This note complements the statement that the FSA has made today in conjunction with the Government's announcement about its Asset Protection Scheme ('the Scheme'). What follows is its assessment of the potential impact that a transaction of this nature would have on the capital position of a firm participating in the Scheme.
Nature of the Scheme
- The Scheme is designated in two tranches:
- a 'First Loss' tranche, whereby losses are fully retained by the participant; and
- 'Senior' tranche, whereby only a designated proportion of losses are retained by the participant ("vertical slice"). The other losses on this Senior tranche will be reimbursed by the Treasury
- The First Loss is a fixed Sterling amount, calculated by reference to the
nominal (i.e. gross) value (as at 31 December 2008) of the assets covered by
the Scheme.
NB: The actual attachment point of the protection may vary for each of the participants in the Scheme, but the principles for designating these tranches are the same for each participant. - The fee payable for the scheme can be paid in cash but will usually be satisfied by the issue of capital instruments by the institution. Specifically the fee may be funded through the issuance of a capital instrument to HMT. If the cost of the scheme is amortised down over the useful life of the contract, then this will mean an up front capital injection equivalent to the full premium payable, less any amortisation of the premium for the first reporting period.
Capital instrument
- It is intended that the capital instruments issued to meet the fee payment will be structured to qualify as 'Core Tier 1 Capital'.
Impact on capital position
- The Scheme is expected to affect the capital position of the firm in the
three following ways:
- if the initial up-front premium is satisfied by the issuance of a capital instrument as described above, there will be an increase in Core Tier 1 capital; and
- the RWAs of the portfolios covered by the Scheme will be significantly reduced (in some cases, to zero);
- under BIPRU 9, the deduction from capital resources taken for the First Loss position, as described below, cannot be more than 8% of the underlying RWAs (plus the expected loss amounts against those assets), and the deduction from Core Tier 1 capital is therefore limited to 50% of this amount.
- The exact capital impact will depend on, among other things, the size of the First Loss deduction. However, taken together, we expect that the above factors will improve participants' capital ratios.
Impact on capital ratios - over time
- Any further losses on the covered portfolio would be expected to have the
following effects on Core Tier 1 Capital:
- losses incurred up to the First Loss threshold would erode Core Tier 1 Capital. This effect would be partially off-set as the deduction from capital resources taken for the First Loss tranche is reduced;
- losses incurred after the First Loss threshold would predominantly be covered by the Scheme. Only those losses relating to the pro-rata share retained by the participant (through the vertical slice) would reduce Core Tier 1 Capital.
Regulatory capital calculation
- The Scheme is intended to protect against credit losses experienced in respect of assets held in the Banking Book, although it is possible that requests for cover to be provided to assets in the Trading Book may be considered by the Treasury on a case-by-case basis. However, the FSA expects the Scheme predominantly to cover assets that are held in the Banking Book, and it discusses the capital treatment of that Scheme here.
- For assets held in the Banking Book, the Scheme has been structured to be considered as eligible unfunded credit protection under the Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU).
- The protection afforded by the Scheme is denominated in the currency of the underlying assets and is structured to match the full maturity of all assets included in the Scheme. There are, therefore, no currency or maturity mis-matches arising from the Scheme.
- The Scheme is intended to be extended to one member within a banking group. Where a group desires to include assets in more than one entity within the Scheme, and it has not been possible to transfer the assets to the participating entity, then the participant may use appropriate intra-group arrangements to distribute the protection within the group. The precise nature of these intra-group arrangements will necessarily depend on the circumstances of the group.
Vertical retained slice
- Given that the participant remains exposed to a pro-rata exposure on the underlying assets through its exposure to the First Loss tranche and the retained vertical slice of the Senior tranche, it is possible for the vertical slice to be considered as a pro-rata exposure to the underlying assets.
Remaining pro-rata exposure
- The remaining pro-rata exposure to the underlying assets should be treated as being subject to a tranched unfunded credit protection arrangement. Given the tranched nature of this protection, the capital treatment for the Scheme is determined by reference to the requirements for a 'synthetic securitisation' and, as such, capital requirements should be calculated for each of the tranches of the Scheme, and not against the underlying assets. For participants using the Internal Ratings Based Approach, this includes the Expected Loss calculation, which is typically set to zero.
First Loss
- the First Loss tranche is unrated and not subject to any credit protection (i.e. it is fully retained by the bank). It is therefore subject to a 1250% risk weight or, alternatively, should be deducted from capital resources. The FSA expects firms would apply the deduction in this case.
- The capital deduction amount is reduced by value adjustments (e.g. provisions for impairment) taken against the assets covered by the Scheme. At inception of the Scheme, this includes impairments already taken and, on an ongoing basis, the deduction is reduced to zero as the First Loss tranche is eroded by an equivalent amount of losses.
- Any deduction taken against the First Loss must be taken 50% from Tier 1 capital, and 50% from Tier 2 capital. When assessing capital ratios of the banks that the FSA supervises, it expects that the Tier 1 deduction be taken fully from Core Tier 1 capital.
Senior tranche
- The Senior tranche, in which losses are reimbursed by the Treasury, is subject to the risk weight of the protection provider, which in this case would typically be 0% and therefore would attract no capital charge.
First Loss - option for additional cover
- The participant may have the ability to request that some part of the losses in the First Loss tranche are covered by an equal cash payment from the Treasury to the participant in exchange for the issuance of further capital instruments. If structured as eligible unfunded credit protection, this part of the First Loss would be considered as covered by the Treasury in the event of losses and would be subject to the risk weight associated with the UK Government, which would typically be 0%.
Overall cap
- The total capital held against the Scheme, including any deduction from capital, is 'capped' at 8% of the risk-weighted assets (RWAs) of the underlying assets, plus the expected loss amounts against those assets. This cap has the effect of replicating the capital requirement that would have applied had the protected assets not been placed under the Scheme.