Archive for the ‘Regulation’ Category

OSFI’s Zelmer Advocates Increased Micro-Management

Thursday, June 26th, 2014

Mark Zelmer gave a speech touting OSFI at the C.D. Howe Institute Housing Policy Conference titled OSFI is on the Case: Promoting Prudent Lending in Housing Finance:

But, by same token, it is clear that the ability of the household sector as a whole to absorb major shocks is less now than it was a decade ago. Moreover, with interest rates near record low levels, there is not much scope for interest rates in Canada or the United States to fall further – something that helped people weather storms in the past. Governor Poloz recently noted in his testimony before the Senate that the Bank of Canada continues to expect a soft landing for the housing market and Canada’s household debt-to-income ratio to stabilize.Footnote 2 But he also acknowledged that imbalances in the housing sector remain elevated and could pose a significant risk should economic conditions deteriorate.

So from a prudential perspective, the environmental risks associated with lending to households are higher now than in the past. With interest rates expected to remain exceptionally low and household indebtedness high, these risks are likely to remain elevated for the foreseeable future.

Well, in the first place, he disingenuously declines to acknowledge the fact that from the banks’ perspective, a huge proportion of their mortgage debt is just as credit-worthy as Canada bonds, given that it’s insured by CMHC. This is the chief imprudence in the current situation and, I believe, the primary source of whatever bubble there might be in the housing market.

He then tries to insert a little revisionist history into the equation:

You may wonder what more a prudential supervisor really needs to do if lenders and private mortgage insurers are well capitalized. But in stress situations, creditors and investors often lose confidence in these institutions before they run out of capital. Recall that some financial institutions lost access to funding markets in the midst of the global financial crisis even though they were reporting healthy regulatory capital ratios at the time. Sitting back and relying on capital is not enough for either financial institutions or prudential supervisors.

Yes, and I also recall that numerous financial institutions went bust even though they were reporting healthy regulatory capital ratios. So let’s not have any more nonsense about healthy regulatory capital ratios.

In the wake of the global financial crisis, many observers are suggesting that bank regulators need to think about their tool kit and employ macro‑prudential tools like changes in loan‑to‑value limits to lean against rising environmental risks. But at OSFI we believe it makes more sense to promote prudent lending all of the time. Hence, the 80 per cent loan‑to‑value limit on conventional mortgages enshrined in the federal legislation; and, where necessary, deep dives like the ones I just described in the current environment.

Conveniently, none of these observers are named or cited, so we can’t check up on this. But the bit about ‘prudent lending’ is a little odd: is he saying that extending a mortgage is imprudent even when it carries a 100% government guarantee?

By the same token, let me note the focus in the B-20 and B-21 guidelines on governance and risk management principles. Such principles are meant to stand the test of time. They do not lend themselves to hard limits that one can vary in response to changing economic and financial conditions.

Frankly, OSFI generally prefers to take a principles-based approach in setting our regulatory and supervisory expectations. Hard limits like the 65 per cent LTV limit on Home Equity Lines of Credit (HELOCs) are more the exception than the rule. The key advantage of a principles-based approach is that it provides us the flexibility we need to tailor supervisory expectations to the situation at hand. This avoids safe harbours and compliance mentalities that breed complacency on the part of regulated entities, not to mention supervisors. Instead, principles help to underscore the point that regulated institutions are expected to use judgment and apply the guidelines to the situations they face on the ground within their own organizations.

And this is exactly the problem: the last thing we need is more herd mentality and nod-and-wink regulation; we know where that got us with Manulife in Canada and other institutions in other places.

All his points about high consumer debt-to-income ratios and so on is not an indicator of the need for principles-based regulation; it is indicative of a need for a counter-cyclical capital buffer. Why don’t we see any interest, let alone any research, into a counter-cyclical capital requirement based on debt-to-income? Funded by, but certainly not executed by, OSFI – we know what happens when those guys pretend to be academics.

At the end of the day, mortgage lenders and insurers must accept that they are responsible for the loans they are granting and insuring, and thus the risks they are running.

Ha! No they ain’t, buddy. The Feds are responsible for CMHC losses … no moral hazard there, no sir, not one bit!

Update: On a related note, Mark Gilbert of Bloomberg writes about Mark Carney’s Central Bank Mission Creep:

No matter how Governor Mark Carney dresses it up, the Bank of England’s decision today to impose caps on mortgage lending amounts to an explicit effort by the central bank to manage asset prices.

Today, he said: “We don’t target house prices, we care about indebtedness. We think that price dynamics in the housing market are going to slow in about a year as incomes pick up.”

There was also a half-buried message in today’s press conference about the central bank’s reluctance to raise interest rates for fear of missing its target of getting inflation back up to an annual pace of 2 percent. By imposing restrictions on lenders, “monetary policy does not need to be diverted to address a sector-specific risk in the housing market,” Carney said. In other words, if Carney can cool the housing market with tighter controls on mortgages, he can keep rates lower for longer.

Market-Based Bank Capital Regulation

Wednesday, March 5th, 2014

Assiduous Reader DR sent me the following query:

Today’s Financial Posts has an article “A better Basel mousetrap to protect taxpayers”, by Finn Poschmann regarding NVCC.

What is your opinion?

A short search brought up the article in question, A Better Basel Mousetrap to Protect Taxpayers, which in turn led me to the proposal by Jeremy Bulow and Paul Klemperer titled Market-Based Bank Capital Regulation:

Today’s regulatory rules, especially the easily-manipulated measures of regulatory capital, have led to costly bank failures. We design a robust regulatory system such that (i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices). One key innovation is “ERNs” (equity recourse notes — superficially similar to, but importantly distinct from, “cocos”) which gradually “bail in” equity when needed. Importantly, although our system uses market information, it does not rely on markets being “right.”

Our solution is based on two rules. First, any systemically important financial institution (SIFI) that cannot be quickly wound down must limit the recourse of non-guaranteed creditors to assets posted as collateral plus equity plus unsecured debt that can itself be converted into equity–so these creditors have some recourse but cannot force the institution into re-organization. Second, any debt guaranteed by the government, such as deposit accounts, must be backed by government-guaranteed securities. This second rule can only realistically be thought of as a very long-run ambition – our interim objective would involve a tight ring-fence of government-guaranteed deposits collateralized by assets that are haircut at rates similar to those applied by lenders (including central banks3 and the commercial banks themselves!) to secured borrowers.

Specifically: first, we would have banks replace all (non-deposit) existing unsecured debt with “equity recourse notes” (ERNs). ERNs are superficially similar to contingent convertible debt (“cocos”) but have important differences. ERNs would be long-term bonds, subject to certain term-structure requirements, with the feature that any interest or principal payments payable on a date when the stock price is lower than a pre-specified price would be paid in stock at that pre-specified price. The pre-specified price would be required to be no less than (say) 25 percent of the share price on the date the bond was issued. For example, if the stock were selling at $100 on the day a bond was issued and then fell below $25 by the time a payment of $1000 was due, the firm would be required to pay the creditor (1000/25) = 40 shares of stock in lieu of the payment. If the stock rebounded in price, future payments could again be in cash.

Crucially, for ERNs, unlike cocos:

  • any payments in shares are at a pre-set share price, not at the current share price or at a discount to it—so ERNs are stabilizing because that price will always be at a premium to the market
  • conversion is triggered by market prices, not regulatory values—removing incentives to manipulate regulatory measures, and making it harder for regulators to relax requirements
  • conversion is payment-at-a-time, not the entire bond at once (because ERNs become equity in the states that matter to taxpayers, they are, for regulatory purposes, like equity from their date of issuance so there is no reason for faster conversion)–further reducing pressures for “regulatory forbearance” and also largely solving a “multiple equilibria” problem raised in the academic literature
  • we would replace all existing unsecured debt with ERNs, not merely a fraction of it—ensuring, as we show below, that ERNs become cheaper to issue when the stock price falls, creating counter-cyclical investment incentives when they are most needed.

OK, so I have difficulties with all this. Their first point is that non-guaranteed creditors “cannot force the institution into re-organization.” Obviously there are many differences of opinion in this, but I take the view that being able to force a company into re-organization – which may include bankruptcy – is one of the hallmarks of a bond. For example, I consider preferred shares to be fixed income – as they have a cap on their total return and they have first-loss protection – but I do not consider them bonds – as they cannot force bankruptcy. The elimination of bankruptcy, although very popular among politicians (who refer to bankruptcy as a form of terrorism) is a very big step; bankruptcy is a very big stick that serves to concentrate the minds of management and directors.

Secondly, they want insured deposits to be offset by government securities. There’s an immediate problem about this in Canada, because insured deposits total $646-billion while government of Canada marketable debt totals $639-billion. You could get around this by saying the CMHC-guaranteed mortgages are OK, but even after years of Spend-Every-Penny pouring fuel on the housing fire, CMHC insurance totals only $559.8-billion (out of a total of $915-billion. At present, Canadian Chartered Banks hold only about $160-billion of government debt. So it would appear that, at the very least, this part of the plan would essentially force the government to continue to insure a ridiculous proportion of Canadian residential mortgages.

And, specifically, they want all (non-deposit) existing unsecured debt with “equity recourse notes”. OK, so how much is that? Looking at recent figures from RBC:

Click for Big

So roughly a quarter of Royal Bank’s liabilities would become ERNs …. and who’s going to buy it? It’s forcibly convertible into equity long before the point of non-viability – that’s the whole point – so for risk management purposes it is equity. If held by another bank, it will attract a whopping capital charge (or if it doesn’t, it should) and it can’t be held by institutional bond portfolios (or if it is, it shouldn’t be). I have real problems with this.

The paper makes several entertaining points about bank regulation:

The regulatory system distorts incentives in several ways. One of the motivations for Citigroup to sell out of Smith, Barney at what was generally believed to be a low price, was that it allowed Citi to book an increase in regulatory capital. Conversely, selling risky “toxic assets” with a regulatory value greater than market is discouraged because doing so raises capital requirements even while reducing risk.[footnote].

[Footnote reads] : Liquidity reduction is another consequence of the current regulatory system, as firms will avoid price-discovery by avoiding buying as well as selling over-marked assets. For example, Goldman Sachs stood ready to sell assets at marks that AIG protested were too low, but AIG did not take up these offers. See Goldman Sachs (2009). For an example of traders not buying even though they claimed the price was too low, see the FCIC transcript of a July 30, 2007 telephone call between AIG executives. “We can’t mark any of our positions, and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back … then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.” Duarte (2012) discusses the recent trend of European banks to meet their requirements to raise regulatory capital by repurchasing their own junk bonds, arguably increasing the exposure of government insurers.

However, don’t get me wrong on this: the basic idea – of conversion to a pre-set value of stock once the market breaches that pre-set value – is one that I’ve been advocating for a long time. They are similar in spirit to McDonald CoCos, which were first discussed on PrefBlog under the heading Contingent Capital with a Dual Price Trigger (regrettably, the authors did not discuss McDonald’s proposal in their paper). ERNs are ‘high-trigger’ instruments, and therefore will help serve to avert a crisis, rather than merely mitigate one, as is the case with OSFI’s NVCC rules; I have long advocated high triggers.

My basic problem is simply that the authors:

  • Require too many ERNs as a proportion of capital, and
  • Seek to Ban the Bond

However, it may easily be argued that these objections are mere matters of detail.

New RBC / NA / CWB reset prefs

Monday, February 3rd, 2014

I have been asked, in an eMail with the captioned title:

Not sure this is going to the right place. Can’t find anyone else to send these comments to.

I owned a number of bank “rate reset” prefs. In the past year, many have been redeemed, and a few have been reset for another 5 years.

There are 3 new issues that recently came out (RY / NA / CWB) with changes to factor in the new Basel capital requirements. My understanding is that basically, if real bad things happen to the bank, the shares can be converted to commons without the holders consent.

In my mind, this is a major negative change to an investor’s position compared to the previous reset prefs. But the pricing of these new issues (either the rate or reset premium) does not seem to give any value to the additional risk. In addition, there does not seem to be any discussion or commentary of the additional exposure anywhere. Is it possible that the people selling these new issues might have a bit of a conflict position (the brokerage houses are all owned by the banks).

Do you have any thoughts on this? If you agree, how does one convince the market that the pricing needs to be adjusted?

I would appreciate any comments you might have – maybe I’m missing something in my thinking. Thank you.

The new issues referred to are:

The desire for change is fueled by political resentment that European banks were bailed out while Tier 1 Capital note-holders were not wiped out and in some cases were unscathed (see my article Prepping for Crises; particularly the footnoted draft version. Or you could just google “burden sharing”).

As I have stressed in the past the big problem is that the Superintendent of Financial Institutions has a huge amount of discretion:

Principle # 3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum Footnote 41, include the following trigger events:

  • a.
    the Superintendent of Financial Institutions (the “Superintendent”) publicly announces that the institution has been advised, in writing, that the Superintendent is of the opinion that the institution has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or

  • b. a federal or provincial government in Canada publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the institution would have been determined by the Superintendent to be non-viable Footnote 42.

The term “equivalent support” in the above second trigger constitutes support for a non-viable institution that enhances the institution’s risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. For greater certainty, and without limitation, equivalent support does not include:

  • i. Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate;
  • ii. open bank liquidity assistance provided by CDIC at or above its cost of funds; and
  • iii. support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation.

In addition, shares of an acquiring institution paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution.

The first trigger is the tricky one, although there are also problems with number 2.

This uncertainty has led DBRS to rate these issues a notch lower than other bank issues (in line with S&P’s earlier decision), but there doesn’t appear to be any market recognition of this analysis.

This is precisely what the regulator wants – they have long been in favour of a low trigger for contingent conversion, in opposition to much of the rest of the world. As discussed on October 27, 2011 (the internal link is broken as part of OSFI’s policy to discourage public discussion of their pronouncements), OSFI dismissed high-triggers; while there were lots of rationalizations in their NVCC roadshow, the real reason was articulated by Ms. Dickson in a speech:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the supervisor has determined that the bank is no longer viable as currently structured. This should result in the contingent instrument being priced as debt. Being priced as debt is critical, as it makes it far more affordable for banks, and therefore has the benefit of minimizing the impact on the costs of consumer and business loans.

So to hell with high-trigger CoCos and their potential to avert a crisis! In normal times, it will be cheaper for the banks to issue low-trigger CoCos and thereby be able to pay their directors more, particularly the ones who are ex-regulators.

So that’s the background. With respect to the reader’s question:

If you agree, how does one convince the market that the pricing needs to be adjusted?

Well, you can’t, really. I get a lot more requests to recommend bank issues, good solid Canajun banks, none of this insurance or utility garbage, on the grounds of “safety”, than I get requests to comment on risk factors particularly applicable to bank issues.

All you can do is make your own assessment of risk and your own assessment of reward, feed all your analysis into the sausage-making machine, hope you’ve made fewer analytical errors than other market participants and that the world doesn’t change to such a degree that analysis was useless anyway. Which isn’t, perhaps, the most detailed advice I have ever given, but it’s the best I can do.

Contingent Capital: The Case for COERCs

Saturday, April 6th, 2013

A question in the comments to my old post A Structural Model of Contingent Bank Capital led me to look up what Prof. George Pennacchi has been doing lately; together with Theo Vermaelen and Christian C. P. Wolff he has written a paper titled Contingent Capital: The Case for COERCs:

In this paper we propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts to equity when the market value of equity or capital falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden, large declines in value. Moreover, the structure eliminates concerns of an equity price “death spiral” as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses. Furthermore, COERCs reduce the problem of “debt overhang,” the disincentive to replenish shareholders’ equity following a decline.

The basic justification for the COERCs is:

In contrast to the Credit Suisse coco bond [with accounting and regulatory triggers], the trigger is based on market value based leverage ratios, which are forward looking, rather than backward looking, measures of financial distress. It also means that at the time of the triggering event the stock price is known, unlike in the case of coco bonds with accounting based capital ratio triggers. As the trigger is driven by the market and not by regulators, regulatory risk is avoided. The conversion price is set at a large discount from the market price at the time of conversion, which means that conversion would generate massive shareholder dilution. However, in order to prevent this dilution, shareholders have an option to buy back the shares from the bondholders at the conversion price. In practice, what will happen is that when the trigger is reached, the company will announce a rights issue with an issue price equal to the conversion price and use the proceeds to repay the debt. As a result, the debt will be (almost) risk-free. In our simulations, we show that it is possible to design a COERC in such a way that the fair credit spread is 20 basis points above the risk-free rate. So although the shareholders are coerced to repay the debt, the benefit from this coercion is reflected in the low cost of debt as well as the elimination of all direct and indirect costs of financial distress. Although at the time of the trigger, the company will announce an equity issue, there is no negative signal associated with the issuance as the issue is the automatic result of reaching a pre-defined trigger.

Market based triggers are generally criticised because they create instability: bond holders have an incentive to short the stock and trigger conversion. Moreover, the fear of dilution may encourage shareholders to sell their shares so that the company ends up in a self-fulfilling death spiral. However, because in a COERC shareholders have pre-emptive rights in buying the shares from the bondholders, they can undo any conversion that is result of manipulation or unjustified panic. Moreover, because bondholders will generally be repaid, they have no incentive to hedge their investment by shorting the stock when the leverage ratio approaches the trigger, unlike the case of coco bonds where bondholders will become shareholders after the triggering event. The design of the contract also discourages manipulation by other bondholders. Bolton and Samama (2010) argue that other bond-holders may want to short the stock to trigger conversion, in order to improve their seniority. However, because the COERCs will be repaid in these circumstances such activity will not improve other bondholder’s seniority.

Further justification is given as:

Our objective is to propose an alternative, an instrument that a value maximizing manager would like to issue, without being forced by regulators. Companies are coerced to issue equity and repay debt by fear of dilution, not by the decision of a regulator. Imposing regulation against the interest of the bank’s shareholders will encourage regulatory arbitrage and may also reduce economic growth.6 If bankers, on the other hand, can be convinced that issuing contingent capital increases shareholder value, then any regulatory “encouragement” to issue these securities will be welcomed. Our proposal is therefore more consistent with a free market solution to the general problem that debt overhang discourages firms from recapitalizing when they are in financial distress. Hence the COERC should be of interest to any corporation where costs of financial distress are potentially important.

It seems like a very good idea. One factor not considered in the paper is the impact on equity investors.

Say you have an equity holding in a bank that has a stock price (and the fair value of the stock price) slightly in excess of the trigger price for its COERCs. At that point, buyers of the stock (and continuing holders!) must account for the probability that the conversion will be triggered and their will be a rights issue. Therefore, in order to avoid dilution, they must not only pay the fair market value for the stock, but they must also have cash on hand (or credit lines) available that will allow them to subscribe to the rights offering; the necessity of having this excess cash will make the common less attractive at its fair market value. This may serve to accelerate declines in the bank’s stock price.

It is also by no means assured that shareholders will be able to sell the rights anything close to their fair value.

A Goldman Sachs research report titled Contingent capital Possibilities, problems and opportunities is also of interest. Canadians panic-stricken by the recent musings in the federal budget (see discussion on April 1, April 2 and April 5) will be fascinated by:

Bail-in is a potential resolution tool designed to protect taxpayer funds by converting unsecured debt into equity at the point of insolvency. Most bail-in proposals would give regulators discretion to decide whether and when to convert the debt, as well as how much.

There is an active discussion under way as to whether bail-in should be a tool broadly applicable to all forms of unsecured credit (including senior debt) or whether it should be a specific security with an embedded write-down feature.

Naturally, this discussion is not being held in Canada; we’re too stupid to be allowed to participate in intelligent discussions.

As might be expected, GS is in favour of market-based solutions and consequent ‘high-trigger’ contingent capital:

Going-concern contingent capital differs substantially from the gone-concern kind. It is designed to operate well before resolution mechanisms come into play, and thus to contain financial distress at an early stage. The recapitalization occurs at a time when there is still significant enterprise value, and is “triggered” through a more objective process with far less scope for regulatory discretion. For investors to view objective triggers as credible, however, better and more-standardized bank disclosures will be needed on a regular basis. Because this type of contingent capital triggers early, when losses are still limited, it can be issued in smaller tranches. This, in turn, allows for greater flexibility in
structuring its terms.

When the early recapitalization occurs, control of the firm can shift from existing shareholders to the contingent capital holders, and a change in management may occur. The threat of the loss of control helps to strengthen market discipline by spurring the firm to de-risk and de-leverage as problems begin to emerge. As such, going-concern contingent capital can be an effective risk-mitigating tool.

GS further emphasizes the need to appeal to fixed income investors:

Contingent capital will only be viable as a large market if it is treated as debt

Whether “going” or “gone,” contingent capital will only be viable as a large market if it is treated as debt. This is not just a question of technical issues like ratings, inclusion in indices, fixed income fund mandates and tax-deductibility, though these issues are important. More fundamentally, contingent capital must be debt in order to appeal to traditional fixed income investors, the one market large enough to absorb at least $925 billion in potential issuance over the next decade.

Surprisingly, GS is in favour of capital-based triggers despite the problems:

A capital-based trigger would force mandatory conversion if and when Tier 1 (core) capital fell below a threshold specified either by regulators (in advance) or in the contractual terms of the contingent bonds. We think this would likely be the most effective trigger, because it is transparent and objective. Investors would be able to assess and model the likelihood of conversion if banks’ disclosure and transparency are enhanced. Critically, a capital-based trigger removes the uncertainty around regulatory discretion and the vulnerability to market manipulation that the other options entail.

Capital-based triggers are also vulnerable to financial reporting that fails to accurately reflect the underlying health of the firm. Lehman Brothers, for example, reported a Tier 1 capital ratio of 11% in the period before its demise – well above the regulatory minimum and a level most would have considered healthy. The same was true for Bear Stearns and Washington Mutual before they were acquired under distress. We think this issue must be resolved for investors to embrace capital-based triggers.

Fortunately there are several ways to make capital ratios more robust, whether by “stressing” them through regulator-led stress tests or by enforcing more rigorous and standardized disclosure requirements that would allow investors to better assess the health of the bank. Such standardized disclosures could relieve regulators of the burden of conducting regular stress tests, and would significantly enhance transparency. The value of stress testing and greater disclosures is one lesson from the financial crisis. The US Treasury’s 2009 stress test illustrates this point vividly. While not perfect, it offered greater
transparency and comparability of bank balance sheets than investors were able to derive from public filings. With this reassurance, investors were willing to step forward and commit capital. The European stress test proves the point as well: it did not significantly improve transparency and thus failed to reassure investors or attract capital.

That is the crux of the matter and I do not believe that the Gordian Knot can be cut in the real world. The US Treasury made their stress test strict and credible because it knew in advance that its banks would pass. The Europeans made their stress test ridiculous and incredible because they knew in advance that their banks would fail.

I liked their succinct dismissal of regulatory triggers:

While flexibility can be helpful, particularly given that no two crises are alike, recent experience shows that some regulators may be hesitant to publicly pronounce that a financial firm is unhealthy, especially during the early stages of distress. There is, after all, always the hope that the firm’s problems will be short-lived, or that an alternative solution to the triggering of contingent capital can be found. Thus a regulator may be unlikely to pull the trigger – affecting not only the firm and all of its stakeholders, but also likely raising alarm about the health of other financial firms – unless it is certain of a high degree of distress. By then, losses may have already risen to untenable levels, which is why this type of trigger is associated with gone-concern contingent capital.

GS emphasizes the importance of the indices:

The inclusion of contingent capital securities in credit indices will also be an important factor, perhaps even more important than achieving a rating. This is because the inclusion itself would attract investors, who otherwise might risk underperforming benchmarks by being underweight a significant component of the index. Credit indices currently do not include mandatorily convertible equity securities, although they can include instruments that allow for loss absorption through a write-down feature. This again contributes to the appeal of the write-down feature (rather than the simple conversion to equity) to most fixed income investors. If contingent capital securities were included in credit indices, this addition would be likely to drive a substantially deeper contingent capital market.

Here in Canada, of course, the usual benchmark is prepared by the TMX, which the regulators allowed to become bank-owned on condition that it improved the employment prospects for regulators. It’s a thoroughly disgraceful system which will blow up in all our faces some days and then everybody will pretend to be surprised.

GS is dismissive of regulatory triggers and NVCC:

A discretionary, “point of non-viability” trigger would likely be attractive to many regulators as it helps them to preserve maximum flexibility in the event of a financial crisis. This can be useful given that no two crises are exactly alike. It could also allow regulators to consider multiple factors – including the state of the overall financial system – when making the decision to pull the trigger. Discretion also gives regulators the opportunity to exercise regulatory forbearance away from the public spotlight.

Yet we believe this preference for discretion and flexibility makes it difficult for regulators to meet one of their most important – yet mostly unspoken – goals, which is to develop a viable contingent capital market. Regulators have certainly solicited feedback from investors, but some seem to believe that simply making contingent capital mandatory for issuers means that investors will buy them. However, from conversations with many investors, we believe that regulators may need to move toward a more objective trigger; if not, the price of these instruments may be prohibitive.

There is another set of participants in a potential contingent capital market: taxpayers. Regulators represent taxpayers’ interests by promoting systemic stability and requiring robust loss-absorption capabilities at individual banks. But the interests of regulators and taxpayers may not always be fully aligned. If taxpayers’ principal goal is to avoid socializing private-sector losses, and to prevent the dislocation of a systemic crisis even in its early stages, then they should want a stringent version of contingent capital – one that converts to equity at a highly dilutive rate, based on an early and objective trigger. The discretion and flexibility inherent in regulatory-triggered gone-concern contingent capital may have less appeal to taxpayers. From their standpoint, gone-concern contingent capital might well have allowed a major financial firm to fail, causing job losses and other disruptions across the financial system. Taxpayers may find the potential risk-reducing incentives created by going-concern contingent capital to be a more robust answer to the problem of too big to fail.

Goldman’s musings on investor preference can be taken as an argument in favour of COERCs:

Traditional fixed-income investors will likely want contingent capital to have a very low probability of triggering, which leads them to prefer an objective, capital-based and disclosure-enhanced trigger. Many investors have indicated their concerns about the challenges of modeling a discretionary trigger: it is very difficult to model the probability of default, the potential loss given default or even the appropriate price to pay for a security that converts under a discretionary and opaque process. Greater transparency is a prerequisite for a capital-based trigger to be seen as credible by investors, because they will need to have greater confidence that banks’ balance sheets reflect reality. We also believe that investors would be more likely to embrace a capital-based trigger if the terms were quite stringent, thereby lowering the probability of conversion.

OSFI: Ineffectual, Uninformed Grandstanding on D-SIBs

Wednesday, March 27th, 2013

The Office of the Superintendent of Financial Institutions has announced:

Canada’s six largest banks have been identified as being of domestic systemic importance, and will be subject to continued supervisory intensity, enhanced disclosure, and a one per cent risk weighted capital surcharge by January 1, 2016.

Grant Robertson of the Globe claims:

The move is designed to avert a liquidity crisis in the sector, and comes on top of the 7 per cent of capital that the Office of the Superintendent of Financial Institutions (OSFI) requires them to hold, which can be easily liquidated by the banks during a time of financial pressure to stabilize operations.

This shows a common confusion between “liquidity” and “solvency”. If you own a house worth a million with no mortgage, but can’t pay for groceries, you are solvent, but illiquid. If you pay for the groceries with all that’s left of the 1.5-million mortage you took on the place five years ago, you are liquid, but insolvent. There was a time when reporters were familiar with their subjects and had the names and ‘phone numbers of experts available to explain arcane elements of business news. Imagine that!

The adjustment to the capital rules under discussion here addresses expectations of solvency but do nothing directly to address liquidity.

Be that as it may, OSFI provided some charts with its cover letter to the banks:

Click for Big

As is OSFI’s habit, the Advisory giving effect to the decision, Domestic Systemic Importance and Capital Targets – DTIs, makes only the slightest possible effort to explain the decision:

The common equity surcharge associated with D-SIB status in Canada will be 1% Risk Weighted Assets (RWA).This surcharge takes into account the structure of the Canadian financial system, the importance of large banks to this financial architecture, and the expanded regulatory toolkit to resolve a troubled financial institution. This means that banks designated as a D-SIB will be required to meet an all-in Pillar 1 target common equity Tier 1 (CET1) of 8% RWA commencing January 1, 2016. The 1% capital surcharge will be periodically reviewed in light of national and international developments. This is consistent with the levels and timing set out in the BCBS D-SIB framework.

The BCBS D-SIB framework provides for national discretion to accommodate characteristics of the domestic financial system, and other local features, including the domestic policy framework. The additional capital surcharge for banks designated as systemically important provides credible additional loss absorbency given:

  • Extreme loss events as a percentage of RWA among this peer group over the past 25 years would be less than the combination of the CET1 (2.5%) capital conservation buffer and an additional 1%; and
  • Current business models of the six largest banks are generally less exposed to the fat tailed risks associated with investment banking than some international peers, and the six largest banks have a greater reliance on retail funding models compared to wholesale funding than some international peers – features that proved beneficial in light of the experience of the last financial crisis.
  • From a forward looking perspective:
    • o Canadian banks that hold capital at current targets plus a 1% surcharge (i.e. 8%) should be able to weather a wide range of severe but plausible shocks without becoming non-viable; and
    • o The higher loss absorbency in a crisis scenario (conversion to common equity or permanent write downs) of the 2% to 3% non-common equity capital in Tier 1 and subordinated debt in total capital required by Basel III also adds to the resiliency of banks.

It gives me a warm feeling inside knowing that OSFI has looked at the past twenty-five years of history to gauge extreme loss events; the Basel II guidelines supposedly calibrated more stringently:

The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years.

OSFI’s document has a few references, but only to other OSFI documents and a few Basel Committee on Banking Supervision hymn books; nothing of any meat, nothing that would provide any comfort that these guys have thought things through and know what they’re doing – but OSFI’s institutional intellectual dishonesty is well known.

Their efforts may be compared – just for starters – with a paper titled Australia: Addressing Systemic Risk Through Higher Loss Absorbency—Technical Note, published by the IMF and reposted by the Australian Prudential Regulation Authority. One of the useful features of this report is “Table 4. Cross-Country Comparison of Approaches to D-SIBs”, which – although one can hardly credit it – looks at what other countries are doing! Here’s an extract:

Country HLA
Singapore 2 percent additional by 2015
Sweden Accelerated adoption of Basel III; plus 3 percent by 2013; 5 percent by 2015
Switzerland 19 percent of RWA total capital, of which up to 9 percent cocos, by 2016
United Kingdom Proposal: 3 percent additional to Basel III and up to 17 percent of RWA loss absorbency for the largest institutions and ring-fenced entities
United States Supplementary Tier 1 of 3 percent of RWA for complex institutions

Now it may very well be that OSFI is taking a prudent route in being so much more lenient with the banks than their international counterparts – but you’d never know it from reading OSFI material. Canadians are forced to take it on trust that the banking regulator knows what it’s doing; and OSFI’s arrogance makes such trust an awfully scarce commodity.

One highly recommended example of how a prudential regulator should operate is the UK’s Independent Commission on Banking – Final Report Recommendations – September 2011:

The Independent Commission on Banking (the Commission) was established by the Government in June 2010 to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition. The Commission was asked to report to the Cabinet Committee on Banking Reform by the end of September 2011. Its members are Sir John Vickers (Chair), Clare Spottiswoode, Martin Taylor, Bill Winters and Martin Wolf.

This report has one of its recommendations highlighted in the table extracted above:

As to that, the Commission recommends that the retail and other activities of large UK banking groups should both have primary loss-absorbing capacity of at least 17%-20%. Equity and other capital would be part of that (or all if a bank so wished). Primary loss absorbing capacity also includes long-term unsecured debt that regulators could require to bear losses in resolution (bail-in bonds). If market participants chose, and regulators were satisfied that the instruments were appropriate, primary loss-absorbing capacity could also include contingent capital (‘cocos’) that (like equity) takes losses before resolution. Including properly loss-absorbing debt alongside equity in this way offers the benefit that debt holders have a particular interest, in a way that equity holders do not, in guarding against downside risk. If primary loss-absorbing capacity is wiped out, regulators should also have the power to impose losses on other creditors in resolution, if necessary.

Assiduous Readers will recognize that I have a fundamental distaste for the trashing of five hundred years of bankruptcy law implied by the last sentence, but at least the rationale is spelt out in credible format – far different from the Canadian model.

OSFI: Life Insurance Regulatory Framework

Thursday, October 4th, 2012

On September 5 the Office of the Superintendant of Financial Institutions announced:

released a Life Insurance Regulatory Framework to provide life insurance companies and industry stakeholders with an overview of regulatory initiatives that OSFI will be focusing on over the period ending 2016. It outlines how the regulatory framework will evolve to ensure Canadians continue to benefit from a strong life insurance industry.

“In laying out OSFI’s initiatives, we hope to encourage discussion and strong participation by industry stakeholders in our regulatory development process,” said Mark Zelmer, Assistant Superintendent, Regulation Sector. “Canadians have benefited from a strong life insurance industry and a flexible, effective regulatory framework. Our initiatives aim to ensure this continues.”

The Framework outlines OSFI’s priorities and addresses issues such as corporate governance and risk management, evolving regulatory capital requirements, and promoting transparent information on the financial condition of life insurance companies to support the regulatory framework.

“This framework addresses OSFI’s key regulatory objectives and its approach to refining regulatory oversight and guidance that is already robust,” continued Mr. Zelmer. “By issuing the regulatory framework at this time, OSFI hopes it will help life insurers and industry stakeholders in their planning processes.”

I missed this at the time, but it was brought to my attention by Assuiduous Reader dudsy in the comments to another thread.

The document is titled Life Insurance Regulatory Framework. Naturally, my main concern is to parse the text for any hints about the application of the NVCC rule to insurers and insurance holding companies:

OSFI recognizes that life insurance companies are in many ways significantly different than banks, particularly due to the long-term nature of traditional life insurance business. Therefore, in considering these developments, OSFI will not indiscriminately implement any of them (e.g., Basel III) into the life insurance regulatory framework.

To achieve these objectives, OSFI will introduce enhancements to the regulatory framework for life insurance companies through:…Revised regulatory capital requirements guidance that:…Links risk measures to the quality of capital
available to absorb losses

OSFI is approaching the review of the regulatory capital requirements with the belief that, in aggregate, the industry currently has adequate financial resources (total assets) for its current risks.

Capital will improve in terms of its ability to absorb losses, from the perspective of both a “going concern” and a “gone concern” basis.

The last seems quite encouraging, as far as NVCC is concerned. More important to OSFI, however is plausible justification for mission creep and increased employment at OSFI:

OSFI may need more specialized resources as these initiatives are incorporated into our regulatory and supervisory frameworks.

They’re going to introduce something called ORSA, which does not, surprisingly, stand for OSFI Retirees Superannuation Arrangement, but Own Risk and Solvency Assessment:

The minimum capital requirements set in OSFI’s regulatory framework may not be adequate to address this institution-specific risk-taking, as the regulatory capital requirements are based on industry averages which, at any point in time, may not fully capture new risk exposures or product developments. For this reason, institutions should have their ORSA process. Life insurance companies should not simply rely on minimum regulatory capital requirements as a proxy or as a starting point for measuring their own risk profile.

ORSA should not be seen as an OSFI compliance requirement but as a sound business practice. This will be reflected in the principles-based approach OSFI will outline in the ORSA Guideline. The ORSA Guideline will build on existing industry practice and OSFI guidance while considering international practices, in addition to seeking input and perspective from Canadian industry stakeholders.

In the section titled “Evolving Regulatory Capital Requirements”, they say:

The objective of this review is to improve our regulatory capital requirements by:…Improving Risk Measurement…Recognize the quality of capital available to absorb losses on both a “going concern” and a “gone concern” basis

The evolution of regulatory capital requirements into a more risk sensitive framework may result in more volatile regulatory capital requirements (capital available and/or capital required). OSFI will consult with industry to assess whether that volatility provides a true reflection of the evolution of the risk and is thus “appropriate” for purposes of setting regulatory capital requirements, or whether the volatility in capital requirements amplifies the variations in risk and is thus “inappropriate.”

Of great interest is their commentary on accounting standards:

Where necessary, OSFI will consider measures to address inappropriate volatility. For example, we will investigate options to moderate the impact of volatility on regulatory capital requirements, when:
1. For remaining long duration liabilities, markets for matching purposes do not exist, and
2. For solvency purposes, accounting/actuarial rules do not appropriately reflect the long-term characteristics of these portfolios.

That might be code for “Don’t worry about the IFRS Insurance Contracts Exposure Draft, guys!” The Insurance Contracts issue is actually mentioned explicitly in the concluding section of the paper:

The IASB insurance contracts project (IFRS 4 Phase II) will have a significant impact. While the extent of the impact is not fully known (and will not be until the final standard is set), OSFI is committed to consulting with industry stakeholders on how the final standard should be incorporated into the regulatory framework. Ideally, our initiatives would incorporate a final IFRS 4 Phase II standard. However, should a significant delay occur in the IASB work, OSFI will continue to move its work forward using current international financial reporting standards.

The section titled “Capital and Risk Measurement”:

The level of protection being tested by OSFI in QIS 3 is for each risk separately to cover a 1-in-200 year event (a rare, but plausible scenario) over a one-year time horizon. OSFI believes this level of protection would be equivalent to the low end of the investment grade range. An adequate provision after one year is defined as the amount of assets required for the insurer to either fulfil its policyholders’ and senior creditors’ obligations over the remaining lifetime of the obligations or to transfer them to another company.

Of great importance is their admission that:

The current approach to determining liability and regulatory capital requirements for financial guarantees embedded in segregated fund products has the following drawbacks:
• It can produce values that are materially lower than the cost of hedging.

The closes that they get to addressing the NVCC issue with respect to preferred shares is:

OSFI believes that high quality capital instruments should form a substantial part of the capital resources of an insurer when times are good. This provides the company, and OSFI, with the flexibility to respond in a constructive way in times of stress.

OSFI will consider these elements in developing guidance for the level and quality of available capital in the revised regulatory capital requirements.

The review of the definition of capital component is necessary to incorporate lessons learned during the recent financial crisis. These relate to the quality of certain capital instruments during periods of stress, the appropriateness of deductions and adjustments made to regulatory capital. The review provides an opportunity to consider each available capital element and assess its contribution to two goals: financial strength and protection of policyholders and creditors.

Revisions will provide increased transparency with respect to the meaning and purpose of both total (protection of policyholders and senior creditors) and tier 1 (financial strength) capital elements.

OSFI believes going concern capital (tier 1) should be largely comprised of equity (common and perpetual preferred shares). Items not considered to be readily available to absorb losses in a stress scenario (i.e., not fungible, not permanent, introduce an element of double-counting) should be deducted from it. Going concern capital is important to support ongoing insurer viability over the longer term given the longer-term nature of the life insurance business.

Gone concern capital (total) helps ensure that policyholders and senior creditors can be paid when the insurer is in winding-up mode. Gone concern capital may include forms of lower-quality “additional” capital components, such as hybrids and subordinated debt instruments that meet minimum quality criteria.

OSFI plans to issue a draft Definition of Capital paper for public consultation in late 2012 or early 2013.

The phrase “lessons learned during the recent financial crisis” might – might! – be taken as a reference to hybrid capital not defaulting when financial institutions were bailed out, which is the justification for the NVCC rule.

However, the last sentence quoted implies that we’ll start getting some meat in the sandwich sometime around year-end … roughly TWO FREAKING YEARS after the NVCC rule was applied to banks.

The timeline section at the back gives the following estimates for “Definition of Capital”:
Project Initiation: 2011Q1
Quantitative Impact Study: 2013Q3
Public Consultation: 2013Q4
Final Guideline issued: 2014
Implementation Milestone: 2015

At this point, I see no reason to change my views regarding the potential for the eventual imposition of the NVCC rules on insurers and insurance holding companies in a similar manner to banks. The draft consultation to be issued around year-end may help firm up the matter; readers and investors should be aware that I may well change the “Deemed Maturity” date for insurers and insurance holding companies.

Credit Suisse to Issue High-Trigger CoCos

Wednesday, July 18th, 2012

Under pressure from the Swiss bank regulator Credit Suisse is issuing High-Trigger CoCos:

Credit Suisse today announced a number of measures to accelerate the strengthening of its capital position in light of the current regulatory and market environment. An immediate set of actions will be implemented to increase the capital by CHF 8.7 billion. Additional capital actions and earnings related impacts are to increase the capital by a further CHF 6.6 billion by year-end 2012.

The measures will result in an expected end-2012 look-through Swiss Core Capital Ratio of 9.4%, compared to the 2018 requirement of 10%. Look-through Swiss Core Capital includes look-through Basel III Common Equity Tier 1 (CET1) and existing participation securities (“Claudius notes”) that qualify as part of the Swiss equity requirement in excess of the 8.5% Basel III G-SIB Common Equity Tier 1 (CET1) ratio.

The measures will result in an expected look-through Swiss Total Capital Ratio of 10.8% at end 2012. This broadly compares to the figure of 5.9% calculated by the Swiss National Bank (SNB) at the end of 1Q12 and published in its 2012 Financial Stability Report. Look-through Swiss Total Capital includes look-through Basel III CET1 and the participation securities (“Claudius notes”). Additionally it includes the Group’s Buffer Capital Notes (“CoCos with high trigger”).

There are no details available on the projected notes, but they have some Tier 2 Buffer Capital Notes outstanding.

For example, there is a USD 2-billion issue of 7.875 per cent. Tier 2 Buffer Capital Notes due 2041:

Interest on the BCNs will accrue from and including 24 February 2011 (the ‘‘Issue Date’’) to (but excluding) 24 August 2016 (the ‘‘First Optional Redemption Date’’) at an initial rate of 7.875 per cent. per annum, and thereafter at a rate, to be reset every five years thereafter, based on the Mid Market Swap Rate (as defined herein) plus 5.22 per cent.

If a Contingency Event or a Viability Event (each as defined herein) occurs, the BCNs shall, subject to the satisfaction of certain conditions, mandatorily convert into Ordinary Shares (as defined herein) which shall be delivered to the Settlement Shares Depository (as defined herein) on behalf of the Holders, as more particularly described in ‘‘Terms and Conditions of the BCNs—Conversion’’. In the event of a Contingency Event Conversion (as defined herein), such Ordinary Shares may, at the election of CSG, be offered for sale in a Settlement Shares Offer as described herein.

Contingency Event means that CSG has given notice to the Holders that CSG’s Core Tier 1 Ratio (prior to the Basel III Regulations Date) or the Common Equity Tier 1 Ratio (on or after the Basel III Regulations Date) is below 7 per cent. as at the date of the financial statements contained in a Quarterly Financial Report and that a Contingency Event Conversion will take place.

Viability Event means that either: (a) the Regulator has notified CSG that it has determined that Conversion of the BCNs, together with the conversion or write off of holders’ claims in respect of any other Buffer Capital Instruments, Tier 1 Instruments and Tier 2 Instruments that, pursuant to their terms or by operation of laws are capable of being converted into equity or written off at that time, is, because customary measures to improve CSG’s capital adequacy are at the time inadequate or unfeasible, an essential requirement to prevent CSG from becoming insolvent, bankrupt or unable to pay a material part of its debts as they fall due, or from ceasing to carry on its business; or (b) customary measures to improve CSG’s capital adequacy being at the time inadequate or unfeasible, CSG has received an irrevocable commitment of extraordinary support from the Public Sector (beyond customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG’s capital adequacy and, without which, in the determination of the Regulator, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable to carry on its business.

The BCNs will be converted into a number of Ordinary Shares determined by dividing the principal amount of each BCN by the Conversion Price in effect on the relevant Conversion Date. ‘‘Conversion Price’’ means (i) at any time when the Ordinary Shares are admitted to trading on a Recognised Stock Exchange, in respect of any Conversion Date, the greatest of (a) the Reference Market Price of an Ordinary Share on the fifth Zurich Business Day prior to the date of the relevant Contingency Event Notice or, as the case may be, the Viability Event Notice translated into United States dollars at the Exchange Rate, (b) the Floor Price on the fifth Zurich Business Day prior to the date of the Contingency Event Notice or, as the case may be, the Viability Event Notice; and (c) the nominal value of each Ordinary Share on the Share Creation Date (being, at the Issue Date, CHF 0.04) translated into United States dollars at the Adjusted Exchange Rate, or (ii) without prejudice to ‘‘Takeover Event and De-listing’’ below, at any time when the Ordinary Shares are not admitted to trading on a Recognised Stock Exchange by reason of a Non-Qualifying Takeover Event or otherwise, the greater of (b) and (c) above.

Very good. There’s a high trigger and conversion at market price. The part I dislike is that the conversion trigger is a regulatory ratio – we found during the crisis that regulatory ratios aren’t worth much in the course of a panic. Still – much better than anything we’re ever likely to see in Canada!

Basel Committee Releases D-SIB Proposal For Comments

Friday, June 29th, 2012

In addition to tweaking the rules on liquidity the Basel Committee on Banking Supervision has released a consulative document regarding A framework for dealing with domestic systemically important banks – important for Canada since we’ve got six of ’em! Provided, of course, that OSFI is honest about the assignments, which is by no means assured.:

Principle 2: The assessment methodology for a D-SIB should reflect the potential impact of, or externality imposed by, a bank’s failure.
Principle 8: National authorities should document the methodologies and considerations used to calibrate the level of HLA [Higher Loss Absorbency] that the framework would require for D-SIBs in their jurisdiction. The level of HLA calibrated for D-SIBs should be informed by quantitative methodologies (where available) and country-specific factors without prejudice to the use of supervisory judgement.

Principle 9: The HLA requirement imposed on a bank should be commensurate with the degree of systemic importance, as identified under Principle 5. In the case where there are multiple D-SIB buckets in a jurisdiction, this could imply differentiated levels of HLA between D-SIB buckets.

[Assessment Methodology Principle 2] 13. Paragraph 14 of the G-SIB rules text states that “global systemic importance should be measured in terms of the impact that a failure of a bank can have on the global financial system and wider economy rather than the risk that a failure can occur. This can be thought of as a global, system-wide, loss-given-default (LGD) concept rather than a probability of default (PD) concept.” Consistent with the G-SIB methodology, the Committee is of the view that D-SIBs should also be assessed in terms of the potential impact of their failure on the relevant reference system. One implication of this is that to the extent that D-SIB indicators are included in any methodology, they should primarily relate to “impact of failure” measures and not “risk of failure” measures.

Principle 7: National authorities should publicly disclose information that provides an outline of the methodology employed to assess the systemic importance of banks in their domestic economy.

[Higher Loss Absorbency Principle 8] 31. The policy judgement on the level of HLA requirements should also be guided by country-specific factors which could include the degree of concentration in the banking sector or the size of the banking sector relative to GDP. Specifically, countries that have a larger banking sector relative to GDP are more likely to suffer larger direct economic impacts of the failure of a D-SIB than those with smaller banking sectors. While size-to-GDP is easy to calculate, the concentration of the banking sector could also be considered (as a failure in a medium-sized highly concentrated banking sector would likely create more of an impact on the domestic economy than if it were to occur in a larger, more widely dispersed banking sector).

[Higher Loss Absorbency Principle 10] 40. The Committee is of the view that any form of double-counting should be avoided and that the HLA requirements derived from the G-SIB and D-SIB frameworks should not be additive. This will ensure the overall consistency between the two frameworks and allows the D-SIB framework to take the complementary perspective to the G-SIB framework.

Principle 12: The HLA requirement should be met fully by Common Equity Tier 1 (CET1). In addition, national authorities should put in place any additional requirements and other policy measures they consider to be appropriate to address the risks posed by a D-SIB.

IAG.PR.A Market-Maker Falls Asleep!

Friday, June 8th, 2012

Assiduous Reader KB writes in and says:

I’m confused about something that happens once in a while and maybe you can clear it up.

There are lots of illiquid preferred shares, and they often have wide spreads. That’s fine as long as everyone is behaving.

If I want to purchase some shares and there isn’t available size at the ask, I have found the shares usually appear if you meet the ask price. I assume the market maker offers up the shares that are required. Same situation on the sell side.

But once in a while like today, I was watching one of my preferred’s (IAG.PR.A) since yesterday it took a rather strange drop in value that you had commented on in the PrefBlog.

Today at 1:13 PM 34 shares changed hands at a reasonable $23.65. Then at 2:56 PM 700 shares traded at $21.71 and 50 shares at $21.66. That’s ridiculous.

My questions is: Where do these shares come from? National Bank bought and sold the 700 and Desjardins sold the remaining 50 to National Bank.

Do these shares come from the market maker or were there people actually willing to sell at that price? You’ve not touched on this subject in PrefLetter or in PrefBlog and the internet doesn’t reveal much, so I decided to ask you directly. Maybe you’re
just as confused as I am.

Actually, I’ve discussed it earlier in the post Fed Up with Shoddy Market-Making!. It was as a result of my frustration with the system that I started publishing the “Wide Spread Highlights” table every day and it was due to my complaints on the topic that I discovered the TMX Close != Last pricing data fiasco.

At vast expense, I have purchased the day’s “Trades and Quotes” file for IAG.PR.A from the TSX. From 9:30 until 4:00 there were 1,023 quotes and three trades.

Easy part first: National was the seller of an odd lot at the offering price and the buyer of an odd lot at the bid price. This almost certainly means that National is the Market Maker. As discussed in the post linked above, Market Makers are required to, among other things, service odd-lot orders at the quote, in exchange for which they receive certain privileges.

The action from 2:55:31 until 2:57:49 is of great interest:

Time Quote Trade
2:55:31 21.66-23.65, 1×2  
2:56:19 21.66-94, 1×2  
2:56:19   700 @ 21.71 (National Bank Cross)
2:56:20 21.66-23.65, 1×2  
2:56:20   50 @ 21.66 (National Bank purchase from Desjardins)
2:57:49 22.00-23.65, 4×2  

All day long the offer was at 23.65, with the exception of less than one second (time-stamping on the file available to me is precise only as to the second), at 2:56:19, when the offer suddenly declined to 21.94, making the spread 0.28. In the same second the trade of 700 shares occured, and in the next second the offer moved back to the 23.65 level, where it was for 6:29:59 of the trading day which lasted 6:30:00.

I must admit that I am very curious about this sequence of events and it does not seem credible that the sudden sharp decline of the offer price was entirely unrelated to the trade of 700 shares that occured during the same single second that the offer was so low. However, I am insufficiently knowledgable regarding the rules to know whether it is legal to front-run an incoming order by changing quote to make the fill seem more reasonable – certainly, if the quote had been 21.66-94 all day long, then a fill of a market order at 21.71 by an internal trade-matching algorithm would be quite reasonable and greatly appreciated.

It is unclear as to whether any front-running occurred at all, even if the change in quote and trade were related. It would be entirely rational for someone to place a limit order inside the quote (well inside the quote, in this case!) and then convert the order to a market order if not immediately filled – although the identity of the broker showing the 21.94 offer for one second is not available in the data I have, and the size was only 200 shares. It would be somewhat more normal for the offer to be allowed to stand for more than a second, as well. However, as became glaringly apparent during the Flash Crash, individual decisions made in the design of protocols and trading algorithms can start looking rather silly when conditions are different from those envisaged at design-time.

I will also point out that the data available to me reflect only the TMX data – I do not have a consolidated tape that would include quotations from Alpha, Pure, etc.

And finally, I will point out that I don’t really understand the relative identities of the buyers and sellers. It strains credulity to imagine that National’s cross of 700 shares was completely unrelated to the sale of 50 shares by Desjardins to National that occurred one second later; but definitive information regarding the precise order flow (back to the actual beneficial owner) is not available to me.

So I will leave it to those more familiar with the intricacies of UMIR and with more access to consolidated tapes to determine whether any jiggery-pokery occured.

All one can do is ask questions – the following eMail has been sent to the Exchange:

On 2012-6-7, the offer price reported by the TMX for IAG.PR.A was 23.65 for the entire day, except for one second commencing 14:56:19. In that second the offer price changed to 21.94 and a cross was executed at 21.71, which was down 1.87 from the closing price on 2012-6-6.

The time-weighted average spread for the full trading session was, according to my calculations using data supplied by the Toronto Stock Exchange, $1.47. The quoted spread exceeded this figure for over four hours in the course of the trading day (to be precise, 4:13:53) and was between $1.95 and $2.00 for nearly all this time (4:10:09).

Can you tell me:
i) Who is the market maker for this security?
ii) What commitments has the market maker made to the exchange regarding the bid-offer spread to be maintained for this security?
iii) When was the last review of the market-maker’s success in meeting the commitments made with respect to bid-offer spread?
iv) What were the results of the last review specified by (iii)?


The Life Insurance Industry and the Long Game

Monday, November 7th, 2011

Julie Dickson of OSFI gave a speech titled The Life Insurance Industry and the Long Game, which gave some gentle hints to the industry, but was short on details regarding the potential for regulatory change:

Should rates continue at the current low level – below 3% on government bonds for a 30-year term – it will be a real game changer for the life insurance sector.

Since life insurers often lock in their assumptions for the expected rate of return when the product is priced, there is an implicit assumption that the life insurer will continue to earn the same average interest rate over the lifetime of the product. When interest rates fall life insurers must reinvest the renewal premiums on new investments at lower rates than originally priced, leading to a compression in the product margin.

As regulators, we want life insurers to maintain healthy solvency ratios and still deliver on their promises to policyholders. If insurers are moving risk from their balance sheets onto policyholders, policyholders need to understand the risks they are assuming – we would not want to see a repeat of the vanishing premium events of the early 1990s.

The low interest rate environment also puts pressure on life insurers to recognize that they must discount their liabilities at the prevailing rate of interest. Currently in Canada, actuarial practice allows life insurers to grade in the effects of a decreasing interest rate environment over 10 years. This is a prudent approach. But we are concerned that a few life insurers may not be moving quickly enough to recognize that a change in strategy is also required. Life insurers need to start making changes to their product portfolios today to mitigate the grading of these low interest rates into the ultimate reinvestment rate (URR) to value long term insurance liabilities.

Through fora like the G-20, the Basel Committee on Banking Supervision, and the Financial Stability Board, international agreements are moving from discussion to implementation. The banking industry has been the focus of the majority of the reforms to date, but the life insurance industry is never far from the discussions.

For example, we see the role of the Chief Risk Officer (CRO) as being of primary importance to both banks and insurers. The first line of defence is the business itself and it must own the risk in its operations. We see the CRO as being another line of defence for the board, shareholders, creditors, policyholders and other significant stakeholders (including regulators and supervisors) to ensure the effective management of risk within a financial institution – sort of like wearing a belt and suspenders, or a check on the front office. We expect the CRO to be independent, to work with the board to ensure there are independent processes and controls throughout the organization, and to serve the interests and concerns of significant stakeholders. Strengthening the role of the CRO is a significant change for some life insurers, but a necessary one.

On the process of stress testing, we know that the recent “simulated crisis” stress test that OSFI asked specific Canadian life insurers to undertake did cause some concerns for those companies, in particular the degree of detail we requested. At the same time, however, we were struck by some of the weaknesses in the operating capacity of companies to provide the material in a timely manner. We have had discussions with industry representatives to review these concerns and are in the process of making changes to the reporting requirements of the 2012 stress test.

An issue that is receiving considerable attention globally is capital. The right amount of regulatory capital needs to be carried for the right risk. As the regulatory capital regime in Canada evolves, the objective will be to ensure this happens. We also encourage insurers to continue to develop their capabilities: economic capital models need to be more than a multiple (or a fraction) of regulatory capital – they need to allocate the right economic capital to the right risk.