Provisions in the current version of the Bank of International Settlements (Basel) proposal that relate to imposing a capital charge on asset-backed commercial paper liquidity lines will a have material effect on the ABCP-dominated Canadian market, experts say.
The current version of the proposal contains a provision that would allow a 20% capital charge for asset-backed commercial paper liquidity lines. However, there is a provision that if these lines are unconditionally cancelable and are restricted in use for market disruption, a 0% risk weighting may still apply.
In Canada, the regulatory regime requires that liquidity back-up lines should be drawn upon only in cases of market disruption. Thus, under the Basel proposal, which exempts liquidity lines used for market disruption, the liquidity back-up lines that comply with this regulatory requirement will continue to be exempt from the 20% capital charge. However, Canadian lines that include elements of credit risk will be the ones that would be moved to a 20% credit conversion.
"If the language of the law stays as it is, one of two things is going to happen," Leon Dadoun, a managing director at CIBC World Markets said. "Either all Canadian liquidity back-up lines are going to migrate to general market disruption availment or those that are currently not holding capital against their liquidity back-up lines are going to have to start holding capital against them."
He noted that this is going to have implications on the market because the pricing on these lines will have to increase in situations where there has been an increase in the capital that is charged.
"Conduit sponsors that want to maintain their returns would therefore need to increase their pricing," he explained. "I think that the only saving grace of these conduits is that they might end up with less than a 20% capital requirement for those back-up lines that don't fit into the exception language."
He noted, however, that it appears the regulators will impose some capital charge for back-up liquidity lines that have some credit risk embedded within them.
Dadoun added that in a properly structured transaction the investor should gain little or no comfort from increased availment rights on liquidity back-up lines. Structured properly, the credit risk should be covered through sufficient credit enhancement and not in the liquidity back-up line.
Aside from these, "the fact that there are different types of liquidity back-up lines in the Canadian market supporting ABCP that trades at identical spreads means that investors are not really concerned about the availment rights associated with liquidity back-up lines," Dadoun said.
On the Different Tranches
In its current version, the Basel proposal imposes varying capital requirements on the different tranches in asset-backed securitizations depending on their respective risk exposure. The amount of risk exposure would be defined by the ratings from a nationally-recognized rating agency.
"The proposals are such that external ratings would be recognized in the various tranches in a securitization," explained Brad Shinn, a senior analyst at the Office of the Superintendent of Financial Institutions, which regulates Canadian financial institutions and pension funds. "What the proposal would do would be to use rating agencies as the independent eye or third party that would help weight the risk associated with those tranches."
The differentiation of risk would have unfavorable implications in the Canadian asset-backed sector because there isn't a deep market for subordinated securities.
Though CIBC's Dadoun believes that having different capital charges for investors in asset-backed securities is a sound concept, he feels that this would have a potential negative impact on the Canadian market.
He explained that in the Canadian market, the way to get sustained market growth is to encourage a situation where financial institutions can start moving some of the more deeply subordinated tranches. He added that to inhibit this through incremental capital charges would be disadvantageous to the Canadian securitization market where the market for high-yielding, lower-rated tranches is already pretty thin.
"This is not to suggest that we necessarily rely on regulated institutions to buy those junior tranches," Dadoun said. "But anytime you take away a potential investor to what is already a pretty thin market, this is going to have a detrimental effect."
OFSI's Shinn said that the provisions in the current Basel proposal would likely push the Canadian market toward senior/subordinate type structures because the capital charge associated with other external credit enhancement may become costly. Thus it may be more cost-effective to apply the senior/subordinate structure, he observed.
Shinn also believes that having another comment period is important.
"It's really to give the industry a chance to focus their comments on specific proposals," he said.
The version of the Basel proposal that went out for comment in June 1999 (comment period ended March 31, 2000) contained items that were up for consideration, rather than reflective of what they would contain in the final version.
The next consultative document would likely be more representative of what the final accord would look like. However, items relating to securitization were more formulated in the June proposal, so the future version of these items would probably be similar.