Question

It is suggested that the initial exclusion of market risk from capital requirements and high regulatory costs in the Basel I Accord, encouraged banks to shift their risk exposure (via securitisation) from priced credit risk to unpriced market risk.

(a). Do you agree? Discuss with examples.

(b). Explain the securitisation process.

Answer 1

(a): Yes, I agree with this. The initial exclusion of market risk from capital requirements and high regulatory costs in the Basel I Accord was a loophole in the regulation and the presence of this loophole encouraged banks to take advantage of the situation through regulatory capital arbitrage. For example there was no capital charge for market risk exposure and this caused failure on the part of banks to differentiate between high quality and low quality commercial credits. This, in turn, led to a substantial increase in the credit risk of bank loan portfolios.

(b): Securitization process entails taking an illiquid asset or a group of illiquid assets and then making use of financial engineering to transform these illiquid assets into a security. For instance MBS (mortgage backed security) is a result of securitization in which a collection of mortgages forms the basis of the security. Thus we can say that securitization is the process of turning assets into securities. In other words specific assets are pooled together and then are repackaged, through financial engineering, as interest bearing securities.