A Specific Transaction Comparison of Basel II Bank and CLO Loan Portfolio Equity Allocation

Abstract

With the recent implementation of Basel II, major European commercial banks will begin to evaluate the marginal amount of Tier 1 regulatory capital required by a specific loan in accordance with the Internal Rating Based Approach (the “IRB Approach”), a precise quantitative framework. Other large banks worldwide will implement Basel II over the next few years, with U.S. banks adopting a modified version. The industry-wide use of the IRB approach will make major banks comparable in one respect to an otherwise quite different type of single-name loan investor, collateralized loan obligation vehicles, or CLOs. CLOs also evaluate the marginal amount of first-loss or unrated capital required by a loan in accordance with a precise quantitative framework, the loan portfolio securitization models that are consistent with criteria made generally available by the major rating agencies (the “Securitization Model”). The IRB Approach and Securitization Model are based on different methodologies and objectives, but the primary inputs for both are the same: a loan's probability of default (PD) and loss given default (LGD). This article examines one potential transaction, the synthetic transfer of a single ?10 million loan exposure (the “Loan”) from a Basel II bank to a CLO. Various PD and LGD values are considered as variable inputs. The basic output of the analysis is the impact on Loan Equity of this transfer, expressed as the difference between (1) the reduction in the bank's regulatory capital (K), and the (2) increase in the CLO's required collateralization level below a BB tranche, as determined in accordance with the IRB Approach and the Securitization Model, respectively.