, no. 1, January, 1-23. Karaoglu, N.E., 2003, Regulatory Capital and Earnings Management in Banks: The Case of Loan Sales and Securitizations, University of Toronto Working Paper, January 25, 2003. Kealhofer, S. The Quantification of Credit Risk. KMV Corporation, January 2000, (unpublished). Keeley, M.C., 19980, Deposit Insurance, Risk and Market Power in Banking, American Economic Review, vol. 80, no. 5, 183-200. Keeley, M.C.and F.T. Furlong, 1990, A Reexamination of Mean-Variance Analysis of Bank Capital Regulation, Journal of Banking and Finance, vol. 14, 69-84. Keeton, W.R., 1989, The New Risk-Based Capital Plan for Commercial Banks, Federal Reserve Bank of Kansas City Economic Review, vol. 74, no. 10, 40-60. Kim, M.S. and W. Kross, 1998, The Impact of the 1989 Change in Bank Capital Standards on Loan Loss Provisions and Loan Write-offs, Journal of Accounting and Economics, 25, 69-99. Kim, S.B. and R. Moreno, 1994, Stock Prices and Bank Lending Behavior in Japan, Federal Reserve Bank of San Francisco Economic Review, 31-42.

58 Klopfer, E., 2002, A Mortgage Insurers Look at Basel II and Residential Mortgage Credit Risk, Housing Finance International, vol. 17, no. 1, 22-32. Krainer, R.E., 2003, Banking, Business Cycles and the Basel Accord: Some Empirical Evidence, University of Wisconsin-Madison Working Paper, April. Krainer, R.E., 2002, Banking in a Theory of the Business Cycle: A Model and Critique of the Basel Accord on Risk-Based Capital Requirements for Banks, International Review of Law and Economics, 21, 413-433. Kryzanowski, L. and G.S. Roberts, 1993, Canadian Bank Solvency, 1922-1940, Journal of Money, Credit and Banking, vol. 25, no. 3, 361-376. Kryzanowski, L. and G.S. Roberts, 1999, Perspectives on Canadian Bank Insolvency During the 1930s: A Note, Journal of Money, Credit and Banking, vol. 31, no. 1, 130136. Kupiec, P.H., 2001, The New Basel Capital Accord: The Devil is in the (Calibration) Details, IMF Working Paper No. WP/01/113, August. Laderman, E.S., 1994, Wealth Effects of Bank Holding Company Securities Issuance and Loan Growth under the Risk-Based Capital Requirements, Federal Reserve Bank of San Francisco Economic Review, 2, 30-41. Lam, C.H. and A.H. Chen, 1985, Joint Effects of Interest Rate Deregulation and Capital Requirements on Optimal Bank Portfolio Adjustments, Journal of Finance, vol. XL, no. 2, June, 563-575. Lavin, A., M.C. Griswold, and G.V. Karels, 1996, The Impact of Risk-Based Captial Standards and Regulatory Examinations on the Portfolio Composition of Commercial Banks, Working Paper. Linnell, I., A Critical Review of the New Capital Adequacy Framework Paper Issued by the Basel Committee on Banking Supervision and its Implications for the Rating Agency Industry. Journal of Banking and Finance, January 2001, pp. 187-196. Lopez, J.A., The Empirical Relationship Between Average Asset Correlation, Firm Probability of Default and Asset Size, Federal Reserve Bank of San Francisco working paper, April 23, 2002. Lown, C.S. and S. Peristiani, 1996, The Behavior of Consumer Loan Rates During the 1990 Credit Slowdown, Journal of Banking and Finance, vol 20, , pp. 167394. Madura, J. and E.R. Zarruk, 1993, Market Reaction to Uniform Capital Adequacy Guidelines in the Banking Industry, Journal of Economics and Finance, Spring, 59-72.

59 Manning, D, 2002, Mortgage Lenders and the New Basel Capital Accord, Housing Finance International, vol. 17, no. 1, 13-21. McCauley, R.N. and R. Seth, 1992, Foreign Bank Credit to US Corporations: The Implications of Offshore Loans, Federal Reserve Bank of New York Quarterly Review, Spring, 52-65. McDonough, W.J., 2002, Commentary: Promoting Financial Stability, International Finance, 5:1, 115-127. Merton, R.C., 1995, Financial Innovation and the Management and Regulation of Financial Institutions, Journal of Banking and Finance, vol. 19, 461-481. Mingo, J.J., Policy Implications of the Federal Reserve Study of Credit Risk Models at Major US Banking Institutions. Journal of Banking and Finance, January 2000, pp. 1533. Monfort, B. and C. Mulder, 2000, Using Credit Ratings for Capital Requirements on Lending to Emerging Market Economies, IMF Working Paper WP/00/69, March. Morgan, G.E., S.D. Smith, 1987, The Role of Capital Adequacy Regulation in the Hedging Decisions of Financial Intermediaries, Journal of Financial Research, vol. X, Spring, 33-46. Moyer, S.E., 1990, Capital Adequacy Ratio Regulations and Accounting Choices in Commercial Banks, Journal of Accounting and Economics, vol. 13, 123-154. Mpuga, P., 2002, The 1998-99 Banking Crisis in Uganda: What was the Role of the New Capital Requirements? Journal of Financial Regulation and Compliance, vol. 10, no. 3, 224-242. Odenbach, M., 2002, Mortgage Securitization: What Are the Drivers and Constraints from an Originators Perspective (Basel I/Basel II)? Housing Finance International, September, 52-62. Pavel, C., 1986, Securitization, Federal Reserve Bank of Chicago Economic Perspectives, vol. 10, July/August, 16-31. Pavel, C. and D. Phillis, 1987, Why Commercial Banks Sell Loans: Am Empirical Analysis, Federal Reserve Bank of Chicago Economic Perspectives, vol. 11, May/June, 3-14. Peek, J. and E.S. Rosengren, 1992, The Capital Crunch in New England, Federal Reserve Bank of New England Economic Review, May/June, 21-31.

60 Peek, J. and E.S. Rosengren, 1995a, The Capital Crunch: Neither a Borrower Nor a Lender Be, Journal of Money, Credit and Banking, vol 27, 3, August, pp. 62538. Peek, J. and E.S. Rosengren, 1995b, Bank Regulation and the Credit Crunch, Journal of Banking and Finance, vol. 19, 679-692. Peek, J. and E.S. Rosengren, 1997, The International Transmission of Financial Shocks: The Case of Japan, American Economic Review, vol. 87, 495-505. Peek, J. and E.S. Rosengren, 1999, Japanese Banking Problems: Implications for Lending in the United States, New England Economic Review, 25-36. Powell, A., A Capital Accord for Emerging Economies? July 11, 2001 World Bank working paper. Purhonen, M., New Evidence of IRB Volatility, Risk, March 2002, pp. S21-S25. Quigley, J.M. and R. Van Order, 1991, Defaults on Mortgage Obligations and Capital Requirements for US Savings Institutions: A Policy Perspective, Journal of Public Economics, vol. 44, 353-369. Rajan, R.G., 2000, Comment, Brookings Wharton Papers on Financial Services 2000, 126-130. Rajan, R.G., 1994, Why Bank Credit Policies Fluctuate: A Theory and Some Evidence, Quarterly Journal of Economics, vol. 109, no. 2, May, 399-441. Reinhart, C. Sovereign Credit Ratings Before and After Financial Crises. Dept. of Economics, University of Maryland. February 21, 2001, presented at the Conference on Rating Agencies in the Global Financial System, Stern School of Business NYU, June 1, 2001. Reisen, H. and J. von Maltzan, Boom and Bust and Sovereign Ratings. International Finance, vol. 2.2, July 1999, pp. 273-293. Reisen, H., Revisions to the Basel Accord and Sovereign Ratings. in R. Hausmann and U. Hiemenz (eds.), Global Finance From a Latin American Viewpoint, IDB/OECD Development Centre, 2000. Rime, B., 2000, Capital Requirements and Bank Behavior: Empirical Evidence for Switzerland, Journal of Banking and Finance, vol. 25, 789-805. RMA, 2000, Credit risk capital for retail credit products: A survey of sound practices. Rochet, J.C., 1992, Capital Requirements and the Behavior of Commercial Banks, European Economic Review, vol. 36, 1137-1178.

61

Roll, R., 2003, Benefits to Homeowners from Mortgage Portfolios Retained by Fannie Mae and Freddie Mac, Journal of Financial Services Research, vol. 23, no. 1, 29-42. Rule, D. The Credit Derivatives Market: Its Development and Possible Implications for Financial Stability. Financial Stability Review, June 2001, pp. 117-140. Saunders, A., Comments on The Macroeconomic Impact of Bank Capital Requirements in Emerging Economies: Past Evidence to Assess the Future, Journal of Banking and Finance, vol. 26, 2002, pp. 905-907. Saunders, A. and L. Allen, 2002, Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms, second edition, New York: John Wiley & Sons. Saunders, A. and H. Thomas, Financial Institutions Management: Second Canadian Edition, Toronto: McGraw-Hill Ryerson, 2001. Saunders, A. and B. Wilson, 1995, If History Could Be Rerun: The Provision and Pricing of Deposit Insurance in 1933, Journal of Financial Intermediation, vol. 4, 396413. Saurina, J. and C. Trucharte, 2003, The Impact of Basel II on Lending to Small- and Medium-Sized Firms: A Regulatory Policy Assessment Based on the Spanish Credit Register, May, Bank of Spain Working Paper. Sharpe, S.A., 1995, Bank Capitalization, Regulation and the Credit Crunch: A Critical Review of the Research Findings, Working Paper 95-20, Federal Reserve Board. Shih, J., A. Samad-Khan and P. Medapa, Is the Size of an Operational Loss Related to Firm Size? Operational Risk, January 2000. Shrieves, R.E. and D. Dahl, 1992, The Relationship Between Risk and Capital in Commercial Banks, Journal of Banking and Finance, vol. 16, 439-457. Simons, K., Why Do Banks Syndicate Loans? New England Economic Review, Federal Reserve Bank of Boston, 1993, pp. 45-52. Stiroh, K.J. and C. Metli, 2003, Now and Then: The Evolution of Loan Quality for US Banks, Federal Reserve Bank of New York Current Issues in Economics and Finance, vol. 9, no. 4, April, 1-7. Stolz, S., 2002, The Relationship Between Bank Capital, Risk-Taking and Capital Regulation: A Review of the Literature, Kiel Institute for World Economics Working Paper No. 1105, February.

62 Sundarajan, V., D. Marston, and R. Basu, 2001, Financial System Standards and Financial Stability: The Case of the Basel Core Principles, IMF Working Paper WP/01/62, May. Szego, G., 1995, Risk-Based Capital in the European Economic Community, Journal of Banking and Finance, vol. 19, 727-729. Thakor, A.V., 1996, Capital Requirements, Monetary Policy and Aggregate Bank Lending: Theory and Empirical Evidence, Journal of Finance, vol. 51, 279-324. Thakor, A.V. and P.F. Wilson, 1995, Capital Requirements, Loan Renegotiation and the Borrowers Choice of Financing Source, Journal of Banking and Finance, vol. 19, 693711. Van Order, R., 2000, The Structure of the Mortgage Market in the United States: A Model of Dueling Charters, Freddie Mac Working Paper, June. Wagster, J.D., 1996, Impact of the 1988 Basel Accord on International Banks, Journal of Finance, vol. LI, No. 4, September, 1321-1346. Wall, L.D., 1989, Capital Requirements for Banks: A Look at the 1981 and 1988 Standards, Federal Reserve Bank of Atlanta Economic Review, March/April, 14-29. Wall, L.D. and T.W. Koch, Bank Loan-Loss Accounting: A Review of the Theoretical and Empirical Evidence. Federal Reserve Bank of Atlanta Economic Review, Second Quarter 2000, pp. 1-19. Wall, L.D. and D.R. Peterson, 1987, The Effect of Capital Adequacy Guidelines on Large Bank Holding Companies, Journal of Banking and Finance, vol. 11, 581-600. Wall, L.D. and D.R. Peterson, 1995, Bank Holding Company Capital Targets in the Early 1990s: The Regulators versus the Markets, Journal of Banking and Finance, vol. 19, 563-574. Wall, L., and M.M. Shrikhande, "Credit Derivatives." Paper presented at the FMA Conference, Chicago, October 1998. White, L., 2002, The Credit Rating Industry: An Industrial Organization Analysis, in R. Levich, ed., Ratings, Rating Agencies, and the Global Financial System, Kluwer Academic Publishing. White, L, 2003, Focusing on Fannie and Freddie: The Dilemmas of Reforming Housing Finance, , Journal of Financial Services Research, vol. 23, no. 1, 43-58. White, N.W. and A. Rai, Market Risk for Foreign Currency Options: Basels Simplified Model, Financial Management, vol. 28, no. 1, Spring 1999, pp. 99-109.

63

Zhou, C., 2001, An Analysis of Default Correlations and Multiple Defaults. The Review of Financial Studies, Summer, pp. 555-576. Appendix List of Abbreviations and Acronyms ABS=asset-backed securities. AMA=advanced measurement approach. Basel I=1988 Basel Accord. Basel II=New Basel Accord. BIS=Bank for International Settlements. BISTRO=Broad Index Secured Trust Offering. BRW=benchmark risk weight. CDO=collateralized debt obligation. CLN=credit-linked note. CLO=collateralized lending obligation. CRA=Community Reinvestment Act of 1977. EAD=exposure at default. GNMA=Government National Mortgage Association that issues securities backed by Federal Housing Association (FHA) government insurance for residential mortgages. GSE=government-sponsored enterprises such as Fannie Mae and Freddie Mac. HMDA=Home Mortgage Disclosure Act of 1975 HPB=Hypotheken-Pfandbriefe. (MBS). HTM=hold to maturity IMF=International Monetary Fund. IRB=Internal Ratings-Based Models of Basel II (Foundations and Advanced).

64

KfW=Kreditanstalt fur Wiederaufbau. LGD=loss given default. LTV=loan-to-value ratio. MBS=mortgage-backed securities. MTM=marked-to-market. OBS=off-balance sheet items. PD=probability of default Repo=repurchase agreement. RW=risk weight. SPV=special purpose vehicle. VAR=value at risk.

65

Table 2.1.1 Pre-Basel Capital to Assets Ratios for International Banks Country Japan Germany Netherlands US Canada UK Switzerland Japan Capital to Asset Ratio 2.11% 3.32 3.52 4.90 5.05 5.41 6.29 Incl. Hidden Reserves 12.35% CA Ratio Std. Dev. 0.44 0.70 0.37 0.91 1.03 1.57 0.65 1.48% Ratio Range (%) 1.60-3.13 2.37-4.20 3.14-3.87 3.53-6.86 4.15-6.98 2.41-7.75 5.86-7.44 9.62-14.89% No. of Banks 10 6 3 22 6 7 5 10 #/% Below Tier 1 Min. 10/100% 4/67% 3/100% 5/23% 0/0% 1/11% 0/0% 0/0%

Source: Wagster (1996), table II, p. 1327

66 Table 2.4.1 Summary of Literature Review on Procyclicality and Systematic Effects in Credit Risk Measures Probability of Default (PD) Some Consensus + correlation with asset values. Time varying with systematic risk component. Loss Given Default (LGD) + correlation with asset and collateral values. Time varying with systematic risk component. Open Questions Relationship between PD correlations and firm credit quality (PD level). Relationship between PD correlations and bankruptcy rules (renegotiation) and macroeconomic shifts. Relationship between LGD correlations and firm credit quality (PD level). Relationship between LGD correlations and bankruptcy rules (renegotiation) and macroeconomic shifts. Sign of correlation between LGD and PD. Relationship between PDLGD correlation and systematic macro effects. Sign of interfirm correlation in EAD. Relationship between EAD correlations and firm credit quality (PD level). Relationship between EAD correlations and bankruptcy rules (renegotiation) and macroeconomic shifts. Integration of market risk and credit risk models.

Correlations Between LGD and PD

Exposure at Default (EAD)

Time varying with systematic risk component.

Source: Allen and Saunders (2002), Table 14.

67 Table 2.5.1 Composition of the Aggregate Debt Security Investment Portfolio of the 25 Largest Banking Organizations in the US (as of Dec. 31, 1999) Debt Security Category US Bond Issues GSE Pass-Through MBS US Treasury & Agency Securities Foreign Bond Issues CMOs (GSE and GNMA)-non pass-throughs GNMA Pass-Through MBS US State & Local Government Securities Other US MBS Total $ Amount (billions) 164.36 136.88 73.74 63.23 56.78 47.20 43.38 28.74 $ 614.31 Percent of Total 26.76 22.28 12.00 10.29 9.24 7.68 7.06 4.68 100.0%

Source: Calem and LaCour-Little (2002), Table 2, p. 30.

Table 2.6.1 Rating Agency Default Probability Assumptions By LTV and By Country for BBB Rating LTV Ranges <= 40% 40.01-50 50.01-60 60.01-65 65.01-70 70.01-75 75.01-80 80.01-85 85.01-90 90.01-95 95.01-98 >=98.01% Australia Germany 2.0% 3.0 3.0 4.0 4.0 6.0 6.0 7.0 9.0 11.0 14.0 16.0 2.0% 3.0 3.0 3.0 4.0 4.0 5.0 6.0 7.0 9.0 10.0 12.0 Holland 3.0% 3.0 3.0 3.0 4.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 Spain 3.0% 3.0 4.0 4.0 4.0 5.0 6.0 7.0 8.0 10.0 12.0 16.0 UK 2.0% 3.0 4.0 5.0 6.0 6.0 7.0 8.0 10.0 13.0 16.0 18.0 US 1.2% 1.8 2.5 3.0 3.7 4.6 6.0 8.1 11.0 15.1 20.6 23.2 6 country average* 0.39 0.49 0.56 0.62 0.73 0.84 1.00 1.20 1.48 1.88 2.31 2.69

Source: Klopfer (2002), Figure 1, p. 24. *Six country averages are expressed relative to a LTV range of 75.01%-80%. For example, a mortgage with LTV between 90.01-95% has a default probability that is 1.88 times higher than the default probability expected on a mortgage with LTV between 75.01-80%.

68

Table 2.6.2 Rating Agency Loss Severity Assumptions By LTV and By Country for BBB Rating LTV Ranges <= 40% 40.01-50 50.01-60 60.01-65 65.01-70 70.01-75 75.01-80 80.01-85 85.01-90 90.01-95 95.01-98 >=98.01% Australia Germany 0.0% 0.0 7.5 16.5 24.3 31.0 36.9 42.1 46.7 50.8 52.3 54.5 0.0% 0.0 3.9 12.7 20.2 26.8 32.5 37.5 42.0 46.0 47.5 49.6 Holland 0.0% 0.0 10.1 18.0 24.8 30.6 35.8 40.3 44.4 48.0 49.3 51.2 Spain 0.0% 0.0 12.7 22.3 30.6 37.7 44.0 49.5 54.4 58.8 60.5 62.8 UK 0.0% 0.0 0.0 8.54 16.29 23.00 28.88 34.06 38.67 42.79 44.32 46.50 US 0.0% 0.0 0.0 6.54 14.29 21.00 26.88 32.06 36.67 40.79 42.32 44.50 6 country average* 0.00 0.00 0.15 0.40 0.63 0.83 1.00 1.15 1.29 1.41 1.46 1.52

Source: Klopfer (2002), Figure 2, p. 24. * Six country averages are expressed relative to a LTV range of 75.01%-80%. For example, a mortgage with LTV between 90.01-95% has a loss severity that is 1.41 times higher than the loss severity expected on a mortgage with LTV between 75.0180%.

Table 2.6.3 Large US Bank Commercial Real Estate Loan Net Chargeoff Data (Losses Net of Recoveries for Banks with Assets Exceeding $10 Billion) Loan Type Commercial Real Estate Real Estate All Bank Loans 2000 0.01% 0.10% 0.44% 1999 -0.01% 0.08% 0.42% 1998 0.00% 0.05% 0.42% 1997 -0.02% 0.07% 0.42% 1996 -0.01% 0.10% 0.38%

Source: Exhibit 2, Handorf (2001), p. 43. Note: Negative net chargeoffs imply that recoveries exceed losses.

69

Table 2.6.4 Mix of Commercial Real Estate Lenders (Percent of US Market) Institution Commercial Banks Life Insurance Cos. Asset-Backed Securities Savings Institutions Businesses Other Source: Handorf (2001), Exhibit 4, p. 48 2000 47.3 % 14.9 15.7 5.5 6.4 10.0 1996 51.6 % 20.8 7.0 6.8 3.8 10.2

70 Table 2.6.5 Comparison of European and US Mortgage Markets and Prudential Supervision and Capital Regulations United States Market Structure
The US central government-sponsored entities, GSEs (Fannie Mae and Freddie Mac), play a central role. They buy mortgage loans from mortgage banks and sell them into the secondary mortgage market. These enterprises enjoy the implicit backing of the US which reduces funding costs by about 50 basis points. The sheer size of the enterprises allows economies of scale. 50% of all outstanding mortgages at the end of 1997 were securitized. This amounted to about $2 trillion, out of a total market of $4.1 trillion.

European Market Structure

There is no national or European government agency to help lenders fund their loans. Mortgage loans have to be funded on the basis of the financial strength of banks or the intrinsic quality of the securities. EU law (Article 87 and 88 of the EC treaty) outlaws state aid in the form of guarantees, as there may be an element of competitive distortion. There are privately-owned, centralized issuing institutions; but their existence is threatened because of differing ratings of originating institutions. Private centralized issuing institutions have difficulties in creating liquidity.

Consequences of US Market Structure:

There is an element of state aid in American mortgage lending. Fannie Mae, Freddie Mac and the Federal Home Loan Bank debt (not MBS) trade at 20-50 basis points over government bonds, on an optionadjusted basis; MBS trade at 70 to 100 basis points over comparable duration government bonds.

Consequences of EU Market Structure:

EU mortgage lenders enjoy no funding advantage through government backing. Mortgage bonds trade 40 to 50 basis points over government bonds. EU MBS currently trade with an average margin of 75 to 150 basis points over government bonds.

US Prudential Treatment
Mortgage Lending: Loans originated and held by banks and thrifts have a 50% risk weight. Mortgage banks, which originate a majority of loans, have limited capital needs as they sell their loans, primarily to GSEs. Loans held by those GSEs have a minimum capital requirement of 2.5% (a 31.25% risk weight). In addition, loans with LTV of 80% or more have mortgage insurance coverage (roughly 5% of the portion over 80%). Loans sold by the GSEs as MBS have a capital requirement of 0.45% (5.625% risk weight). A majority of loans sold as MBS are in fact held by banks and thrifts with a risk weight of 20%. Only GNMA-insured securities have a 0% risk weight. Funding: MBS issued by US GSEs have a 20% risk weight. MBS issued by other institutions have a 20% risk weight (if AAA-rated) under the Basel II standardized approach. Consequences: Funding instruments are inexpensive.

EU Prudential Treatment
Mortgage Lending: On balance sheet; 50% or 100% risk weighting.

MBS: 50% risk weighting (directive 98/32/EC). Mortgage bonds: 10% risk weighting (directive 89/647/EEC) and 50% weighting of mortgage loan. Consequences: Funding instruments are relatively costly and capital intensive.

Source: Manning (2002), Tables 1 and 2, p. 18.

71

FIGURE 2.1
Figure 15.9 BISTRO structure.
(Under BIS I market risk capital rules, the intermediary bank can use VAR to determin capital requirement of its residual risk position.)
Senior & Subordinated Notes

Fee

Fee

Originating Bank Contingent payment on losses exceeding 1.5% of portfolio Credit Swap on $10 billion Portfolio

Intermediary Bank

BISTRO SPV

Capital Market Investors

$700 million Contingent payment on losses $700 million exceeding 1.5% of US Treasury portfolio securities

Credit Swap on First $700 Million of Losses

Source: Saunders and Allen, (2002), Figure 15.9.