www.palgrave-journals.
com/jbr
Basel II and securitising bank holdings
of foreign currency government debt
Wassim N. Shahin
and Elias El-Achkar


School of Business, Lebanese American University, P.O. Box 36, Byblos, Lebanon
tel: þ 961 9 547254; fax: þ 961 9 547256; e-mail: wshahin@lau.edu.lb
Wassim N. Shahin is Dean, School of
Business, Lebanese American University,
Byblos, Lebanon.
Elias El-Achkar is Director of Research,
Association of Banks in Lebanon, Saifi, Beirut,
Lebanon.
ABSTRACT
The Basel II Accord on capital standard, which will
take effect in 2007 in many countries, requires banks
to hold a larger amount of capital than was specified
in Basel I against their holdings of certain categories
of assets, one of which is foreign currency government
debt. The Accord impacts many countries but mostly
has major capital implications for around 110
countries with export credit arrangement risk scores
of category seven and category four to six, which are
the highest risk scores applicable to nations in the
Basel agreement. This paper examines one aspect of
the balance-sheet implications of the Basel II Accord
concerning capital held by commercial banks against
their holdings of foreign currency government debt
(Eurobonds) issued by their own governments. Basel
II attaches 150 per cent risk weight to this asset for
countries with classification risk of seven and 100 per
cent for countries with classification risk of four to six.
Using a simplified numerical model applied on two
countries’ representatives of the two classification
groups, the analysis shows a major necessary increase
in capital to meet the requirements specified in Basel
II. This necessitates a bank balance sheet reshuffling
away from this asset into assets with lower risk
weights. Banks, however, have to continuously
subscribe to this asset due to the large amounts of
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dollarised debt in highly dollarised countries, the
reduced ability of many countries to market debt
internationally and for other relevant reasons. There-
fore, we present analysis that relies on the securitisa-
tion process to suggest a new proposal that has not
been applied or practised yet, in which banks may not
have to raise a large amount of additional capital for
debt they subscribe to by securitising some of the
foreign currency government bonds held on their
balance sheets.
Journal of Banking Regulation (2007) 8, 353–364.
doi:10.1057/palgrave.jbr.2350053
INTRODUCTION
The Basel II Accord on capital standard or the
Basel II capital adequacy framework is sup-
posed to take effect in 2007 in a large number
of countries. This Accord requires banks to
hold a larger amount of capital than was
specified in Basel I against their holdings of
certain categories of assets, one of which is
foreign currency government debt. This new
regulatory framework has capital effects for
banks in all countries. Since Basel II, however,
ties credit risk weights to internal or external
ratings, major capital implications arise for
around 110 countries with export credit
arrangement (ECA) risk scores of category
seven and category four to six, which are the
highest risk scores applicable to nations in the
Basel agreement.1
Several studies have examined various
aspects of the implications of Basel II as will
be discussed in the next section. This paper
Vol. 8, 4 353–364 Journal of Banking Regulation 353
 Basel II and securitising bank holdings of foreign currency government debt
examines one aspect of the balance-sheet
implications of the Basel II Accord concerning
capital held by commercial banks against their
holdings of foreign currency government debt
(Eurobonds) issued by their own governments.
Basel II attaches 150 per cent risk weight to this
asset for countries with classification risk of
seven and 100 per cent for countries with
classification risk of four to six. Historically,
every downgrading of a country’s creditworthi-
ness by international private agencies as a result
of worsening public finances has been accom-
panied by a rating downward of commercial
banks issuing shares when these banks hold
large amounts of foreign currency government
debt. It is believed that this debt carries foreign
exchange risk, as the country is issuing it in a
currency other than its own, making the
probability of default higher in case of
domestic currency depreciation. Given this
fact, the new Accord implies that at a time
when a country’s rating has been downgraded,
its banks are required by regulators to provide
additional capital against their holdings of its
foreign currency debt when banks’ rating has
also been reduced. Raising capital, as a result,
may be very costly and difficult. Using
numerical cases from two countries’ represen-
tatives of the two classification groups (seven
and four to six), the analysis shows the need for
a major increase in capital for both groups to
meet the requirements specified in the new
Basel II Accord. This necessitates a bank
balance sheet reshuffling away from this asset
into assets with lower risk weights. Banks,
however, have to continuously subscribe to
government debt in foreign currency based on
the large amount of dollarised debt in highly
dollarised countries.2 Domestic banks are also
the major subscribers to this debt due to the
reduced ability of many countries to market it
internationally. In addition, countries often use
‘moral suasion’ to convince banks to hold it.
Therefore, we present analysis that relies on the
securitisation process to suggest a new proposal
in which circumventing some additional capital
requirements (ACR) against foreign currency-
354 Journal of Banking Regulation Vol. 8, 4 353–364 & 2007 Palgrave Macmillan Ltd, 1745-6452 $30.00
held government debt becomes possible. In the
suggested scenario that has not been applied or
practised yet, banks may not have to raise a
large amount of additional capital for debt they
subscribe to by securitising some of the foreign
currency government bonds held on their
balance sheets.
The paper is organised as follows. The next
section provides a brief overview of some of the
literature addressing Basel II and its implica-
tions. The following section states and com-
pares the risk weights of foreign currency-held
debt in both the Basel I and the Basel II
Accords and discusses the process of securitisa-
tion in the new Accord. The succeeding
section relies on a numerical model showing
the level of additional capital necessary in the
Basel II framework by applying the new rules
to two countries each representing a different
classification group, Lebanon (risk group of
seven) and Turkey (risk group of four to six).
The penultimate section provides the me-
chanics of the securitisation proposal and uses
a numerical example on the same two
countries showing the potential reduction in
the additional required capital if the securitisa-
tion process of foreign currency-held debt is to
be adopted as a new concept. The last section
concludes with bank policy implications.
LITERATURE REVIEW
The purpose of this section is to fit the present
study in the context of the type of studies
addressing the Basel II Capital Accord. These
studies were at least of three types. The first
group includes various publications of the Basel
Committee on Banking Supervision providing
detailed explanations of the key elements of the
Accord such as the three pillars on minimum
capital requirements, supervisory review and
market discipline, the three approaches for
calculating credit risk and operational risk, and
the implementation of the new Accord.
The second group of studies attempted at
explaining the various approaches, comparing
the different rating programmes, delving
further into the rationale and design of the

revised capital standards, and studying some of
the major differences between Basel I and Basel
II Capital Accords.3
The current study fits the third group of
papers that addressed the impact of the new
Accord on the banking firm and the macro-
economy.4 To cite few examples, studies of this
type have specifically examined the impact of
Basel II on risk allocation in the banking sector
and its implications for bank capital adequacy,
the cyclical implications of the new capital
standards, and auditing and bank capital
regulation. Rime starts with the notion that
Basel II introduces two approaches for the
calculation of credit risk: an internal ratings-
based approach that will be used by large
sophisticated banks and a standardised approach
used by smaller less-sophisticated ones. Then,
he uses a two-period model with two possible
future states to analyse decisions facing low-
and high-risk borrowers. The results he reaches
show that because the two types of banks
compete in the loan market, the new regula-
tory framework may induce smaller banks to
specialise in granting loans to high-risk bor-
rowers and the larger banks to specialise in low-
risk borrowers with an ambiguous effect on
financial stability.
Kashyap and Stein address one of the many
concerns of the Basel II capital requirement,
mainly its cyclical implications. The Accord is
believed to exacerbate business cycle fluctua-
tions by forcing a bank in an economic
downturn to hold more capital against its
current loan portfolio as its existing nonde-
faulted borrowers will be downgraded by credit
risk models. Given the difficulty in raising
additional capital in bad times, banks may cut
down on lending activities contributing to a
worsening of the initial downturn. The authors
examine the cyclicality aspects of Basel II by
developing a conceptual framework question-
ing the optimality of the proposed regulations.
Basel II is found to be sub-optimal by having a
single time-invariant risk curve rather than a
family of risk curves with the capital charge
being reduced when economy-wide bank
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Shahin and El-Achkar
capital is scarce relative to lending opportu-
nities. Simulations are then conducted support-
ing the theoretical reasoning. These findings
are in line with other studies that have
examined the pro-cyclicality of Basel II.5
Prescott examines the issue of auditing and
bank capital regulation. He bases his hypothesis
on the premise in Basel II stipulating that banks
can use their internal rating systems to
determine the risk of an asset by estimating
several key numbers such as the probability of
default, the loss given default, the exposure at
default and asset maturity.
Banks then rely on these numbers using a
regulatory formula to determine capital re-
quirements. The author argues about the
incentives that banks have to report the true
risks of an asset. Therefore, he moves the focus
from pillar one of the proposal that is mainly
concerned with setting the capital requirements
to pillar two that deals with supervisory review
and uses models where regulatory audits affect
the incentives for banks to send accurate
reports. The author finds that stochastic
auditing strategies are more effective than
deterministic ones and that the frequency of
an audit should depend on the amount of
capital banks hold.
This paper fits the third category of studies
in that it examines the implications of the new
Accord on the banking firm. It, however,
analyses a different issue dealing with the effect
of the new capital standards on the banking
firm’s balance sheet through its impact on
foreign currency bank-held government debt.
In addition, it provides a new proposal to
buttress the consequences of the new regula-
tion on the amount of required additional
capital.
RISK WEIGHTS OF FOREIGN
CURRENCY-HELD DEBT AND
SECURITISED ASSETS IN THE
BASEL ACCORD
This section discusses the differences in the risk
weights attached to foreign currency govern-
ment debt held by banks in Basel I and Basel II
Vol. 8, 4 353–364 Journal of Banking Regulation 355
 Basel II and securitising bank holdings of foreign currency government debt
and of the securitisation framework in the
Capital Accord. Basel I Capital Accord (1988)
related capital to the different on-balance-sheet
asset and off-balance-sheet items or exposure of
banks, weighted according to their relative risk
(mainly in terms of credit risk). Five weights
were proposed: 0, 10, 20, 50 and 100 per cent.
Some flexibility was introduced in deciding on
which weight should apply to some types of
assets. In this paper, the attention is particularly
drawn on claims on central governments and
particularly those denominated in the foreign
currency and funded in that currency. It was
concluded in the Basel I Capital Accord that
domestic supervisory authorities should be free
to apply a zero or a low weight to claims on
governments if they desire to incorporate
interest rate risk, suggesting as an example a
10 per cent risk weight for all the securities
issued by governments or a 10 per cent risk
weight for those securities maturing within less
than a year and 20 per cent for those with a
maturity of one year and above. This structure
holds for OECD countries and non-OECD
countries, provided claims are denominated in
the national currency and funded by liabilities
in the same currency. Therefore, this zero or
low weight to claims on governments did not
incorporate the exchange rate risk. Although
claims on central governments denominated in
national currency and funded in that currency
were given a risk weight of 0 per cent, claims
on central governments outside the OECD
(unless denominated in national currency and
funded in that currency) fell under the 100 per
cent risk weight category.
The Basel II Capital Accord in 2004
retained key elements of the 1988 capital
adequacy framework, including the require-
ment for banks to hold capital equivalent to at
least 8 per cent of their risk-weighted assets.
The calculation of minimum capital require-
ments is, however, for credit risk, operational
risk and trading book issues (including market
risk). Further, the total risk-weighted assets are
determined by multiplying the capital require-
ments for market risk and operational risk by
356 Journal of Banking Regulation Vol. 8, 4 353–364 & 2007 Palgrave Macmillan Ltd, 1745-6452 $30.00
12.5 (ie the reciprocal of the minimum capital
ratio of 8 per cent) and adding the resulting
figures to the sum of risk-weighted assets for
credit risk. The revised framework provided a
number of options for determining the capital
requirements for credit and operational risks,
allowing banks and supervisors to select
approaches that are most appropriate for their
operations and their financial market infra-
structure. Basel II proposed to measure the
credit risk either under the standardised
approach based on external credit assessment
of eligible institutions or under the internal
ratings-based approach, allowing banks to use
their internal rating systems for credit risk
subject to the explicit approval of supervisors.
Under the standardised approach, claims on
sovereigns (claims on governments) will be risk
weighted according to the credit assessment or
country risk scores assigned by institutions such
as Standard & Poor’s or ECAs whose assessment
is considered as the OECD methodology.6 This
latter establishes eight risk score categories for
these claims on governments from 0 to 7. ECA
risk scores of 0 and 1 will receive a risk weight
of 0 per cent, while countries with a score of
2 and 3 will have risk weights of 20 and 50 per
cent, respectively. Those with risk scores from
4 to 6 will receive a risk weight of 100 per cent.
ECA risk score of 7 corresponds to a risk
weight of 150 per cent. At national discretion,
however, a lower risk weight may be applied to
claims on sovereigns of incorporation denomi-
nated in domestic currency and funded in that
currency (ie having corresponding liabilities
denominated in the domestic currency).7
The implications of applying the new capital
adequacy framework as far as claims on central
governments are concerned are as follows.
Regarding claims on central government
denominated in domestic currency, countries
with a sovereign credit assessment risk of 20 per
cent (A to A) and above (below A) cannot
anymore justify a zero-per cent weight (as it
used to be under Basel I). This is particularly
true for countries with high sovereign risk
(100–150 per cent). Differently, under Basel I,

the risk weight attributed to claims on the
government in foreign currency is either a zero
per cent (for OECD countries) or 100 per cent
(for non-OECD countries). In applying Basel
I, many countries did not adhere fully to this
rule and attributed a risk weight that lies
between these two extremes. It is therefore
obvious that a higher sovereign risk rating
when moving from Basel I to Basel II entails
additional cost and vice versa. OECD countries
that have an ECA risk score of 2 and above or
alternatively a credit assessment of A þ and
below will incur additional cost, the size of
which will depend on their rating. Non-
OECD countries with an ECA risk score of
7 or a credit assessment risk of 150 per cent
(over 70 countries) or alternatively having a
credit assessment of below B will also have to
meet ACR.
Therefore, countries with a sovereign credit
assessment risk of 150 per cent must use this
risk weight on claims on central government
denominated in foreign currency instead of
previously using the 100 per cent risk weight.
Countries with a risk score of 4–6 per cent
must use the 100 per cent risk weight on bank
foreign currency-held debt instead of using one
that lies between 0 and 100 per cent. Countries
with sovereign credit assessment risk of below
100 per cent can, however, benefit from using a
lower risk weight on claims on central
government denominated in the foreign cur-
rency (instead of previously using the 100 per
cent risk weight).
As far as securitisation is concerned, banks
must apply the securitisation framework for
determining regulatory capital requirements on
exposures arising from this process. An origi-
nating bank may, however, exclude securitised
exposures from the calculation of risk-weighted
assets only if some conditions are met, such as
the following: significant credit risk associated
with the securitised exposures has been trans-
ferred to third parties, the transferor does not
maintain effective or indirect control over the
transferred exposures, the securities issued are
not obligations to the transferor, the transferee
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Shahin and El-Achkar
is an SPE (special purpose entity)and the
securitisation does not contain some additional
clauses allowing for alterations in the original
contract conditions. Underlying instruments
that can be securitised may include but are not
restricted to loans, commitments, asset-backed
and mortgage-backed securities, corporate
bonds, equity securities and private equity
investments.8
The analysis in this paper assumes first that
these conditions are met and therefore excludes
the securitised exposures from the calculation
of risk-weighted assets. Secondly, the paper
recommends securitising foreign currency
bank-held government bonds not specifically
addressed in Basel along lines similar
to securitising corporate bonds and other
instruments.
ADDITIONAL CAPITAL IMPACT OF
BANK-HELD FOREIGN CURRENCY
GOVERNMENT DEBT: A NUMERICAL
FRAMEWORK
This section develops a model and then uses a
numerical framework to examine the impact of
changing the risk weight of foreign currency-
held debt on bank capital.
A simplified model
According to the Basel Accord, minimum
Capital Requirements can be specified as
follows:
kXmZ ð1Þ
where k is the total minimum capital required
under Basel; m the minimum capital required as
a percentage of risk-weighted assets equal to 8
per cent; Z the total risk-weighted assets
including balance-sheet- and off-balance-
sheet-adjusted assets.
Under Basel I,
X
n X
m
Z¼ Xi oi þ Gj nj ð2Þ
i¼1 j¼1
P
where ni¼ 1Xi oi is the sum of risk-weighted
assets; Xi the set of assets items; oi the set of risk
weights attributed to each category of assets;
Vol. 8, 4 353–364 Journal of Banking Regulation 357
 Basel II and securitising bank holdings of foreign currency government debt
Pm
j ¼ 1Gjnj the sum of risk-weighted off-
balance-sheet activities; Gj the set of off-
balance-sheet items adjusted by their conver-
sion factors; nj the set of risk weights attributed
to each category of off-balance-sheet items.
Substituting (2) into (1) allows us to write9
" #
Xn Xm
kXm Xi oi þ Gj n j ð3Þ
i¼1 j¼1
Given that we are examining the impact of a
change in the risk weight attached to foreign
currency
Pn bank-held debt, we spell-out
i ¼ 1xi oi that includes this asset and other
assets.
Therefore, total bank assets and their
weights are expressed as
X1 o1 þ X2 o2 þ Xn on
ð9Þ
Substituting (4) into (3), we get:
" #
X m
kXm X1 o1 þ X2 o2 þ Xn on þ Gj nj
j¼1
Each of the assets Xi is a function of a set of
independent variables affecting asset demand
such as return differentials and a regulatory
variable under the direct control of the Basel
regulator. In addition, the weights oi are
expressed as functions of a set of independent
variables such as the risk of each asset, country
risk and the same regulatory variable affecting
asset demand equations. We specify each asset
demand and weight function as follows:
Xi ¼ Xi ðai ; OÞ
oi ¼ oi ðbi ; OÞ
where ai is the vector of variables affecting asset
demand. The components of each vector are
the same for all assets based on asset demand
theory; bi the vector of variables affecting
weight functions; O the Basel regulatory
variable assumed to be under the direct control
of the regulator. This variable is altered to
reflect a change in the Basel regulation.
358 Journal of Banking Regulation Vol. 8, 4 353–364 & 2007 Palgrave Macmillan Ltd, 1745-6452 $30.00
Substituting (6) and (7) into (5) allows us to
rewrite (5) as follows:
"
kXm X1 ða1 ;OÞo1 ðb1 ; OÞþX2 ða2 ; OÞ
#
X
m
o2 ðb2 ; OÞþXn ðan ;OÞon ðbn ;OÞ þ Gj Uj
j¼1
ð8Þ
A change in the regulatory variable O affects
the weight of a given asset and the demand for
this asset. Given that we are examining the
change in this regulatory variable as specified in
Basel II, we differentiate (8) with respect to O
to get:
dk=dOXm½X 01 o1 þ X1 o 01 þ X 02 o2
ð4Þ þ X2 o 02 þ X 0n on þ Xn o 0n
Equation (9) shows how a change in the
regulatory variable affects asset demand and
weight functions. This paper considers the
impact of a change in the regulatory variable
ð5Þ concerning the risk weight attached to foreign
currency bank-held government debt on bank
capital. Let X1 represent this asset and o1 its
weight. A simple numerical example holding
all other changes constant allows us to show the
importance of this impact on bank capital.
Numerical country cases
The model specified fits the standardised
approach rather than the foundations or the
advanced internal ratings-based one as most of
the banks in countries with classification risks
of seven and four to six are relatively small and
ð6Þ
unsophisticated banks compared to ones in the
G-10 countries with classification risks of two
ð7Þ
and three. Therefore, as the Basel documents
and the literature of various central banks state,
relatively small and unsophisticated banks are
expected to use the standardised approach.
Rime (2005) bases his hypothesis on this
assumption. Our aim, in this section, is to
attempt and assess any potential ACR and
therefore any additional cost of capital that
would arise from applying the risk weights of

Basel II capital adequacy framework on the
portfolio of claims of banks on the government
in foreign currencies. For the sake of argument
and to show the severity of the new policy on
bank capital given that banks do not initially
react by altering their asset holdings, we
examine the amount of additional capital
required only based on the change in the risk
weight attached to foreign currency bank-held
government debt. As a result, all terms in
Equation (9) are assumed to be equal to zero
except for X1o10 . This term in Equation (10)
reflects the change in total capital necessary to
uphold the new weight given the amount of
foreign currency bank-held government debt
and other assets and weights.
Let dk=dO ¼ mX1 o 01
We apply Equation (10) to the case of two
representative countries from different risk
groups, namely Lebanon and Turkey. Lebanon
represents the group of countries with a risk
classification of 7 commanding a sovereign
credit risk weight of 150 per cent on foreign
currency bank-held government debt under
Basel II. Turkey represents the group of
countries with a risk score from 4 to 6 (Turkey
assigned 5) receiving a credit risk weight of 100
per cent.10
Given m ¼ 8 per cent in applying Equation
(10) for Lebanon (a developing non-OECD
country), it becomes clear that the ACR on
holding claims on the government in foreign
currency for the Lebanese banking sector when
applying Basel II credit risk weights is around
Table 1 Additional capital requirements: Lebanon
Additional capital requirements (ACR)=mX1o10
ACR/total assets
Return on assets (ROA) — (2003)
ACR/total capital
Return on equity (ROE) — (2003)
Source: Monthly Bulletin, Central Bank of Lebanon, various issues.
Annual Report 2003, Association of Banks in Lebanon, 2004.
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Shahin and El-Achkar
$703m (Table 1). This is based on December
2004 figures for claims on the government in
foreign currency held by banks X1 ($8,792m)
and the latest sovereign credit risk rating for
Lebanon (150 per cent). Under Basel I,
Lebanon applied a sovereign credit risk weight
of 30–50 per cent on claims on the government
in foreign currency, but to be more conserva-
tive in our calculation we applied a 50 per cent
risk weight on all the portfolio of banks of such
claims. Therefore, o10 is 100 per cent or is the
difference between the new weight of 150 per
cent and the previous weight of 50 per cent.
For the sake of showing the large size of this
figure, interestingly enough, the $703m ACR,
when expressed as a percentage of total assets of
the Lebanese banking sector, constituted
ð10Þ
around 1.04 per cent, a ratio that much exceeds
the return on assets (ROA) for this sector (0.7
per cent) for the year 2003 (the latest available
data). Further, the ACR constituted also 18.2
per cent of the total capital accounts of banks as
of end 2004 and this ratio is in turn much
above the 12.5 per cent return on equity
(ROE) for the year 2003. This would really
show how big is the additional capital cost of
applying Basel II capital adequacy framework
concerning bank-held government debt in
foreign currency.11
Another case study is that of Turkey (a
developing OECD country). At the end of
2003, commercial banks in Turkey had a
$9,373m portfolio of claims on the government
in foreign currency or X1. The current
sovereign risk rating of Turkey is 100 per cent
=[(0.08)(8792)(1.50.5)] =$ 703m
703/67786 =1.04%
=0.7%
703/3853 =18.2%
=12.5%
Vol. 8, 4 353–364 Journal of Banking Regulation 359
 Basel II and securitising bank holdings of foreign currency government debt
Table 2 Additional capital requirements: Turkey
Additional capital requirements (ACR)=mX1o10
ACR/total assets
Return on assets (ROA) — 2003
Return on assets (ROA) — 2002
ACR/total capital
Return on equity (ROE) — 2003
Return on equity (ROE) — 2002
Source: Banks in Turkey, 2003; The Banks Association of Turkey, June 2004.
under Basel II compared to zero per cent under
Basel I making o10 ¼ 100 per cent. Thus the
ACR or cost is $750m (Table 2). This
constitutes around 0.44 per cent of total assets
of banks as of end of December 2003 compared
to an average ROA of 1.53 per cent for the
years 2002–2003. Although the cost is much
less than that calculated for Lebanon, it is still
considered large. The ACR to total capital was
3.33 per cent, also much less than the average
ROE (12.4 per cent) for the years 2002–2003.
The cases of Lebanon and Turkey show the
severity of the new rule governing the risk
weight attached to foreign currency bank-held
government debt on additional bank capital.
This supports the case of asset reallocation as
one way of reducing the impact on capital
and promotes the suggested proposal for
securitisation as one of the means to reduce
potential costs.
SECURITISING FOREIGN CURRENCY
GOVERNMENT DEBT TO REDUCE
EXPOSURE TO BASEL II: A PROPOSAL
FOR CONSIDERATION
Raising the risk weights of foreign currency
government debt for banks operating in
countries classified in high-risk categories of
seven and four to six will be causing a major
impact on bank capital. The cases of two
representative countries shown in the previous
section serve to highlight this impact. This
necessitates a reconsideration of holding these
assets and creates a need for asset allocation.
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=[(0.08)(9373)(1.0-0.0)] =$ 750m
750/171886 =0.44%
=2.16%
=0.9%
750/22501 =3.33%
=16.48%
=8.3%
This section provides a proposal to circumvent
part of the impact of the new risk weight on
bank capital.
Securitisation proposal
The analysis is proposing removing some of the
foreign currency government debt held by
banks from a typical bank’s balance sheet
through securitisation to reduce risk-adjusted
assets and thus additional capital. The process is
in line with the early securitisation of bank
loans that became more common among banks
in response to the changing capital regulations
in the 1980s. Given the risky nature of loans,
regulators in the United States and several other
countries started requiring banks to hold
primary capital of at least 6 per cent against
loans and other balance-sheet assets. Since
raising additional capital is costly, several banks
started transferring the ownership of their loans
to an SPE to circumvent new capital require-
ments.12 In the same spirit of reducing capital
cost, we propose securitising foreign currency
bank-held government debt carrying a higher
risk weight and, thus a higher capital cost under
the Basel II Accord as explained in the earlier
sections of the paper. This proposal is not the
typical securitisation one based on pooling
assets with different risks and exposures to
achieve many of the standard benefits of
securitisation. It involves aggregating and
securitising bonds with different coupon rates
and maturities for the purpose of reducing
capital costs only, as happened in the early

Figure 1 Mechanics of securitisation proposal
securitisation process, and not specifically for
the other advantages of securitisation. We can
argue that the securitisation operation can be
designed to be as flexible as needed compared
to selling these bonds in a secondary market
not necessarily characterised by depth, breadth
and resiliency. The newly issued securities
could command flexibility and options regard-
ing face value, nature of interest rates, maturity,
option clauses and even early amortisation in
the case of downgrading the initial securitised
assets, making them highly attractive to poten-
tial investors. This section discusses the me-
chanics of the suggested securitisation proposal
of foreign currency government debt held by
banks rather than of loans using a similar
operational approach.13
The proposal is explained in Figure 1 and is
described as follows. Securitising bank-held
foreign currency government debt requires a
group of banks to act together as originators of
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Shahin and El-Achkar
the process by setting aside these assets (moving
them off their balance sheets) and passing them
on to an SPE or issuer. This SPE takes owner-
ship of the pooled bonds and issues securities or
financial claims in the open market based on the
value and the expected yield of the bonds. The
asset-backed securities are sold to domestic and
international investors. The funds from securities
sale flow back to banks to be directed into other
balance-sheet activities that carry a risk weight
lower than the one assigned to foreign currency
government debt. As in the rest of the
securitisation literature, a trustee is appointed
to ensure that the issuer or the SPE fulfills all the
requirements of the transfer of assets to the pool
and provides all the services promised to
investors including where stipulated fulfilling
any guarantees in case assets default. In addition,
investors in these securities will receive added
protection against default in the form of credit
and liquidity guarantees supplied under contract
Vol. 8, 4 353–364 Journal of Banking Regulation 361
 Basel II and securitising bank holdings of foreign currency government debt
by one or more reputable international financial
institutions commanding high credit rating. It is
also to be mentioned that the countries issuing
Eurobonds command acceptable sovereign credit
ratings allowing them to float, in international
markets, foreign currency bonds underwritten
by major international investment banks carry-
ing investment grade AAA such as Goldman
Sachs, BNP Parisbas and United Bank of
Switzerland (UBS). Therefore, the risk of default
of assets underwritten by such investment banks
can be measured and managed even though it
translates into a higher risk weight in compar-
ison to other bank balance-sheet assets. In
addition, foreign currency government bonds
constitute a part of government debt, with banks
holding a portion of this amount. Given also that
banks securitise parts and not necessarily all of
their holdings as suggested in various numerical
ð11Þ
scenarios, large and high-graded international
financial institutions should be able to guarantee
the amount of securitised assets. The newly
issued securities would carry a return lower than
the initial yield on Eurobonds to reflect the
reduction in risk resulting from the credit and
liquidity guarantees.
This proposal, beyond the capital reduction
attached to the lower risk-adjusted assets, can
benefit banks in two additional ways related to
minimum capital requirements. The first is an
upgrading of their ratings. In fact, every
downgrading of a country’s creditworthiness
by international private agencies as a result of
worsening public finances has been accompa-
nied by a rating downgrade of commercial
banks holding foreign currency government
debt as was stated earlier. Secondly, funds from
securities sale flow back to banks and could be
invested partly in loans to the private sector or
any other asset carrying a lower risk weight
than foreign currency government debt. These
loans, although in foreign currency and
matched by liabilities in this currency, usually
command higher interest rates than Eurobonds
yield and lower risk weights raising bank
profitability and efficiency measures such as
the ROA.
362 Journal of Banking Regulation Vol. 8, 4 353–364 & 2007 Palgrave Macmillan Ltd, 1745-6452 $30.00
A numerical scenario
The purpose of this section is to show how
securitising some of the foreign currency bank-
held government debt can reduce the previous
impact on bank capital highlighted in the
previous analysis. Considering Equation (10),
our purpose is to show that given the new
weights attached to all assets, reallocating assets
through securitisation away from foreign cur-
rency government debt and reinvesting the
proceeds into assets with lower risk weight
reduces the capital impact. In order to do so,
we rely on Equation (10) and reconsider the
change in the asset quantities subject to a
change in the regulatory variable given the new
risk weights of Basel II (assuming the change in
weights is zero). Equation (10) is rewritten as:
dK=dOXm½X 01 o1 þ X 02 o2
For numerical convenience, assume two assets
1 and 2 (dropping Xnon) where the first asset is
foreign currency bank-held government debt
with the second asset carrying a lower risk
weight than the first as is shown in Table 3 for
Lebanon and Turkey. Let the bank securitise a
certain amount of the first asset. The potential
gains or losses from securitisation in terms of
risk reduction and less capital requirements are
calculated using Equation (11). It would turn
out that the higher the per cent of bank-held
foreign currency bonds securitised with the
proceeds reinvested in other assets of lower risk
weights, the larger the gains.
In applying Equation (11) for Lebanon, we
assume that half of the claims on the govern-
ment in foreign currency are securitised (50 per
cent) and the proceeds (same amount) are
reinvested in assets carrying lower risk weights
than 150 per cent. Assume 50 and 100 per
cent.14
Let initial X1 ¼ $8,792m for Lebanon and
$9,373m for Turkey (same figures as in
previous section), and X10 ¼ X20 ¼ 50 per cent
of the initial amount. The figure for X10 is
$4,396 for Lebanon and $4,687 for Turkey
while X20 is $4,396 for Lebanon and $4,687 for

Table 3 Potential reduction in additional required capital: Lebanon and Turkey
Potential reduction in additional required capital: Lebanon
Assumption: 50% of claims on government in FC are securitised and
proceeds reinvested in 50% risk-weighted assets ACR=m[X10 o1+X20 o2]
Assumption: 50% of claims on government in FC are securitised and
proceeds reinvested in 100% risk-weighted assets ACR==m[X10 o1+X20 o2] =$176m
Potential reduction in additional required capital: Turkey
Assumption: 50% of claims on government in FC are securitised and
proceeds reinvested in 50% risk-weighted assets ACR=m[X10 o1+X20 o2]
Turkey. Let o1 ¼ 150 per cent, o2 ¼ 50 and
100 per cent, respectively.
The same reasoning was also applied to
Turkey. But because the current sovereign credit
risk rating of Turkey falls between BB þ and B
(ie risk weight of 100 per cent), the reinvestment
of proceeds has to be in 50 per cent risk-
weighted assets or below to make gains. The
results in Table 3 illustrate the potential reduction
in the required additional capital.
CONCLUDING REMARKS
A literature has been emerging on the
implications of Basel II, which will be applied
in 2007, concerning explaining its key ele-
ments, its various approaches, its rationale and
design, and its impacts on banks and the
macroeconomy. This paper contributes to the
existing studies by examining the implications
of changing the risk weight attached to bank
holdings of foreign currency government debt
on banks’ ACR. Using examples from two
representative countries with different risk
classification shows that the impact on addi-
tional capital requirement is rather large. This
may necessitate a reshuffling of various balance-
sheet assets away from government debt
denominated in foreign currency towards assets
with lower risk weights. Banks, however, have
to continuously subscribe to this asset based
first on its high share in total government debt
due to the dollarised nature of various countries
with high classification risk; and secondly,
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Shahin and El-Achkar
=0.08[(4396)(1.5)+(4396)(0.5)]
=$352m
=0.08[(4396)(1.5)+(4396)(0.5)]
=0.08[(4687)(1)+(4687)(0.5)]
=$187m
because of the reliance of governments on
selling their debt to banks due to many reasons,
are of which is their reduced ability to market it
internationally. The paper presents a new
proposal that has not been applied or practised,
yet that allows banks to buttress some of the
impacts of Basel II on ACR against foreign
currency-held bonds. The new proposal that is
assumed to meet the Basel conditions on
excluding securitised exposures from the calcu-
lation of risk-weighted assets calls for securitising
some of the foreign currency bank-held govern-
ment bonds. A framework is developed and a
numerical scenario on reinvesting the securitisa-
tion proceeds in lower risk-weighted assets
shows the reduction in ACR for the two
representative countries considered earlier. This
reduction is necessary as raising additional capital
may be very costly and difficult for banks at a
time when their rating could be reduced due to
their holdings of additional foreign currency
government debt.
REFERENCES AND NOTES
(1) Country Risk Classification of the Partici-
pants to the ‘Arrangement on Officially
Supported Export Credits’ as of 29th April,
2005. Export Credit Arrangement web-page
of the Trade Directorate, OECD’s website
(www.oecd.org).
ECA risk scores:
0–1 2 countries
2 21 countries
Vol. 8, 4 353–364 Journal of Banking Regulation 363
 Basel II and securitising bank holdings of foreign currency government debt
3 13 countries
4–6 43 countries
7 66 countries.
(2) Many of the countries falling into these two
groups have highly dollarised deposits. Banks
as a result need to hold dollar denominated
assets to minimise currency risk. This is one
major reason why countries issue a large
portion of their debt in dollars given that
banks are major subscribers to this debt.
Additional reasons are that governments issue
debt in foreign currency at lower interest
rates (minimising debt cost) and for longer
maturities than debt in domestic currency as
subscribers fear domestic currency depreciation.
(3) See Cornford, A. (2000) ‘The Basel Com-
mittee’s proposals for revised capital stan-
dards: Rationale, design and possible
incidence’, United Nations Conference on
Trade and Development, Geneva, G-24
Discussion Paper No. 3, May. Also see
Jackson, P. (2002), ‘Bank capital: Basel II
developments’ Financial Stability Review
(December), pp. 103–109.
(4) See Kashyap, A. and Stein, J. (2004) ‘Cyclical
implications of the Basel II capital standards-
Federal Reserve Bank of Chicago (Quarter 1),
pp. 18–30. Also see Prescott, E. (2004),
‘Auditing and bank capital regulation’, Economic
Quarterly, Federal Reserve Bank of Richmond
(Fall), pp. 47–63. Also see Rime, B. (2005),
‘Will Basle II lead to a specialisation of
unsophisticated banks on high-risk borrowers?’,
International Finance, Vol. 8, No. 1, pp. 29–55.
(5) See Cosanday, D. and Wolf, U. (2002)
‘Avoiding pro-cyclicality’, RISK, (October),
pp. 520–521. Also see Purhonen, M. (2002),
‘New evidence of IRB volatility,’ RISK
(March), pp. 521–525.
(6) See endnote 1.
(7) A general overview of the credit risk-claims
on sovereigns in Basel II is found in
‘International convergence of capital mea-
surement and capital standards’, Basel Com-
mittee on Banking Supervision’, (June 2004),
pp. 15–16.
(8) A general overview of the securitisation
framework in Basel II, is found in ‘Interna-
tional convergence of capital measurement
364 Journal of Banking Regulation Vol. 8, 4 353–364 & 2007 Palgrave Macmillan Ltd, 1745-6452 $30.00
and capital standards’, Basel Committee on
Banking Supervision’, (June 2004), pp. 113–136.
(9) Basel II adds to Equation (3) capital require-
ments for operational risk and market
risk where (3) becomes:
Pn Pm
kXm[g(ko+km)+ i=1Xi oi+ j=1Gjnj]
where g is a constant equal to 12.5 per cent
being the reciprocal of the minimum capital
ratio of 8 per cent, ko the capital requirement
for operational risk and km the capital
requirement for market risk.
(10) See detailed explanations of various risk
weights in ‘Risk weights of foreign cur-
rency-held debt and securitised assets in the
basel accord’ section. Countries with risk
classification of 1–3 are excluded from our
analysis as they benefit from the new
regulation since they can now use a lower
risk weight than 100 per cent used under
Basle 1. In addition, risk weights are 50 and
20 per cent for countries with risk classifica-
tion of 3 and 2, respectively. It would be hard
to reinvest the proceeds of securitisation in
assets carrying risk weights lower than 50 and
20 per cent.
(11) The comparison is just done to show the size
of the additional required capital in compar-
ison to the size of total assets and already
existing capital. The analysis does not state
nor suggests that the additional required
capital eats the major part of ROA as
additional capital is not a component of costs
but the cost of capital itself.
(12) See Emre Ergungor, O. (2003) ‘Securitiza-
tion’, Economic Commentary, Federal Reserve
Bank of Cleveland, August.
(13) The analysis ignores the costs of the secur-
itisation process and various guarantees as
well as the gains and residual interest income
from it as such issues are not of relevance for
the topic under consideration.
(14) As expected, the largest gains are associated
with the securitisation of all the portfolio of
claims on government in foreign currency
and the reinvestment of proceeds in a 50 per
cent credit risk-weighted asset. The potential
gains are around $703m.