Blog Post The Impact of Basel III on Mortgage Servicing Rights
The Impact of Basel III on Mortgage Servicing Rights
The Basel Committee on Banking Supervision issued Basel III in 2011, which established stricter capital requirements for depository financial institutions (DFI) in comparison to Basel I and Basel II requirements. Under the current Basel III requirements, DFIs are only allowed to count 10% of their mortgage servicing rights (MSR) toward Common Equity Tier 1 (CET1), which is the DFIs loss-absorbing form of capital as defined by Basel III. The portion of the DFI’s MSRs that is not included in the CET1 calculation is subject to a risk weighting of 250%.
Such strenuous capital requirements will create challenges for many community banks, credit unions and other small and mid-size DFIs. Many of them will have to release their MSRs to meet the CET1 requirements. The release of MSRs will limit mid-size DFIs’ opportunities to maintain and develop relationships with their customers, which will invariably result in the loss of cross-selling opportunities.
One strategy that has been considered by some is the selling of an interest-only (IO) strip of MSR to a third party, which would allow the DFI to remain the master servicer and perform the servicing function, while “selling” a portion of the MSR income stream to another party, thereby reducing the size of the MSR asset on its books. This has been problematic, however, since the DFI’s continuing involvement as the master servicer results in a transaction that does not qualify as a sale for financial statement purposes, but rather a financing. The result of such treatment is that the full value of the MSR asset, including the portion that is stripped off and sold, remains on the balance sheet.
So while selling IO strips is not a feasible strategy, there is good news for smaller depositories. The Federal Reserve, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency proposed that certain DFIs with less than $250 billion in total assets AND less than $10 billion in foreign exposure be excluded from the stricter capital requirements imposed by Basel III. The proposed requirements would allow mid-size DFIs to retain their MSRs, which will help DFI’s maintain client relationships and take back some of the market share they have yielded to non-depositories in recent years. However, the rule is only in effect for two years and is dependent on the agencies proposed rule be mid-size DFIs through their “simplified capital requirement” effective January 1, 2020.
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