FRM Exam Part II · An Introduction to Securitisation

Regulation and Capital Treatment of Securitisation

Updated 11 October 2026 · Fact-checked

Post-crisis securitisation rules aim to fix weak incentives and opaque risk. Risk retention makes originators keep a share of the deal. The Basel securitisation framework sets capital for securitisation exposures by approach hierarchy. STS criteria give simple, transparent, comparable deals lower capital. You solve questions by identifying the rule, then applying it.

Understand Regulation and Capital Treatment of Securitisation

Before 2007, many banks used the originate-to-distribute model. They made loans, packaged them into securities and sold them. Because the loan risk left their books, they had weak reasons to screen borrowers well. Investors also leaned on ratings and could not see the underlying assets. Post-crisis reforms target these two problems: misaligned incentives and poor transparency.

Risk retention is the fix for incentives. The originator, sponsor or arranger must keep a minimum economic interest in the securitisation, so it shares losses with investors. In the EU the minimum is 5% of the securitisation's nominal value, and retention can be held in several permitted ways, such as a vertical slice (5% of each tranche), or the first-loss tranche. The US rule is also generally 5% credit risk retention, with exemptions, for example for qualified residential mortgages. Hedging or selling the retained piece is generally prohibited. Always check which jurisdiction a question refers to.

The Basel securitisation framework sets risk-weighted assets for a bank's securitisation exposures, whether as originator, sponsor or investor. It uses a hierarchy of approaches: first the internal ratings-based approach (SEC-IRBA), where the bank has approval and can model the underlying pool; then the standardised approach (SEC-SA), which uses the capital the pool would attract under the standardised credit risk rules; then the external ratings-based approach (SEC-ERBA), which uses external ratings; and a fallback risk weight of 1,250% if none can be used. Risk weights rise with seniority falling, tranche thinness and longer maturity. A floor applies, with 15% as the general floor for non-STS exposures.

The framework also tests significant risk transfer. An originating bank may exclude securitised assets from its capital calculation only if it has transferred meaningful credit risk to third parties. If not, it must keep holding capital against the underlying pool. Banks also cannot get capital relief for implicit support, meaning support given beyond contractual obligations.

STS securitisation means simple, transparent and comparable. Criteria cover simplicity of the underlying assets and structure, transparency of data and cash flows, and comparability through standardisation. Qualifying deals get lower risk weights, with a lower floor (10% for senior STS positions) than non-STS (15%). STS is not a guarantee of safety. It means the structure is easier to analyse.

Key formulas to remember

Risk-retention minimum: Retained interest ≥ 5% of securitised exposures (EU and generally US); Retention may be vertical, first-loss or other permitted forms. The retained piece cannot generally be hedged or sold.
Basel approach hierarchy: SEC-IRBA → SEC-SA → SEC-ERBA → 1,250% risk weight; Use the first approach the bank is permitted and able to apply. Jurisdictions may restrict ERBA use.
Fallback risk weight: RWA = 1,250% × exposure; Equivalent to a full deduction at 8% capital. Applies when no approach can be used.
Capital from RWA: Capital requirement = RWA × minimum capital ratio; At an 8% ratio, a 1,250% weight gives capital equal to 100% of exposure (1,250% × 8% = 100%).
Risk-weight floors: Non-STS: 15%; senior STS: 10%; Floors apply to securitisation exposures under the Basel framework. Check the question for the specific category.

How to solve Regulation and Capital Treatment of Securitisation questions

Use this order for any question on securitisation regulation or capital.

1Identify the bank's role: originator, sponsor or investor. Rules differ by role.
2Identify which rule is tested: risk retention, significant risk transfer, approach choice, STS or capital arithmetic.
3For retention, check the form held and whether it is at least 5% and unhedged.
4For capital, work down the hierarchy: IRBA, then SA, then ERBA, then 1,250%. Pick the first available.
5Check STS status and apply the lower floor or lower weights if qualified.
6Compute RWA = weight × exposure, then capital = RWA × capital ratio.
7Test the answer: does a junior tranche carry a higher weight than a senior one?
8Choose the option that matches the rule's exact condition, not a similar-sounding one.

Quickest way: Rule-matching shortcut

When to use it: Use when the question names a rule and offers four plausible statements.

Underline the rule being tested (retention, SRT, hierarchy, STS).
Recall the single core idea: retention aligns incentives, SRT allows capital relief, STS lowers weights, 1,250% is the fallback.
Eliminate options that reverse the idea, such as allowing hedging of retained interest.
For arithmetic, compute weight × exposure × ratio and check the unit.
Confirm the remaining option does not overstate STS as risk-free.

Common mistakes in Regulation and Capital Treatment of Securitisation

Saying risk retention means the originator keeps 5% and may then hedge it.
Students remember the 5% and forget the purpose is skin in the game.
Fix: Remember that hedging or selling the retained piece generally defeats the rule and is prohibited.
Applying the ERBA before checking if IRBA or SA is available.
Ratings feel easier to use than modelling.
Fix: Follow the hierarchy: IRBA, then SA, then ERBA, then 1,250%.
Treating the 1,250% weight as a capital charge of 1,250%.
Mixing RWA with capital.
Fix: Multiply by the capital ratio. At 8% the capital equals 100% of the exposure.
Assuming STS means no credit risk.
The word 'simple' suggests safety.
Fix: STS means clearer, more comparable structures. Risk remains, only the capital treatment is more favourable.
Giving capital relief to an originator that sold a thin tranche but kept most risk.
Focus on the sale rather than the risk transferred.
Fix: Check significant risk transfer. Without it, the bank keeps holding capital for the underlying pool.

Worked examples

Example 1

A bank holds a securitisation exposure of $200 million. No IRBA or SA is available, no valid external rating exists, and the fallback applies. At a minimum capital ratio of 8%, what capital is required?

Show the solution

With no approach available, the risk weight is 1,250%.
RWA = 1,250% × $200 million = 12.5 × $200 million = $2,500 million.
Capital = 8% × $2,500 million = $200 million.

Answer: $200 million, i.e. a full deduction equal to the exposure.

Example 2

A securitisation sponsor sells the securitised loans, keeps a 5% vertical slice of every tranche, then buys protection that fully hedges that slice. Does it meet the risk retention requirement?

Show the solution

A 5% vertical slice is a permitted retention form.
The purpose is for the sponsor to bear losses alongside investors.
Hedging the slice transfers the loss exposure to a third party.
Generally, retained interest may not be hedged or sold, so the sponsor holds no real economic interest.

Answer: No. The slice is the right size and form, but the full hedge breaches the rule's condition.

Exam tips

Questions often hinge on one condition, such as no hedging or the approach hierarchy. Read for it.
Always convert RWA to capital with the stated ratio, and check currency units.
Do not state a jurisdiction's rule as universal. Use the one the question names.
Remember that senior and STS positions get lower weights, and thinner junior tranches get higher ones.
Link this topic to the subprime crisis lessons: incentives, opacity and ratings reliance.

Practice questions from An Introduction to Securitisation

Regulation and Capital Treatment of Securitisation: frequently asked questions

What is the risk retention rule in securitisation?

It requires the originator, sponsor or arranger to keep a minimum economic interest, generally 5%, in the deal. The aim is to align its interests with investors. The retained interest generally cannot be hedged or sold.

What does STS securitisation mean?

STS stands for simple, transparent and comparable. Deals meeting the criteria get more favourable capital treatment, such as a lower risk-weight floor. It does not remove credit risk.

In what order are Basel securitisation approaches applied?

The hierarchy is SEC-IRBA, then SEC-SA, then SEC-ERBA, and finally a 1,250% risk weight if none can be used. A bank uses the first approach it is allowed and able to apply.

What is significant risk transfer?

It is the test that an originating bank has passed enough credit risk of the securitised assets to third parties. Only then can it reduce capital against those assets. Otherwise it must keep holding capital for the pool.