PREPAYMENT RISK IN SECURITIZATION TRANSACTION: ASSESSMENT AND CAPITAL ALLOCATION

The advent of Basel I capital adequacy proposal led to the growth of securitization transactions, as by making certain assets off-balance sheet, a bank could hold less capital on an overall basis in the Basel I regime. However, this led to an increase in the concentration of credit risk in the books of the concerned financial institutions. The credit risk related securitization transaction increases manifold if the underlying assets contain prepayment provisions, i.e., the borrowers are allowed to prepay their loans. This paper discusses the two alternative approaches that exist for assessment of prepayment risk in the case of securitization transaction. It also spells out the provisions contained in the Basel II accord regarding prepayment risk and capital allocation.