Introduction to Structured Finance

APPENDIX A

The Basel II Framework and Securitization

Banks and financial institutions are subject to a range of regulations and controls. Among the primary ones are concerned with capital adequacy, the level of capital a bank must hold to cover the risk of its many activities on and off the balance sheet. A capital requirements scheme proposed by a committee of central banks acting under the auspices of the Bank for International Settlements (BIS) in 1988 has been adopted universally by banks around the world. These are known as the BIS regulatory requirements or the Basel capital ratios, from the town in Switzerland where the BIS is based.¹ Under the Basel requirements all cash and off-balance-sheet instruments in a bank's portfolio are assigned a risk weighting, based on their perceived credit risk, that determines the minimum level of capital that must be set against them.

A bank's capital is, in its simplest form, the difference between assets and liabilities on its balance sheet, and is the property of the bank's owners. It may be used to meet any operating losses incurred by the bank, and if such losses exceeded the amount of available capital then the bank would have difficulty in repaying liabilities, which may lead to bankruptcy. However, for regulatory purposes, capital is defined differently. In its simplest form, regulatory capital is comprised of those elements on a bank's balance sheet that are eligible for inclusion in the calculation of capital ratios. “Regulatory ...