Regulatory Framework for Secondary Mortgage Markets

Regulatory Framework for Secondary Mortgage Markets Britt Gwinner The World Bank March 10-13, 2003

Outline • Motivations to regulate • Areas of regulation • Which regulator • Basel II as a framework, its impact on capital requirements • International accounting standards

Why Regulate? • Establish trust in the mortgage finance market • Protect consumers – good disclosures, fair loan terms • Protect & inform investors – against issuer bankruptcy, conflict of interest, fraud • Facilitate transactions and pricing with information • Preserve integrity of the financial system • Reduce transaction costs by establishing standards, disclosures

Clear, Detailed Disclosures • Consistent format – facilitate comparisons • To borrowers – to understand the loan commitment, closing costs, prepayment fees • To investors – Distinctions from traditional bonds – uncertainties of collateral cash flows – expected default and prepayment rates • About the issuer – Complete financial statements, loan & bond servicing capacity

Financial Regulations • Capital, liquidity, insider lending, underwriting quality, financial controls, servicing operation • Trade-offs • Between simple capital rules and adequate reflection of risk • Between simple and complex stress testing • Simple and complex accounting disclosures

Which Regulator? • Banking regulator, central bank, securities regulator • Prevent regulatory arbitrage – i.e., tailoring charter or activities to seek looser rules • Regardless of whether institution takes deposits • Consistent rules for capital, liquidity, disclosures, insider lending • Focus on integrity of financial system, not just safety of deposit holders

Basel II - Three Pillars • Minimum capital requirement • Improved link to specific risks • Supervisory review process • Sound internal processes, risk assessments • Market discipline • Enhanced disclosures by banks

Basel II Minimum Capital Approaches – Credit Risk • Standardized – Percentage risk weights, more categories than Basel I, may refer to external ratings – easiest to apply in new mortgage markets • Internal Ratings Based (IRB) – Banks may use own credit assessments, subject to methodological and disclosure standards • Requires substantial data and analytic capabilities

Standardized Approach-Retained Mortgages • Retained residential mortgages carry a 40 percent risk weight • For example, • 30 million mortgage portfolio • Capital Required = 0.96m = 30m * 0.40 * 0.08 Or, 3.2 percent of total portfolio

IRB Risk Weights-Retained Mortgages

Securitization Simplified Individual Mortgages Credit Allocation (Also vertical slicing for maturity) Pooled, Sold to SPV AAA Sold to Pension Funds, Insurance Companies A Retained by Issuer Unrated

Standardized Approach Example

IRB Approach Example

Accounting Issues • Reporting literature complex • Some areas of “emerging practice” exist • Key is clear disclosure of assumptions, risks to values and earnings as reported

Concluding Remarks • Mortgage finance requires robust requirements for disclosures and risk management • In emerging markets, data restrictions and rating agency limits likely to affect the use of more risk-sensitive capital measures such as IRB • Regulators have their work cut out for them to tailor Basel II and IAS rules to their markets

Regulatory Framework for Secondary Mortgage Markets