In a new report published yesterday commenting on the October 2002 changes to the Basel II Securitization proposals, Fitch Ratings agrees that it is appropriate to assign higher capital charges to subordina ted securitization tranches ra ted 'BBB' and lower than to similarly-ra ted corporate exposures in constructing regulatory capital regimes for banks.

However, Fitch believes that it is important to ensure that the allocation of capital across securitization tranches is 'capital neutral' vis-…-vis the underlying pool of assets.

According to the report, when the capital charges on individual tranches are added up under the Basel internal ratings-based (IRB) securitization proposals, they result in substantially more capital being required (in the absence of applying a cap which is permissible only in certain instances) than the amount of regulatory capital that would have been required had the portfolio not been securitized. The driver of this 'premium' on securitization is the level of capital assigned to the more subordinate tranches. This suggests that the weights as developed by the Committee have the potential to be overly punitive and, in Fitch's view, are likely to result in the misallocation of capital relative to underlying risk across individual securitization tranches as well as unintended behavioral effects. 'While we think the charges should be recalibra ted downwards, we support assigning higher capital charges to 'BBB' and lower-ra ted structured tranches than to similarly-ra ted corporates,' said report co-author Kim Olson. 'However, it should not be necessary for an investing bank to hold substantially more capital on securitized assets than the amount of regulatory capital (which already contains a substantial buffer above the true economic risk of the underlying assets) that would have been required it the portfolio has not been securitized.'

The report also notes that under the Revised Standardized approach and the IRB approach, different capital charges are assigned to securitization tranches that have exactly the same external rating. Relative to the IRB approach, the Revised Standardized approach levies higher capital requirements on most investment-grade tranches and lower capital requirements on certain non-investment grade tranches. Fitch believes that this difference may lead to a new round of gaming techniques, wherein standardized banks sell high-quality tranches to 'IRB' banks and purchase lower-quality ones from 'IRB' banks. The end result would be a double-sided erosion of the asset quality of Revised Standardized banks.

The report 'Basel II Securitization Proposals: Primer and Observations' is available by going to www.riskcenter.com.