Final FFIEC Recourse Rule (October 25, 2001)

The FDIC recently became the first of the Federal bank and thrift regulatory agencies¹ (the "agencies") to approve final rules relating to the agencies’ long-running recourse project. Assuming that the other agencies approve the rules in time for publication in the Federal Register by the end of November, the rules will be effective January 1, 2002, subject to limited grandfathering as discussed below.

The new rules amend the agencies’ existing risk-based capital standards to:

1. Vary the capital requirements for securitization positions according to their risk level, using credit ratings from nationally recognized statistical rating organizations (referred to below as "external ratings") to measure risk.
2. Permit the limited use of a bank’s qualifying internal risk rating system, program ratings or qualifying software to determine the capital requirement for certain unrated direct credit substitutes.
3. Require banks to deduct from Tier 1 capital the amount of credit-enhancing interest-only strips (defined in the rules) that exceeds 25 percent of Tier 1 capital for regulatory capital purposes.
4. Require a dollar in risk-based capital for each dollar of residual interests (dollar-for-dollar capital requirement) not deducted from Tier 1 capital, except those qualifying under the ratings-based approach.

Importantly, the new rules do not include the so-called "managed assets" approach, which would have required the sponsor of a revolving period securitization that involves an early amortization feature to hold capital (based on a 20% risk weight) against the securitized assets. We discuss each of these points, and some other important features of the new rules, further below.

The new rules are the product of two different notices of proposed rulemaking: (1) a March 2000 proposal², which was the last in a series of recourse project proposals; and (2) a separate September 2000 proposal³ relating more specifically to the capital treatment of "residual interests." The two proposals were inconsistent in some respects, and those inconsistencies have been resolved in the final rules. The final rules have also incorporated a number of important industry comments that mitigate some of the harsher aspects of particularly the September 2000 residual interest proposal.

The final rules overlap with many ideas that are under discussion at the international level in the context of the proposed new Basel capital accord, but the focus of the U.S. rules is narrower. While the Basel accord addresses the overall capital framework for banking organizations, the U.S. rules are limited to securitizations. Even in the realm of securitizations, the U.S. rules deal only with recourse (including residual interests) and direct credit substitutes. They do not deal with liquidity commitments, as the Basel proposals do. These additional matters will eventually be taken up by the agencies, assuming a successful completion of the new Basel accord. Also, the managed assets approach originated in the Basel process and is still under consideration there.

Under the new rules, qualifying securitization positions that have been rated in any of the following categories by nationally recognized statistical rating organizations will be assigned risk weights based on their ratings in effect from time to time as follows:

This ratings-based approach is available for both "traded" positions and positions that are not traded, but additional requirements apply to non-traded positions. A position will be considered "traded" if, at the time it is rated by an external rating agency, there is a reasonable expectation that in the near future:

• the position may be sold to investors relying on the rating; or
• a third party may enter into a transaction (e.g., a loan or repurchase agreement) involving the position if the third party relies on the rating.

Traded positions will only need one external rating to qualify for this approach. Non-traded positions will have to be rated by more than one rating agency, the ratings must be one category below investment grade or better for long-term positions (or investment grade or better for short-term positions) by all rating agencies providing a rating, the ratings must be publicly available and the ratings must be based on the same criteria used to rate securities that are traded.

In all cases, if a position has split ratings, the lower rating will apply. An unrated position that is senior in all respects to a rated traded position may qualify for the same treatment as the rated traded position.

The agencies will retain the authority to over-ride the ratings-based capital treatment of a position when they deem appropriate as well as to specify the capital treatment for new instruments that are not covered by the amended risk-based capital rules. In general, the agencies are retaining authority to ensure that the economic substance of transactions, rather than merely their form, complies with the rules.

Securitization positions that are not externally rated or are rated below the lowest categories shown above will generally be subject to a "gross up" treatment. As explained in the draft adopting release for the new rules:

The agencies have, however, provided three methods for banks to avoid gross-up treatment of unrated positions. These three methods are in addition to the inferred ratings permitted on certain positions that are senior to rated positions as described above. The first of the three methods is only available for direct credit substitutes that the bank provides to multi-seller conduits that it sponsors. The other two may be used more generally for direct credit substitutes and recourse obligations, but even they may not be used to set capital for residual interests (as discussed further below). None of the three methods can be used to qualify for a risk weight lower than 100%.

First, some banking organizations will be able to use an internal risk rating system to apply the ratings-based approach to direct credit substitutes that the bank provides to multi-seller conduits that it sponsors. The internal risk ratings would have to map to some external rating agency’s ratings and would then be used to place a direct credit substitute into one of the risk weights included in the standard ratings-based approach, consistent with the corresponding rating (subject to the 100% minimum referred to above). This is a more limited use of internal risk ratings than is ultimately contemplated by the Basel proposals, and the agencies characterize it as a step towards potential adoption of the broader use contemplated by Basel. In order to use this internal risk rating approach, a bank will have to convince its primary regulator of the adequacy of its rating system. The final rules list several characteristics that the agencies expect to see in these systems (see Appendix I to this memorandum).

Second, banking organizations will be able to use a rating obtained from a rating agency or other third party satisfactory to the agencies on a program level (as opposed to ratings of specific positions). The banking organization would be required to demonstrate that the program rating meets the same standards generally used by nationally recognized statistical rating organizations for rating traded positions.

Third, banking organizations may rely on qualifying credit assessment computer programs to rate otherwise unrated direct credit substitutes in securitizations. This method is intended primarily for banking organizations with limited involvement in securitization activities. Banking organizations with extensive securitization activities generally could use this approach only if it was an integral part of their risk management systems, and their systems fully capture the risks of their securitization activities.

The March 2000 recourse publication proposed additional capital requirements for sellers or sponsors relating to revolving securitizations that include an early amortization feature. Under this proposal, which is also under discussion in the Basel process, a bank would have been required to include off-balance sheet assets securitized through these structures in the bank’s risk-weighted assets when determining risk-based capital requirements. A risk weight of 20% would have been applied to these "managed assets," resulting in a minimum 1.6% risk-based capital charge.

We cannot predict whether Basel will ultimately follow the agencies’ current action in rejecting the managed assets approach. A Basel Working Paper published earlier this month assumed that the managed assets approach would ultimately apply within Basel’s so-called "standardized approach" and also envisions no capital relief for revolving securitizations in the context of an internal-ratings based approach. Within the U.S., the draft adopting release for the new rules indicates that the agencies will continue to examine the special capital needs that they believe arise from revolving structures. They may issue additional rules or guidance on this topic in the future.

The recourse project in general, and the March 2000 recourse proposals in particular, dealt extensively with recourse provided by banks when they sell financial assets, including retained subordinated interests in securitizations. Nevertheless, after the publication of the March 2000 proposals, the agencies became concerned that they had not fully addressed the risks inherent in these and other "residual interests" retained by banks when they securitize their own assets. In particular, the agencies were concerned about the difficulty of valuing residual interests, the volatility of their value and their importance in a couple of high profile recent bank failures.

To remedy this perceived shortcoming, the agencies issued the September 2000 residual interest proposal. Important elements of that proposal have been adopted as part of the new rules.

The new rules include as a residual interest any on-balance sheet asset that represents an interest created by a GAAP sale of financial assets, and that exposes a bank to credit risk directly or indirectly associated with the transferred asset that exceeds a pro rata share of the bank’s claim on the asset. Examples of residual interests are credit-enhancing interest-only strips, spread accounts, cash collateral accounts, retained subordinated interests and other forms of over-collateralization, and similar assets that function as a credit enhancement. Residual interests generally do not include interests purchased from a third party, except that purchased credit-enhancing interest-only strips are residual interests. "Credit-enhancing interest-only strips" are separately defined⁴ and separately regulated, because the agencies view them as possibly the most volatile and difficult to value category of residual interests.

Credit-enhancing interest-only strips will be subject to a "concentration limit" under which the amount of these assets counted in determining a bank’s Tier 1 capital may not exceed 25% of the bank’s total Tier 1 capital. This is similar to, but more limited than, one of the proposals published in September 2000, which would have subjected a broader category of residual interests to this limit and made the 25% limit apply to the aggregate of these assets and two other categories of assets (non-mortgage servicing assets and purchased credit card relationships) that are already similarly limited.

In addition, banks will be required to hold dollar-for-dollar capital against the total amount of any residual interests they hold, except for (a) credit-enhancing interest-only strips that have been deducted from capital due to the concentration limit described above and (b) residual interests that qualify for a lower capital amount under the external ratings-based approach described above. This too is similar to one of the September 2000 proposals, but with important differences.

The similarity is that this rule, like the September 2000 proposal, could result in a bank holding more capital against residual interests than what it was required to hold against the related assets in their entirety when they were held on the bank’s balance sheet. This can only happen if a bank has retained residual interests that exceed the amount of the on-balance sheet capital requirement for the related assets. The agencies are concerned that when a bank does this it may show that the normal minimum capital requirement was too low for these particular assets.

The two exceptions to the dollar-for-dollar requirement address important objections that were raised in comments on the September 2000 proposals. The first (relating to credit-enhancing interest-only strips that have been deducted from capital because of the concentration limit) avoids a regulatory redundancy, in which banks could theoretically have been required to hold more than 100% capital against some of these assets. The second allows banks to avoid the dollar-for-dollar requirement by obtaining qualifying external ratings if they are retaining large residual interests for some reason other than extraordinary loss risks in the underlying assets.

The draft adopting release for the rules makes clear that residual interests include "accrued but uncollected interest on transferred assets that, when collected, will be available to serve in a credit-enhancing capacity." This means that these assets will be subject to the dollar-for-dollar capital requirement. The FDIC takes the position that this is not a change from current rules, though a number of institutions apparently have not treated accrued interest this way in the past.

The final rules also continue the current policy of permitting banks to apply the capital requirements relating to residual interests after subtracting associated deferred tax liabilities.

The final rules also provide the first formal regulatory definition of "recourse" for risk-based capital purposes and modify the definition of "direct credit substitute." The new definitions can be summarized as follows:

• "Recourse" is defined as any arrangement in which a bank retains risk of credit loss in connection with an asset transfer, if the credit risk exceeds a pro rata share consistent with the banking organization’s retained interest in the assets. This definition is generally consistent with prior proposals and prior regulatory usage of the term.
• "Direct credit substitute" is defined as any arrangement in which a banking organization assumes a risk of credit loss from assets it has not transferred, again if the credit risk exceeds a pro rata share consistent with the banking organization’s interest in the assets.

Consistent with prior proposals, the final rules call for capital charges only against arrangements that create exposure to credit or credit-related risks. The rules also reiterate the agencies’ long-standing position that "implicit recourse" may exist when a banking organization assumes risk of loss without an explicit contractual requirement to do so. The agencies may require a banking organization that behaves in this way to hold capital in the same manner as if express contractual recourse existed or may take other actions, as they deem appropriate on a case-by-case basis.

The definitions of "recourse" and "direct credit substitute" also include non-exhaustive lists of typical recourse arrangements or direct credit substitutes, which in each case include credit derivates through which a bank retains or assumes the applicable types of risks. The rules also provide additional detail about the treatment of some of the arrangements that may constitute recourse or direct credit substitutes, including lines of credit, seller representations and warranties, servicer advances and clean-up calls.

As to clean-up calls, the final rules for the first time seem to promise a uniform endorsement by the agencies of clean-up calls up to 10% of the original pool balance. However, the agencies do not want clean-up calls to be used as a means of providing support for a troubled portfolio. To minimize this risk, the final rules will state that a bank that a bank should not repurchase receivables that are 30 days or more past due when exercising a clean-up call. Alternatively, banks may repurchase loans at the lower of their estimated fair value or their par value plus accrued interest.

Some banks have previously qualified to determine regulatory capital requirements for assets held in their trading books under a set of market risk rules that are separate and different from the main risk-based capital rules. The draft adopting release for the final rules confirms that banks that operate under the market risk rules will apply those rules, rather than the new rules described here, to positions in their trading books arising from asset securitizations, including recourse obligations, residual interests and direct credit substitutes.

The final rules also retain the favorable special capital calculation for small business obligations that implements section 208 of the Community Development and Regulatory Improvement Act.

Perhaps because of their heightened concern about residual interests, the agencies have provided a shorter transition period for the new rules than the prior recourse project publications had anticipated. In particular, the rules do not provide any extra transition time for asset securitizations with no fixed term, e.g., asset-backed commercial paper conduits. The transition and effectiveness provisions approved by the FDIC say simply that:

• The rules will be effective January 1, 2002.
• Any transaction covered by rules that is settled on or after that date is subject to the capital requirements established by the rule.
• Banks that have entered into transactions prior to the effective date may elect early adoption, as of the date of publication, of any provision of the final rule that results in a reduced risk-based capital requirement.
• Conversely, banks that enter into transactions prior to the effective date that result in increased regulatory capital requirements may delay the application of the rules to those transactions until December 31, 2002.

Presumably the one-year delay to December 31, 2002 applies to transactions in multi-seller asset-backed commercial paper conduits established before January 1, 2002, even if the particular transaction closes after that date. However, the rules are not very clear on this. At any rate, the rules seem to permit conduit sponsors only that one-year period to qualify their internal ratings-systems and avoid gross-up capital treatment of their program credit enhancements.

1. The agencies involved are the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision. In this memorandum, banks, bank holding companies and thrifts are referred to collectively as "banks."
2. 65 Fed. Reg. 12320 (March 8, 2000).
3. 65 Fed. Reg. 57993 (September 27, 2000).
4. Credit-enhancing interest-only strip means an on-balance sheet asset that, in form or in substance, (i) represents the contractual right to receive some or all of the interest due on transferred assets; and (ii) exposes the bank to credit risk directly or indirectly associated with the transferred assets that exceeds a pro rata share of the bank’s claim on the assets, whether through subordination provisions or other credit enhancement techniques.