Category: Regulation

Regulation

OSFI Does Not Grandfather Extant Tier 1 Capital

OSFI has released an Advisory titled Treatment of non-qualifying capital instruments:

This Advisory does not apply to regulated life insurance companies, insurance holding companies, federally regulated property and casualty insurance companies or cooperative credit associations. OSFI will, after consultation, determine how and to what extent the Basel III rule changes will be applied to these federally regulated institutions and additional guidance will be released in due course.

Beginning on January 1, 2013, DTIs would be expected to comply with the applicable cap on the first fiscal quarterly reporting date of each year (refer to Appendix A for a description of the applicable percentages) and for subsequent reporting periods until a new cap applies.
The rules to be applied to govern the phase-out of non-qualifying capital are as follows:

  • 1. Capital instruments issued prior to September 12, 2010 that previously qualified as regulatory capital but do not meet the Basel III criteria for regulatory capital will be considered non-qualifying capital instruments and subject to the phase-out described in this Advisory.
  • 5. The cap will apply separately to Additional Tier 1 and Tier 2 capital. As the Basel III cap refers to the total amount of non-qualifying instruments outstanding within each tier of capital, some instruments in a tier may continue to fully qualify as capital while others may need to be excluded to comply with the cap.
  • 6. OSFI expects DTIs to comply with the Basel III requirements concerning the phase-out of non-qualifying capital instruments, while maximizing the amount of available regulatory capital and, to the maximum extent practicable, giving effect to the legitimate expectations of the parties to such capital instruments (as evidenced by the terms of such instruments). Accordingly, a DTI should prioritize redeeming capital in a way that will give effect to the following priorities:
    • (a) Maximize the amount of non-qualifying capital instruments outstanding during the Basel III transition period (based on the assumption that all capital will be redeemed at the earliest regular9 par redemption date); and
    • (b) Minimize the amount of capital that would be subject to a regulatory event.

Asinine. OSFI’s contempt for the capital markets shines through their pious muttering about “the legitimate expectations of the parties to such capital instruments”. They would much rather that the markets are a casino.

For more on the Basel rules, see BIS Finalizes Tier 1 Loss Absorbancy Rules.

Look for a big, big market pop in PerpetualDiscount prices on Monday.

Update, 2011-2-5: Josh Greenwood, Financial Post, Hybrid capital gets staged phase out.

Update, 2011-2-5: Doug Alexander and Frederic Tomesco, Bloomberg, Canada Banks Urged by Regulator to Limit Early Redemptions on Hybrid Bonds:

Prices for the securities have plunged on concern that the regulator may allow the banks to redeem the notes early at par, or as much as 30 percent below current prices.

TD Capital Trust’s 10 percent notes due in June 2108 sold by Toronto-Dominion fell 15.6 percent to 129.78 cents on the dollar in the six months through yesterday, while Scotiabank Tier 1 Trust’s 7.8 percent notes due in June 2108 dropped 5.8 percent. Declines in the period average 7.5 percent, according to Bloomberg data.

Update, 2011-2-8 .John Greenwood, Financial Post:

According to Bloomberg, $450-million of TD notes with annual interest of 10% and a call date of 2039 shot up to $136 from $127 on Monday, the most recent period for which prices are available. A similar issue of $300-million of 10.25% hybrids sold by CIBC callable in 2039 rose to $140 from $131.

Bank of Nova Scotia’s 7.8% notes with a call date of 2019 rose to $117 from $114.

The price moves come after a statement by the Office of the Superintendent of Financial Institutions on Friday telling banks not to take advantage of prospectus wording allowing issuers to redeem hybrids at par value if a regulatory event had taken place.

The majority of issues had call dates between 2019 and 2021, but at least two were callable in 2039.

Because of the high coupons, the bonds trade significantly above par value. For instance, the TD notes were changing hands in August at nearly $160 before slumping to $130 by mid-November amid concern about whether or not the new Basel rules constituted a regulatory event.

Similarly, the CIBC notes were fetching as much as $155 in August but by mid-November they declined to 127%.

Contingent Capital

OSFI Announcement on Non-Qualifying Capital Instruments

OSFI has announced:

Media are invited to participate in a briefing via teleconference with the Office of the Superintendent of Financial Institutions (OSFI) on two Advisories relating to BASEL III: Treatment of non-qualifying capital instruments under Basel III and Non-Viability Contingent Capital.

Mark White, Assistant Superintendent, Regulation Sector, will provide a brief overview and will be available to answer questions.

Media who wish to participate must confirm their attendance with Léonie Roux, Communications and Consultations.

Please note that all details are subject to change. All times are local.

DATE: Friday February 4, 2011
TIME: 4:00 PM
PLACE: 613-960-7518 (Ottawa)
1-888-265-0903
Participant pass code: 725300

Update, 4:21pm: Good old OSFI, hopelessly incompetent and secretive as always!

I notified Ms. Roux of my intent to participate and was answered with:

Good afternoon,
Please note that today’s conference call is for media only.

A separate conference call is being set up for analyts and investors that may wish to participate.

The conference call will take place on Monday morning at 11:30AM, an advisory will be issued shortly.

I responded:

I represent media via my blog at http://www.prefblog.com

No response. So I called in at about 4:01pm and got some fragments of seemingly random open-mike buzz.

OSFI has deleted the original advisory and replaced it with one that does not include a telephone number or pass code.

OSFI: The dumbest shits on the planet.

Contingent Capital

OSFI Seeking to Manipulate Bond Indices and Retail Investors?

Barry Critchley of the Financial Post has written a piece titled Banks prepare for CoCos that contains the interesting assertion:

“We would expect that the banks would make use of the contingent market for the incremental 3.5% of their capital because holding the balance in common equity could potentially adversely affect profitability,” said Altaf Nanji, an analyst with RBC Capital Markets.

But lots of things have to be clarified before that issuance starts.

– The securities have to be rated. And that’s not a slam dunk given that the securities are convertible if certain trigger points are reached. So far, Fitch is the only ratings agency that has rated any of the securities, though Standard & Poor’s has issued a request for comment on them.

– The determination has to be made whether the securities should be in a bond index. Certainly OSFI wants them in the index and has make its plan very clear.

Shades of Hades, or at least the UK! Assiduous Readers will remember the tergiversations that were the topic of the post Merrill Keeps Lloyds ECNs out of UK Bond Indices that started when UK authorities made a similar attempt to debase the bond indices.

There’s only one teensy little problem with putting CoCos into bond indices: they’re not freaking bonds! If you don’t have the ability to bankrupt your debtor for being a day late or a dollar short, you’re not a bond-holder.

Canadian retail investors should be concerned, since bond ETFs are the most reasonable way for a bond investor to get exposure to bonds and there is already a high degree of aldulteration in bond ETFs, as I pointed out in my article Bond ETFs. On the positive side, there is the chance that a sharp divergence of opinion on the matter may lead to a wider variety of bond indices being marketted. REAL bond indices, I mean, not garbage like the DEX HYBrid index, discussed on September 30, 2010.

Update, 2011-2-7: A Reader has advised me (in rather polemical language!) that he considers my views on the DEX HYBrid Index to be significantly influenced by a conflict of interest, to wit: in late 2006, following the purchase by the TSX of the bond indices from Scotia Capital, it occurred to me that there was the potential for doing some kind of business with the Exchange based on my HIMIPref™ software, analytics, and indices (at that time, TXPR did not exist). I contacted them, they expressed curiosity and I made a presentation to them.

Sadly, nothing came of this attempt and my correspondent alleges that I have been left with a conflict of interest that renders it impossible for me to present my views on the DEX HYBrid Index as being independent.

I don’t see it. If I harboured such a violent grudge over every unsuccessful sales pitch I’ve made over the years, I wouldn’t have time for much else! However, given the nature of the allegations and the language used, I deem it proper to err on the side of disclosure. So make your own minds up regarding my motivation for disrespecting the DEX HYBrid Bond Index!

My correspondent has been invited to post a comment on the blog stating his views, or to provide me with a rebuttal that will be given equal time; to date, this invitation has been declined.

Administration

Fed Up with Shoddy Market-Making!

The market-maker for BAM.PR.J did a really shitty job yesterday. According to information supplied by TMX DataLinx the quote at 14:51:59 was 25.66-26.69 and the spread stayed in the range of ninety-seven cents to a dollar six until the close – over an hour. It really is time that the Market Maker system was reformed, if the smiley-boys aren’t going to take it seriously.

In a nutshell, every TMX-listed security has a market maker. The Market Makers service odd-lots, take responsibility for the top-secret Minimum Guaranteed Fill function and agree to maintain a spread on their securities below a certain level. In return, they get a very nice privileges: they can elect to participate in trading on the passive side, taking a cut of up to 30% of the passive side’s fill on every trade [see comments]. This is deemed to be a fair trade-off, and I’m not about to say it isn’t.

But it can only a fair trade-off if the privileges are earned, and it can only be viewed as a fair trade-off if details of the Market-Maker’s execution of his side of the contract are viewable.

There are no details given of any kind of auction system whereby, for instance, a dealer willing to enforce a $0.25 spread can simply take the privileges away from an extant market maker only willing to enforce $0.50. There are no details given of the committments made. There are no details given on actual Market-Maker performance. The TMX claims to monitor Market Maker performance and remove privileges in the event of poor performance, but since no details are given the credibility of this claim is open to question.

I am sick and bloody tired of B-School snots at the TMX telling me not to worry my pretty little head about such complicated matters because the TMX is in charge and on the case. I am outraged that I was told that seven seconds at the close was a inconsequential period for a wide spread on SLF.PR.E at year-end, when it is well known that this is sufficient time to analyze and react to literally thousands of quotation changes. If the TMX is going to grant preferential trading privileges, over-riding the price-time priority they purport to consider holy, they should damn well prove that those preferential trading privileges have been won and earned in a competitive market place.

There’s not much I can do about this, but that’s never an excuse for doing nothing. Accordingly, from this day forward I will be publicizing the daily half-dozen highest excess spreads according to the “Last” quotes (with any luck, they will soon be the “Closing” quotes) available to me. Excess Spread is defined as the spot rate less the average spread as computed by HIMIPref™. Issues considered for inclusion in the list are, and will continue to be, restricted to those incorporated in the HIMIPref™ Preferred Share Indices.

The table for January 27 looks like this:

Wide Spread Highlights
Issue Index Quote Data Notes
BAM.PR.J OpRet Quote: 25.65 – 26.69
Spot Rate : 1.0400
Average : 0.6729
YTW SCENARIO
Maturity Type : Soft Maturity
Maturity Date : 2018-03-30
Maturity Price : 25.00
Evaluated at bid price : 25.65
Bid-YTW : 5.06 %
HSB.PR.D Perpetual-Discount Quote: 23.62 – 24.05
Spot Rate : 0.4300
Average : 0.2761
YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2041-01-27
Maturity Price : 23.38
Evaluated at bid price : 23.62
Bid-YTW : 5.34 %
PWF.PR.M FixedReset Quote: 26.54 – 27.00
Spot Rate : 0.4600
Average : 0.3404
YTW SCENARIO
Maturity Type : Call
Maturity Date : 2014-03-02
Maturity Price : 25.00
Evaluated at bid price : 26.54
Bid-YTW : 3.85 %
BAM.PR.G FixedFloater Quote: 22.70 – 23.20
Spot Rate : 0.5000
Average : 0.3971
YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2041-01-27
Maturity Price : 25.00
Evaluated at bid price : 22.70
Bid-YTW : 3.49 %
HSB.PR.E FixedReset Quote: 27.47 – 27.75
Spot Rate : 0.2800
Average : 0.1836
YTW SCENARIO
Maturity Type : Call
Maturity Date : 2014-07-30
Maturity Price : 25.00
Evaluated at bid price : 27.47
Bid-YTW : 3.80 %
CM.PR.P Perpetual-Discount Quote: 25.18 – 25.56
Spot Rate : 0.3800
Average : 0.2909
YTW SCENARIO
Maturity Type : Call
Maturity Date : 2012-11-28
Maturity Price : 25.00
Evaluated at bid price : 25.18
Bid-YTW : 5.08 %
Contingent Capital

BIS Finalizes Tier 1 Loss Absorbancy Rules

The Bank for International Settlements has announced:

minimum requirements to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss.

This is yet another example of bureaucrats ursurping the role of the courts:

The terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by an internationally active bank must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event … Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).

4. The trigger event is the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and (2) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority.

5. The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.

In a rational world, the issuing banks will include another trigger for conversion that occurs well before the point of non-viability can credibly be discussed by regulators, as I have urged in the past.

A trigger based on the price of the common stock would greatly reduce uncertainty in evaluating these instruments; allow hedging in the options market; provide a smoother transition of Tier 1 Capital to common equity; and, most importantly, provide far better protection of overall financial stability. It will be interesting to see if that happens – but frankly, I’m betting against it.

Update, 2011-1-14: There has been some speculation that the phase-out of the existing Tier 1 Capital rules will mean that extant PerpetualDiscounts will be redeemed (at par!). This is based on the section of the release titled “Transitional Arrangements”:

Instruments issued on or after 1 January 2013 must meet the criteria set out above to be included in regulatory capital. Instruments issued prior to 1 January 2013 that do not meet the criteria set out above, but that meet all of the entry criteria for Additional Tier 1 or Tier 2 capital set out in Basel III: A global regulatory framework for more resilient banks and banking systems, will be considered as an “instrument that no longer qualifies as Additional Tier 1 or Tier 2” and will be phased out from 1 January 2013 according to paragraph 94(g).

The linked document was discussed in the PrefBlog post Basel III. The relevant paragraph, 94(g), states in part:

Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. This cap will be applied to Additional Tier 1 and Tier 2 separately and refers to the total amount of instruments outstanding that no longer meet the relevant entry criteria. To the extent an instrument is redeemed, or its recognition in capital is amortised, after 1 January 2013, the nominal amount serving as the base is not reduced.

So the thinking is that extant PerpetualDiscounts will no longer qualify as Tier 1 capital and be considered by the banks to be too expensive to keep on the books.

The most recent OSFI speech was by Mark White and, as noted on January 12, didin’t really have much to say. With respect to new Tier 1 rules, he stated:

Existing non-common tier 1 and tier 2 instruments which do not meet the new requirements will, on an aggregate basis, be subject to an annual, steadily increasing phase-out from 2013 to 2023. To avoid the bail-out by taxpayers of capital in a failed bank, it is also expected that all non-common capital will ultimately be required to be written-off, or to convert to common shares, if a non-viable bank will receive an infusion of government capital.

On December 16, 2010 OSFI responded to the release of the Basel III text to signal that work is continuing on the transition for non-qualifying capital instruments – and that further guidance will be issued as implementation progresses. We realize that many are anxiously awaiting guidance on how non-qualifying capital will be phased out in Canada. However, it could do a disservice if OSFI provides premature guidance before the minimum international requirements are set. Suffice it to say that OSFI currently expects, at a minimum, to follow the minimum transition requirements with respect to phasing-out disqualified capital. Our goals will be to maximize the regulatory capital in the system and, where practicable, to give effect to the legitimate expectations of the issuers and investors.

OSFI’s December 16 release was discussed briefly on the market update of that day.

Once the Basel III rules text governing NVCC requirements has been finalized by the BCBS, OSFI intends to issue guidance clarifying the phase-out of all non-qualifying instruments by DTIs, including OSFI’s expectations with respect to rights of redemption under regulatory event [footnote] clauses.

Footnote: In general, a regulatory event may be defined as receipt by the bank of a notice or advice by the Superintendent, or the determination by the bank, after consultation with the Superintendent, that an instrument no longer qualifies as eligible regulatory capital under the capital guidelines issued by OSFI. The definition of regulatory event is governed by the terms of the capital instrument and interested persons should refer to the relevant issuance documents.

So what do I think? Mainly I think it’s too early to tell.

First off, the preferred shares may be grandfathered, as previously speculated. OSFI has shown no hesitation in grandfathering instruments in the past – they did this with Operating Retractible issues. One argument in favour of this idea is that it’s relatively easy to come up with a coercive exchange offer: CIT did this, as discussed on October 2, 2009, as did Citigroup (see also the specific terms).

Another reason not to get too excited is the length of time involved. If the banks (and insurers) are forced to redeem their prefs over a ten year period, they’re not going to redeem the lowest coupon ones first! If you look at something priced at, say, $22, and consider you might have to wait until 2023 to get your money … that’s thirteen years, an increment of $0.23 p.a. Call it a 1% yield increment. Very nice – but you’re locked in for all that time and there’s a fair amount of uncertainty.

Regulation

EC: L'etat, C'est Nous

The European Commission has released a new package of proposals aimed at eliminating that pesky rule-of-law thing with respect to insolvent banks.

The press release emphasizes that the decisions have been made:

Currently, there are very few rules at EU level which determine which actions can and should be taken by authorities when banks fail and, for reasons of financial stability, cannot be wound up under ordinary insolvency rules. This consultation seeks input on the technical details underpinning the policy issues identified in the Communication of 20 October 2010.

For instance, they are going to give themselves:

resolution tools which empower authorities to take the necessary action, where bank failure cannot be avoided, to manage that failure in an orderly way such as powers to transfer assets and liabilities of a failing bank to another institution or to a bridge bank, and to write down debt of a failing bank to strengthen its financial position and allow it to continue as a going concern subject to appropriate restructuring

Well, I guess we should be pleased that they’re only going to take “necessary” actions, and that all restructurings will be “appropriate”. We can also celebrate the assurance that all burden sharing will be fair:

Fair burden sharing by means of financing mechanisms which avoid use of taxpayer funds. This might include possible mechanisms to write down appropriate classes of the debt of a failing bank to ensure that its creditors bear losses. Any such proposals would not apply to existing bank debt currently in issue. It also includes setting up resolution funds financed by bank contributions. In particular the Consultation seeks views on how a mechanism for debt write down (or ‘bail-in’) might be best achieved, and on the feasibility of merging deposit guarantee funds with resolution funds.

The published FAQs note:

9. What is the proposal to write down creditors (‘bail in’) and how would it work?

The objective is to develop a mechanism for recapitalising failing institutions so that it can continue to provide essential services, without the need for bail out by public funds. Fast recapitalisation would allow the institution to continue as a going concern, avoiding the disruption to the financial system that would be caused by stopping or interrupting its critical services, and giving the authorities time to reorganise it or wind down parts of its business in an orderly manner. In the process, shareholders should be wiped out or severely diluted, and culpable management should be replaced. The consultation seeks views on two broad approaches to achieving this objective.

The first approach would involve a broad statutory power for authorities to write down or convert unsecured debt, including senior debt (subject to the possible exclusions for certain classes of senior debt that may be necessary to preserve the proper functioning of credit markets). It is not envisaged that such a power would apply to existing debt that is currently in issue, as that could be disruptive.

The second approach would require banks to issue a fixed amount of ‘bail-in’ debt that could be written off or converted into equity on a specified trigger linked to the failure of the bank. This requirement would be phased in over an appropriate period and, again, it is not envisaged that any existing debt already in issue would be subject to write down.

Unsurprisingly, the arbitrary nature of this plan is under attack:

In one scenario under consideration, regulators may get the power to write down or convert senior debt, with possible exceptions “to ensure proper functioning of credit markets.” These exceptions may include deposits, secured debt such as covered bonds, short-term debt, and well as trades in derivatives and certain other financial instruments, the commission said.

Another option is to force banks to issue a fixed amount of bonds with contracts stating that they could be written down or converted if certain conditions are met.

‘Danger’

This second option “will give much more clarity and certainty, as banks, regulators and investors will have to address the issues explicitly in advance,” PricewaterhouseCoopers LLP director Patrick Fell said. “There is a danger otherwise that we wait until problems emerge” to clarify how so-called bail-ins, in which investors contribute to shoring up banks in difficulty, would work in practice.

Writedowns or conversions would apply only to debt issued after the measures become law, the commission said.

The idea of bail-ins of all senior debt holders is “an incredibly complicated, difficult and ultimately very politically sensitive thing to do,” Bob Penn, a lawyer at Allen & Overy LLP in London, said in a telephone interview. “It feels to me like an entirely unworkable option,” he said.

Lapdog Carney will be pleased: he’s been urging the elimination of bondholder rights for some time.

What will be most interesting is to see how the European banks finance themselves after these measures become law. I, for one, would be a little leery of investing in financial instruments subject to arbitrary write-down, and that don’t have three hundred years of bankruptcy law behind them – and demand a spread to compensate for the extra uncertainty.

Regulation

Bill C-501

Bill C-501 is a Liberal-sponsored bill to amend the Bankruptcy and Insolvency Act and other Acts – although its chief proponent found it impossible to find any support for its provisions in a major speech.

John Manley explains in Bill C-501: Myths & Reality:

The proposed legislation would force bankrupt companies to give so-called “super-priority” status to unfunded pension plan liabilities, on the grounds that this will help to ensure benefits are paid if a company goes out of business.

DBRS Comments on Pension Fund Bill C-501:

Based on present information, the enactment of Bill C-501 would have potentially negative consequences for the ratings of certain Canadian-based companies and would likely add volatility to bond markets on a whole as market participants reacted to the meaningful change. The primary impact would relate to the reality that bondholders of entities with DBs would now rank behind the new senior obligation. Secondary effects would likely include the reality that the overall credit strength of some entities may be weakened by changes that would result in higher funding costs and accentuated liquidity challenges, noting that this would likely be concentrated within weaker credits, particularly during periods of stress.

Douglas Rienzo, a Pension & Benefits partner at Osler, comments:

Extending super-priority status to the entire solvency deficit could place significant additional burdens on the financial capacity of DB plan sponsors, impede their ability to cost-effectively raise capital, adversely affect their ability to invest in Canada’s economy and remain competitive, and, ultimately, impair their ability to fund their pension obligations.

For example, the proposed amendments to the BIA and CCAA could have the following implications:

  • •the elevation of billions of dollars of potential pension claims ahead of lenders in the priority ladder;
  • •the revaluation by credit markets of assets available for security and the deduction of higher-priority claims, thus resulting in a significant reduction of available credit; and
  • •the creation of immediate default situations, based on covenants in existing trust indentures restricting the existence of claims that would have priority over the existing lender.

While the protection of members’ accrued benefits in a restructuring or bankruptcy situation may well be a public policy goal worth pursuing, the unintended consequences of Bill C-501 could include not only the weakening of the financial viability of DB plan sponsors, but possibly the wholesale abandonment of DB plans by corporate Canada.

As far as preferred shares go, this is pretty much a non-issue: the default assumption is that if an operating company defaults at all on its preferreds, that implies a total loss on the preferred shares. The senior bondholders and pension retirees can fight amongst themselves for whatever’s left over.

Update, 2011-6-23: Died on the order paper.

Regulation

SEC Entrenches Selective Disclosure

The Securities and Exchange Commission spent 2010 busily entrenching the practice of selective disclosure with respect to the credit quality of investible intruments.

In 17 CFR Parts 240 and 243 “Amendments to Rules for Nationally Recognized Statistical Rating Organizations”:

Under the re-proposed amendments: (1) NRSROs that are hired by arrangers to perform credit ratings for structured finance products would have been required to disclose on a password-protected Internet Web site the deals for which they have been hired and provide access to that site to non-hired NRSROs that have furnished the Commission with the certification described below; (2) NRSROs that are hired by arrangers to perform credit ratings for structured finance products would have been required to obtain representations from those arrangers that the arranger would provide information given to the hired NRSRO to non-hired NRSROs that have furnished the Commission with the certification described below as well; and (3) NRSROs seeking to access information maintained by the NRSROs and the arrangers pursuant to the new rule would have been required to furnish the Commission an annual certification that they are accessing the information solely to determine credit ratings and would determine a minimum number of credit ratings using the information.

So the SEC acknowledges – and, in fact, emphasizes – that it is difficult, if not impossible, to asset the credit quality of a structured-finance instrument without acess to material non-public information.

Currently, when an NRSRO is hired to rate a structured finance product, some of the information it relies on to determine the rating is generally not made public. As a result, structured finance products frequently are issued with ratings from only one or two NRSROs that have been hired by the arranger, with the attendant conflict of interest that creates. The amendments to Rule 17g-5 are designed to increase the number of credit ratings extant for a given structured finance product and, in particular, to promote the issuance of credit ratings by NRSROs that are not hired by the arranger. This will provide users of credit ratings with more views on the creditworthiness of the structured finance product. In addition, the amendments are designed to reduce the ability of arrangers to obtain better than warranted ratings by exerting influence over NRSROs hired to determine credit ratings for structured finance products. Specifically, opening up the rating process to more NRSROs will make it easier for the hired NRSRO to resist such pressure by increasing the likelihood that any steps taken to inappropriately favor the arranger could be exposed to the market through the credit ratings issued by other NRSROs.

… and only NRSROs are granted access to that information. Investors (or “Investor Scum”, as I believe they are generally known to regulators) must be made dependent upon NRSROs for assessments of credit quality – this will, of course, make it easier to blame them for that dependence when – as will inevitably happen in a competitive economy – things go pear-shaped.

Later, in an exemption to address extra-territoriality the SEC repeated:

Rule 17g-5(a)(3), among other things, requires that the NRSRO must:

  • Maintain on a password-protected Internet Web site a list of each structured finance product for which it currently is in the process of determining an initial credit rating in chronological order and identifying the type of structured finance product, the name of the issuer, the date the rating process was initiated, and the Internet Web site address where the arranger represents the information provided to the hired NRSRO can be accessed by other NRSROs;
  • Provide free and unlimited access to such password-protected Internet Web site during the applicable calendar year to any NRSRO that provides it with a copy of the certification described in paragraph (e) of Rule 17g-5 that covers that calendar year;12 and
  • Obtain from the arranger a written representation that can reasonably be relied upon that the arranger will, among other things, disclose on a password-protected Internet web site the information it provides to the hired NRSRO to determine the initial credit rating (and monitor that credit rating) and provide access to the web site to an NRSRO that provides it with a copy of the certification described in paragraph (e) Rule 17g-5.13

… and DBRS confirms that every single particle of information that they use to rate structured finance wil be on these semi-seqret websites:

To ensure compliance with the Representation Agreement, DBRS requests the Arranger not provide new information orally to DBRS. Rather, the Arranger should post all new information on its website at the same time as it provides it to DBRS. Discussions between the Arranger and DBRS about the application of DBRS methodologies that do not relate to a transaction or a potential transaction would not need to be posted.

I have long argued that Regulation FD (and the corresponding Canadian National Policy 51-201) must be repealed; instead, it is being entrenched. One wonders when the first scandal regarding leakage of passwords will occur.

Regulation

BIS Releases Central Counterparty Risk Weighting Consultation

The Banking Subcommittee of the Bank for International Settlements has released a consultation paper titled Capitalisation of bank exposures to central counterparties:

Generally speaking, the Committee proposes that trade exposures to a qualifying CCP will receive a 2% risk weight. In addition, default fund exposures to a CCP will, in accordance with a risk sensitive waterfall approach (based on a CCP’s actual financial resources and hypothetical capital requirements), be capitalised according to a method that consistently and simply estimates risk arising from such default fund.

As has been discussed on PrefBlog, the purpose of Central Counterparties is to increase the vulnerability of the global financial system to single-point failure, and to provide additional extra-judicial power to bureaucrats who will be empowered to decide who gets to be a member of the Clearing Corporation.

This is considered to be far superior to a system in which the bank at risk makes a credit assessment and, when a trade is going their way, either gets collateral for the exposure or accepts an increment to Risk-Weighted Assets. Such a system would require banks such as CIBC to be as thoughtful about their counterparty exposure as Goldman Sachs; decent risk-management procedures in the industry would leave regulators with less to do.

With the new system, CIBC will be able to load up the Central Counterparty with billions in exposure to the Bank of Downtown Medicine Hat, without having to worry overmuch about its credit quality – the exposure will be covered by the other clearinghouse members.

One of the great problems with the Panic of 2007, we are told, was moral hazard. What I initially misunderstood was the regulators’ attitude: it’s not that they feel there was too much of it; they feel that there wasn’t enough, so they have designed a system to create more.

Sic transit gloria mundi.

Regulation

Basel III

The Basel Committee on Banking Supervision has released the Basel III: A global regulatory framework for more resilient banks and banking systems:

To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including central counterparties. The capitalisation of bank exposures to central counterparties (CCPs) will be based in part on the compliance of the CCP with such standards, and will be finalised after a consultative process in 2011. A bank’s collateral and mark-to-market exposures to CCPs meeting these enhanced principles will be subject to a low risk weight, proposed at 2%; and default fund exposures to CCPs will be subject to risk-sensitive capital requirements. These criteria, together with strengthened capital requirements for bilateral OTC derivative exposures, will create strong incentives for banks to move exposures to such CCPs. Moreover, to address systemic risk within the financial sector, the Committee also is raising the risk weights on exposures to financial institutions relative to the non-financial corporate sector, as financial exposures are more highly correlated than non-financial ones.

It is worthwhile thinking about how the CCP exposure will blow up – because it will, never fear! I have often stressed the poor design inherent in developing a system so exposed to long-term single point failure, but the desperate need of the regulators to be seen as doing something has overwhelmed such antiquated notions as common sense.

On the other hand, it is good to see that risk-weights on exposure to financial institutions is being raised, but the details need to be examined. Unfortunately, they appear to apply only to collateralized derivative transactions, not to bank paper itself.

They also tout the introduction of a leverage ratio cap:

One of the underlying features of the crisis was the build up of excessive on- and off-balance sheet leverage in the banking system. The build up of leverage also has been a feature of previous financial crises, for example leading up to September 1998. During the most severe part of the crisis, the banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital, and the contraction in credit availability. The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives:

  • constrain leverage in the banking sector, thus helping to mitigate the risk of the destabilising deleveraging processes which can damage the financial system and the economy; and
  • introduce additional safeguards against model risk and measurement error by supplementing the risk-based measure with a simple, transparent, independent measure of risk.

    17. The leverage ratio is calculated in a comparable manner across jurisdictions, adjusting for any differences in accounting standards. The Committee has designed the leverage ratio to be a credible supplementary measure to the risk-based requirement with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration.

The previously agreed capital requirements are confirmed:

All elements above are net of the associated regulatory adjustments and are subject to the following restrictions (see also Annex 1):

  • Common Equity Tier 1 must be at least 4.5% of risk-weighted assets at all times.
  • Tier 1 Capital must be at least 6.0% of risk-weighted assets at all times.
  • Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk-weighted assets at all times.

Of greatest interest to preferred share investors are the rules regarding eligibility for inclusion in “Additional Tier 1 Capital”. Most of this is a simple continuation of extant rules, but:

Dividend/coupon discretion:
a. the bank must have full discretion at all times to cancel distributions/payments(footnote)
b. cancellation of discretionary payments must not be an event of default
c. banks must have full access to cancelled payments to meet obligations as they fall due
d. cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.

footnote: A consequence of full discretion at all times to cancel distributions/payments is that “dividend pushers” are prohibited. An instrument with a dividend pusher obliges the issuing bank to make a dividend/coupon payment on the instrument if it has made a payment on another (typically more junior) capital instrument or share. This obligation is inconsistent with the requirement for full discretion at all times. Furthermore, the term “cancel distributions/payments” means extinguish these payments. It does not permit features that require the bank to make distributions/payments in kind.

Heretofore, it has been possible (unlikely, but possible) that preferred shares could default while Innovative Tier 1 Capital pays in full. If I’m reading this section correctly, the footnote means that, in principle if not necessarily in practice, all elements of Tier 1 Capital will be parri passu.

The footnote nearly gave me a heart attack, as in and of itself it appears to prohibit the preference of dividends; however, such an interpretation conflicts with point (d), which explicitly allows seniority to common.

Also of interest is section 12:

Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument.

This would appear to prohibit margining in stock accounts. Come to think of it, I’m not sure if this has ever been addressed: can you buy TD common on margin in your TDW account?

The discussion of subordinated debt is interesting:

May be callable at the initiative of the issuer only after a minimum of five years:
a. To exercise a call option a bank must receive prior supervisory approval;
b. A bank must not do anything that creates an expectation that the call will be exercised;(19) and
c. Banks must not exercise a call unless:
i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank(20); or
ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.(21)

Footnotes:

(19) An option to call the instrument after five years but prior to the start of the amortisation period will not be viewed as an incentive to redeem as long as the bank does not do anything that creates an expectation that the call will be exercised at this point.

(20) Replacement issues can be concurrent with but not after the instrument is called.

(21) Minimum refers to the regulator’s prescribed minimum requirement, which may be higher than the Basel III Pillar 1 minimum requirement.

In Canada, one wonders whether footnote (19) will prohibit bank-owned brokerages from quoting the yields on sub-debt to a presumed maturity due to a call at the start of the amortization period. It should; but this might damage the long term career prospects of OSFI personnel, so I’m not holding my breath.

Market pressures – due to the way sub-debt is sold – are so extreme as to make the call de facto mandatory; it is very disappointing that BIS is not addressing this problem.

Given the abuses that have ocdurred in the sub-debt market over the past few years due to market expectation of such a call, I am rather disappointed to see that such calls are still allowable.

Of interest to Citigroup is:

69. Deferred tax assets (DTAs) that rely on future profitability of the bank to be realised are to be deducted in the calculation of Common Equity Tier 1.

Citigroup now has a Tier 1 Capital Common Ratio of 2.16% and a Tier 1 Capital Ratio of 11.92%; although it looks like they’re playing games in the press release:

Citi remained one of the best capitalized banks with $125.4 billion of Tier 1 Capital and a Tier 1 Common ratio of 10.3% at the end of the third quarter 2010.

When in doubt, invent a new non-GAAP, non-BIS ratio, that’s what I say! The 2009 Annual Report is more forthcoming with calculation methodologies:

Of Citi’s approximately $46 billion of net deferred tax assets at December 31, 2009, approximately $15 billion of such assets were includable without limitation in regulatory capital pursuant to risk-based capital guidelines, while approximately $26 billion of such assets exceeded the limitation imposed by these guidelines and, as “disallowed deferred tax assets,” were deducted in arriving at Tier 1 Capital. Citigroup’s other approximately $5 billion of net deferred tax assets primarily represented approximately $3 billion of deferred tax effects of unrealized gains and losses on available-for-sale debt securities and approximately $2 billion of deferred tax effects of the pension liability adjustment, which are permitted to be excluded prior to deriving the amount of net deferred tax assets subject to limitation under the guidelines. Citi had approximately $24 billion of disallowed deferred tax assets at December 31, 2008.

Back to BIS … I’m very pleased to see this:

Banks are also required to make available on their websites the full terms and conditions of all instruments included in regulatory capital. The Basel Committee will issue more detailed Pillar 3 disclosure requirements in 2011.

Also of interest are the specifics of the Capital Conservation Buffer:

131. The table below shows the minimum capital conservation ratios a bank must meet at various levels of the Common Equity Tier 1 (CET1) capital ratios. For example, a bank with a CET1 capital ratio in the range of 5.125% to 5.75% is required to conserve 80% of its earnings in the subsequent financial year (ie payout no more than 20% in terms of dividends,share buybacks and discretionary bonus payments). If the bank wants to make payments in excess of the constraints imposed by this regime, it would have the option of raising capital in the private sector equal to the amount above the constraint which it wishes to distribute. This would be discussed with the bank’s supervisor as part of the capital planning process. The Common Equity Tier 1 ratio includes amounts used to meet the 4.5% minimum Common Equity Tier 1 requirement, but excludes any additional Common Equity Tier 1 needed to meet the 6% Tier 1 and 8% Total Capital requirements. For example, a bank with 8% CET1 and no Additional Tier 1 or Tier 2 capital would meet all minimum capital requirements, but would have a zero conservation buffer and therefore by subject to the 100% constraint on capital distributions.

Individual bank minimum capital conservation standards
Common Equity Tier 1 Ratio Minimum Capital Conservation Ratios (expressed as a percentage of earnings)
4.5% – 5.125% 100%
5.125% – 5.75% 80%
>5.75% – 6.375% 60%
>6.375% – 7.0% 40%
> 7.0% 0%

Unfortunately, the Countercyclical Buffer remains a matter of regulatory discretion:

Each Basel Committee member jurisdiction will identify an authority with the responsibility to make decisions on the size of the countercyclical capital buffer. If the relevant national authority judges a period of excess credit growth to be leading to the build up of system-wide risk, they will consider, together with any other macroprudential tools at their disposal, putting in place a countercyclical buffer requirement. This will vary between zero and 2.5% of risk weighted assets, depending on their judgement as to the extent of the build up of system-wide risk.

The leverage cap looks pretty loose

The Committee will test a minimum Tier 1 leverage ratio of 3% during the parallel run period from 1 January 2013 to 1 January 2017.

161. Banks should calculate derivatives, including where a bank sells protection using a credit derivative, for the purposes of the leverage ratio by applying:

  • the accounting measure of exposure plus an add-on for potential future exposure calculated according to the Current Exposure Method as identified in paragraphs 186, 187 and 317 of the Basel II Framework. This ensures that all derivatives are converted in a consistent manner to a “loan equivalent” amount; and
  • the regulatory netting rules based on the Basel II Framework.

(iii) Off-balance sheet items
162. This section relates to off-balance sheet (OBS) items in paragraphs 82-83, (including 83(i)), 84(i-iii), 85-86, and 88-89) of the Basel II Framework. These include commitments (including liquidity facilities), unconditionally cancellable commitments, direct credit substitutes, acceptances, standby letters of credit, trade letters of credit, failed transactions and unsettled securities. The treatment of the items included in 83(ii) and 84, ie repurchase agreements and securities financing transactions is addressed above.

163. The Committee recognises that OBS items are a source of potentially significant leverage. Therefore, banks should calculate the above OBS items for the purposes of the leverage ratio by applying a uniform 100% credit conversion factor (CCF).

164. For any commitments that are unconditionally cancellable at any time by the bank without prior notice, banks should apply a CCF of 10%. The Committee will conduct further review to ensure that the 10% CCF is appropriately conservative based on historical experience.

It’s going to take quite a while to digest all this!