Wednesday, 5 March 2008, 15:30 (ET)
The Bank of Canada is seeking comments from direct participants in the Large Value Transfer System (LVTS) and other interested parties on the proposed eligibility criteria for accepting asset-backed commercial paper (ABCP) as collateral for the Bank of Canada's Standing Liquidity Facility (SLF). Written comments are requested by 14 March 2008. The final terms and conditions for accepting ABCP as collateral for the SLF will be announced by 31 March 2008. Recognizing that the market for ABCP in Canada is still evolving, the Bank of Canada intends to review these criteria in a year's time and announce the results of that review by 30 June 2009.
Background
The ABCP market in Canada expanded rapidly from the 1990s to mid-2007, becoming a significant part of the Canadian money market. During the summer of 2007, ABCP markets around the world experienced significant stress, as concerns related to U.S. sub-prime mortgages spread more broadly into global credit markets. In Canada, trading in ABCP was significantly affected, particularly the non-bank-sponsored segment of the market. In an effort to pursue an orderly restructuring of the Canadian market for non-bank-sponsored structured finance ABCP, major financial market players reached a standstill agreement (the Montreal Accord). Liquidity was also affected in the bank-sponsored segment, prompting sponsors to hold their unsold paper until market conditions improved.
Since then, a number of positive developments have occurred in the market for bank-sponsored ABCP in Canada. Liquidity provisions for many bank-sponsored ABCP programs have been strengthened and, in the majority of cases, liquidity agreements no longer include a general market disruption (GMD) clause. In addition, credit-rating agencies operating in Canada and sponsors of ABCP programs have indicated their commitment to improving transparency for ABCP investors.
On 12 December 2007, the Bank of Canada announced that it would expand the list of securities eligible to be pledged as collateral for the SLF to include certain types of Canadian-dollar-denominated ABCP. The release stated that to be accepted as collateral by the Bank, ABCP would need to meet certain criteria. These include being bank-sponsored, covered by a liquidity provision that meets global standards, and backed by traditional assets of an acceptable credit quality. The release also noted that ABCP backed by collateralized debt obligations (CDOs) and other highly structured assets would not be considered at this time. As well, higher standards of disclosure and additional credit ratings would be required before the Bank would begin to accept ABCP as collateral.
Two broad policy objectives have guided the Bank's assessment of the specific terms and conditions that should be attached to the acceptance of ABCP as SLF collateral. First, the eligibility criteria should mitigate any risks to the Bank that might be associated with accepting ABCP securities as collateral for the SLF. Second, the eligibility criteria should facilitate the development of a well-functioning market for ABCP by promoting more transparency for investors and by encouraging an active secondary market for these securities.
Considerations
The Purpose of SLF Collateral
Under the Bank of Canada Act, any lending by the Bank of Canada must be fully secured. Lending against collateral protects the Bank against counterparty risk and thus against the risk of financial loss. The securities acceptable as collateral for SLF loans are also eligible for intraday credit in the LVTS.
In setting its policies for SLF collateral, the Bank is guided by certain general principles:
- Collateral should be of high quality in which the Bank obtains a valid first priority security interest.
- The effects of the Bank's collateral policy on the pricing of credit risk and credit intermediation should be minimal.
- The collateral policy should support the operational efficiency and effectiveness of the Bank's own operations and those of market participants, applying market best practices where appropriate.
- The Bank should be transparent and accountable for its collateral policy.
Key Considerations Specific to ABCP
ABCP has unique characteristics relative to other fixed-income securities currently accepted as SLF collateral. Assessment of the risks related to ABCP includes accounting for the importance of the sponsor to the value of the program, the liquidity provisions and credit enhancements of the program, as well as the composition and structure of the program's assets.
The ABCP sponsor plays an important role in the ABCP program. A sponsor will typically source the underlying assets, provide promotion, marketing, and distribution of the securities, and act as the financial services agent for the program. Often, the sponsor will also be the main provider of liquidity and/or credit support. A high credit rating for the sponsoring institution from at least two external credit-rating agencies would be an important indicator of a high-quality sponsor.1
The liquidity facility is also a key part of the value of an ABCP program because of timing mismatches between payment obligations to ABCP holders and the cash flows from the program's assets. As the events of the past summer illustrated, the market price of an ABCP security can be significantly affected by the terms of the liquidity agreement. There is no industry-wide definition for the term "global liquidity standards." While requirements may differ slightly across rating agencies, there is consensus on a number of key elements. The two most significant of these are an obligation to provide funding, except in the event of insolvency of the conduit or near-default status of the underlying assets, and the absence of a GMD clause.
A related consideration is the relationship between the institution pledging the ABCP as collateral, the liquidity provider(s), and other key participants in an ABCP program. Should an institution perform one of these functions for an ABCP program and then pledge paper from that program, the Bank must consider the additional risks associated with these close links in the event of a pledger default. The Bank's current policy for SLF collateral indicates that private sector securities are not eligible if they are issued by either the pledging institution or entities related to it. While ABCP differs from conventional private sector debt securities in that it is backed by specific assets that are protected in the event of the insolvency of the conduit, the value of the underlying assets, excluding the value provided by the pledger, is difficult to determine without a separate credit assessment. Restricting eligibility to securities where no significant close links to the pledger exist may limit the amount pledged in the short run, but may encourage a more active secondary market for ABCP.
The composition and nature of the assets underlying an ABCP program must also be considered, particularly the structural and credit risks associated with new or complex products. Assessing these risks can be particularly difficult, given a lack of data regarding the assets held and their past performance. The overall credit quality of an ABCP program is affected not only by the characteristics of the underlying assets, but also by credit enhancements, which can be applied to individual pools of assets, as well as at a broader, program level. The more complex the underlying assets, the more difficult they are to value and the greater the amount of resources that are required to assess the risks associated with those assets.
To confirm the eligibility of an ABCP security as SLF collateral and to perform its due diligence, the Bank must be able to review key program information. From an efficiency standpoint, the supporting documentation should be accurate, concise, and available to all investors. This is consistent with the Bank of Canada's announcement on 12 December 2007, in which the Bank indicated its desire to contribute to a broader transparency objective by establishing eligibility requirements for SLF collateral that would promote higher standards for disclosure. Towards this same objective, the Bank will continue to work with other stakeholders to improve disclosure standards for ABCP in Canada. Sponsoring institutions should have an interest in providing relevant investment information to all investors to promote a more active secondary market for ABCP in Canada.
Proposed Eligibility Criteria
Given the factors outlined above, the Bank is considering accepting, as collateral for the SLF, ABCP programs that meet the following criteria:
- The program is sponsored by a deposit-taking institution that is federally or provincially regulated and that has a minimum stand-alone credit rating equivalent to at least A. This would be evidenced by the sponsor receiving the equivalent of at least an A as the second-highest rating from a minimum of two senior, unsecured, long-term credit ratings.
- The liquidity agreement(s) include an obligation to provide funding except in the event of insolvency of the conduit or near-default status of the underlying assets.
- The program must not contain any actual or potential exposure to securitized assets, with the exception of National Housing Act mortgage-backed securities.
- The program has received the highest possible short-term credit rating from at least two rating agencies.
For those programs that qualify, the following terms and conditions would apply to the Bank's acceptance of ABCP securities as collateral:
- The pledger does not have close links to the program; i.e., the pledger cannot be the sponsor or financial services agent for the ABCP program, nor can the pledger provide liquidity support to the program.
- The program must not utilize financial leverage to acquire assets.
- Only senior tranches will be accepted.
- The security must not contain an embedded option, such as extendibility.
- No more than 20 per cent of the value of the collateral pledged by one institution can be ABCP sponsored by a single institution.
- Only Canadian-dollar securities are eligible to be pledged as collateral.
- The margin requirement is likely to be close to the existing margin requirements for bankers' acceptances and commercial paper.
The Bank would retain the right to refuse any ABCP program for which the risk to the Bank is inappropriately high.
In addition, the Bank is proposing the following transparency requirements as part of its eligibility criteria:
- The Bank must receive a single, concise document that is provided by and validated by the sponsor, and that includes all relevant investment information.
- This document must be easily accessible to all investors.
- The sponsor must agree to provide timely disclosure to all investors of any significant change to the information contained in this document.
- At a minimum, relevant investment information would include:
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- The identity of the sponsor, the financial services agent, and liquidity providers
- The range of assets that may be held by the program, including maximum or minimum proportion, if applicable, and when/how asset composition could change
- Characteristics of the asset pools, including at a minimum: composition, foreign currency exposures, performance measures, credit enhancements, and hedging methods. Other information such as average remaining term, current payment speeds, and geographic locations should be disclosed if relevant to the investor.
- Where the investor could obtain updates of relevant investment information
- The nature of the liquidity facilities, including the amount of support from each liquidity provider
- The nature and amount of program-wide credit enhancements
- The flow of funds, including payment allocations, rights, and distribution priorities
The Bank will also consult other available documents, including credit-rating reports, to assess whether an ABCP program meets its criteria.
Request for Comments
Comments on the proposed eligibility criteria, including any clarification of terms and/or suggested wording, are requested in writing by 14 March 2008. In addition, the Bank of Canada would also welcome comments on a modification of the proposed criteria to include acceptance of ABCP programs that (may) contain a minimal percentage of securitized assets, say 10 per cent, subject to the application of a higher margin requirement.
Please address written comments to:
ABCPconsultations@bankofcanada.ca
For further information, please contact:
Jeremy Harrison
Public Affairs
Bank of Canada
613 782-8782
1.
It is important to consider credit ratings that are not based on an assumption of an implicit government guarantee. For example, DBRS issues intrinsic assessment ratings for financial institutions, and Moody's issues ratings of bank financial strength, which strip out from their official credit ratings the implicit support to a bank that is assumed to be provided by public authorities.
