NEW YORK - The U.S. regulator's eligibility criteria for ABCP liquidity may be less of a minefield for arbitrage conduits than previously anticipated, depending largely on the U.S. regulators' implementation of Basel II, according to speakers and chatter among attendees at last week's seminar on the topic, hosted by the ABCP group at Credit Suisse First Boston.

Essentially, an ABCP facility as risk weighted under Basel II's Internal Assessment Approach (IAA) may yield better economics than applying the U.S. regulators newly published standardized approach. While U.S. regulators apply a 10% credit conversion factor to eligible liquidity (effective September 2004, with a one-year grace period), the cost of securing the 10% CCF could outweigh the benefits. Moreover, the option to use the standardized approach may not exist for many of the banks providing ABCP liquidity.

According to the Basel guidelines - and somewhat reiterated at last week's conference - banks that choose the advanced internal ratings approach (A-IRB) for any of their credit exposures will have to apply the advanced approach across the board. That said, there are onerous requirements and standards that must be met - subject to regulatory approval - for a bank to use the advanced IRB.

David Kearns, supervisory financial analyst at the Federal Reserve Board, said that only about 10 U.S. banking institutions - the largest and most financially sophisticated - would meet the guidelines for using advanced IRB under Basel's premise. Interestingly, these banks likely provide a good chunk, perhaps the bulk, of liquidity in the U.S. ABCP market. If this is the case, the eligibility requirements - considered impractical in application by many market participants - may be far less reaching, as they seemingly don't apply under the advanced IRB.

As previously reported, meeting the criteria for eligible liquidity under the standardized approach can strip the economics from ABCP conduits - particularly the arbitrage variety (see ASR 7/12). For these, typical liquidity can fund out initially investment-grade rated securities that have migrated down to the triple-C level (or near default). However, for eligibility under the new U.S. rules, liquidity can only fund rated securities down to triple-B minus. After that, a loss is absorbed by credit enhancement.

"If liquidity is converted to the eligible format at renewal, there's going to be a major impact on the level of credit enhancement [required for ABCP to maintain its rating for securities arbitrage programs]," said Manjeet Kaur, a director at Standards & Poor's, who spoke at last week's seminar.

If liquidity is not permitted to fund out securities below investment grade, "the credit enhancement will be many, many multiples of what we currently have," Kaur added. "I think the viability of the securities arbitrage program really does come in to question."

Jim Croke, partner at Cadwalader, Wickersham & Taft, who delivered the "Basel Overview" at CSFB's seminar, noted that similar eligibility requirements have existed for as many as five years in the U.K., and the conduit market has developed quite successfully in that time. "I think these vehicles are still viable and there's evidence in the success of these conduits in the U.K.," Croke said.

Cost of capital versus

credit enhancement

Basel's IAA approach is an ABCP-specific segment of the advanced IRB for capital treatment of securitized exposures. Under the IAA, best-case ABCP liquidity draws a 100% credit conversion factor, and a 7% risk weight (multiplied by 8% to cash equivalent); this is compared to the U.S standardized regime, which calls for a 10% CCF for less-than-one-year eligible liquidity, with a 20% risk weighting (multiplied by 8% to cash equivalent).

The 16 basis point floor offered by the standardized approach could still command significantly more credit enhancement, particularly for conduits that hold rated securities.

Because of the credit enhancement implications of converting to eligible liquidity, from an overall economic perspective, some market players consider the 56 basis point floor for liquidity under the IAA a preferable solution.

It's a matter of time

What's not completely clear, however, is when the different capital requirements will be in effect, especially for U.S. entities that plan to implement the U.S. version of the advanced rules, which will be in development over the next three years at least. Obviously, in order to truly implement the advanced rules, they have to be in existence.

By the Fed's new rules, conduit liquidity must conform to the eligibility requirements as of September 2005, a one-year period of transition from the September 2004 effective date.

According to a regulator source involved with the U.S. implementation of Basel II, unofficially, a bank that qualifies for the advanced IRB will run parallel assessments beginning - at the latest - next September. The parallel assessments will provide two measures, a theoretical capital charge under the standardized approach and a theoretical capital charge under the advanced IRB approach.

As to which figure is actually used, "It's imaginable that there will be temporary guidance by then," the source said.

In any event, the full U.S. implementation of Basel II will follow at least one quantitative impact study and one or two rounds of notices of proposed rulemakings (NPRs), which are followed by commentary periods. The regulators have pegged U.S. implementation as far away as 2008.

The U.S. regulators published their standardized approach for conduit liquidity on July 20, and the guidelines are similar, in substance, to Basel II's standardized approach (which weights best-case liquidity at 20%). Basel II's standardized approach has a similar set of criteria for eligible liquidity. Also, for facilities that are limited to funding market event risk (by specified standards), there is a 0% CCF, though such facilities must be secured by underlying assets.

The market changes anyhow

Regardless of how or when, come September 2005, conduit economics will change, as liquidity facilities in the U.S. that have historically enjoyed 0% capital will move to at least a 10% CCF and a corresponding weighting in the standardized approach.

The end of the free ride, so to speak, has been the driver for many of the alternative liquidity solutions, such as extendible CP, and conduits sponsored by third parties who are either not bank-regulated or are not concerned with balance sheet issues.

S&P's Kaur mentioned that if conduits are forced to liquidate their rated exposures, there could be an increase in CDOs of ABS.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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