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OK – found it!

It’s section 2128.03.3.1 Liquidity Facilities Supporting ABCP of the Fed Supervision Manual – 2007:

The Board’s risk-based capital guidelines impose a 10 percent credit-conversion factor on unused portions of eligible short-term liquidity facilities supporting ABCP. A 50 percent creditconversion factor applies to eligible ABCP liquidity facilities having a maturity of greater than one year. To be an eligible ABCP liquidity facility and qualify for the 10 or 50 percent credit-conversion factor, the facility must be subject to an asset-quality test at the time of inception that does not permit funding against (1) assets that are 90 days or more past due, (2) assets that are in default, and (3) assets or exposures that are externally rated below investment grade at the time of funding if the assets or exposures were externally rated at the inception of the facility. However, a liquidity facility may also be an eligible liquidity facility if it funds against assets that are guaranteed—either conditionally or unconditionally—by the U.S. government, U.S. government agencies, or by an OECD central government, regardless of whether the assets are 90 days past due, in default, or externally rated investment grade.

This rule appears to be similar to the Canadian requirements. There was a note in the source for this post that changes in the international rules were expected, but that these might not impact Canada. I will be checking to see whether the relevant section of the Fed manual was changed in the intervening period.

Update: Got it! Notice of Final Rule, Liquidity Facilities Supporting ABCP:

Under the current risk-based capital standards, liquidity facilities with an original maturity of over one year (that is, long-term liquidity facilities) are converted to an on-balance sheet credit equivalent amount using the 50 percent credit conversion factor. Prior to this final rule, liquidity facilities with an original maturity of one year or less (that is, short-term liquidity facilities) were converted to an on-balance sheet credit equivalent amount utilizing the zero percent credit conversion factor. As a result, such short-term liquidity facilities were not subject to any risk-based capital charge prior to this rule.
…
After consideration of the comments, the agencies have decided to impose a 10 percent credit conversion factor on eligible short-term liquidity facilities supporting ABCP, as opposed to the 20 percent credit conversion factor set forth in the NPR. A 50 percent credit conversion factor will continue to apply to eligible long-term ABCP liquidity facilities. These credit conversion factors will apply regardless of whether the structure issuing the ABCP meets the definition of an “ABCP program” under the final rule. For example, a capital charge would apply to an eligible short-term liquidity facility that provides liquidity support to ABCP where the ABCP constitutes less than 50 percent of the securities issued causing the issuing structure not to meet this final rule’s definition of an “ABCP program.” However, if a banking organization (1) does not meet this final rule’s definition of an “ABCP program” and must include the program’s assets in its risk-weighted asset base, or (2) otherwise chooses to include the program’s assets in risk-weighted assets, then there will be no risk-based capital requirement assessed against any liquidity facilities that support that program’s ABCP. In addition, ineligible liquidity facilities will be treated as recourse obligations or direct credit substitutes.

The resulting credit equivalent amount would then be risk-weighted according to the underlying assets or the obligor, after considering any collateral or guarantees, or external credit ratings, if applicable. For example, if an eligible short-term liquidity facility providing liquidity support to ABCP covered an asset-backed security (ABS) externally rated AAA, then the notional amount of the liquidity facility would be converted at 10 percent to an on-balance sheet credit equivalent amount and assigned to the 20 percent risk weight category appropriate for AAA-rated ABS.6

I love the internet!

Update, 2007-10-4: CFO magazine published a very good article, Longer Paper Routes dealing with the issues. The relationship to the Financial Accounting Standards Board’s  Financial Interpretation No. 46 (FIN 46) was discussed in The Securitization Conduit in 2002.

Some people – normal people – may be curious as to why I’m spending so much time on this, when it doesn’t have anything much to do with preferred shares or bonds … it’s banking regulation that has mainly an effect on the money market. Well, it’s all background, and I’ll study it for the same reason as I study banking panics and bankruptcies. The better I understand it, the more likely I am to avoid related pitfalls in the future … and all pitfalls in the financial markets are related.

I have developed a hypothesis regarding the collapse of the Canadian non-bank ABCP market that I am now attempting to falsify:

• When the ABCP market was in its development stages, Canadian banking regulation was more strict than the international norms.
• This strictness made it uneconomic to issue ABCP with a global liquidity guarantee.
• Hence, the market developed with a Market Disruption guarantee.
• The US market banking regulation was looser; it was cheaper for the banks to offer global liquidity; they did so.
• Enron happened.
• US banking regulations became much closer to Canadian levels of strictness. By this time the ABCP market was well entrenched and was able to bear the additional cost.
• The Canadian market was also well entrenched. ABCP was selling just fine and there was no pressure to change the liquidity provision
• Liquidity provisions suddenly became important. Kablooie!

I’m going to keep gnawing away at this one …

Another Update, 2007-10-4: How much does Global Liquidity cost? Let’s make the following assumptions:

• The underlying assets of the ABCP have a 100% risk-weight
• There’s a 10% Credit Conversion Factor
• The guaranteeing bank (“Bank”) wishes to maintain Tier 1 Capital Ratios at 10%
• The Bank does not consider it necessary to change anything else
• The Bank wants return on equity of 15%
• There are no other costs to the Bank related to the guarantee.
• There is no overcollateralization in the conduit.

There are probably other assumptions inherent in the following calculation, but I’ll work them out eventually! So we calculate:

• $1.00 is to be financed
• If on the books of the bank, this would be $1.00 of risk-weighted assets
• At a CCF of 10%, the liquidity guarantee adds $0.10 to risk-weighted assets
• To maintain Tier 1 Capital at 10%, the Bank needs an additional $0.01 of capital
• To get a return on equity of 15%, this $0.01 needs to earn $0.0015
• Therefore, the cost of the guarantee is 15bp

15bp! That’s a lot! And this calculation is making some fairly generous assumptions as well. The 15bp has to come out of somebody’s pocket:

• An additional cost to the borrower
• Reduced profit for the sponsor
• Reduced spread earned by the investors

Considering that the Commercial Paper / T-Bill 90-day spread was only about 30bp last March, 15bp is an enormous cost.

So how, assuming I’m not barking up the completely wrong tree here, was the US market able to absorb it?

The article Developments and Issues in the Canadian Market for Asset-Backed Commercial Paper, published in the Bank of Canada Financial System Review in 2003 is most interesting.

Because the assets are typically of longer maturity than the ABCP financing them, some sort of liquidity buffer is required to protect against rollover risk and timing mismatches. Hence, ABCP issuance programs purchase liquidity protection. At a minimum, such protection must safeguard against what the Office of the Superintendent of Financial Institutions (OSFI) calls a “general market disruption,” which is defined by market participants as a situation in which “not a single dollar of corporate or assetbacked commercial paper can be placed in the market—at any price.”9

A general market disruption is a highly unlikely event, and Canadian liquidity facilities, which do not cover anything beyond this minimum criterion, have never been triggered. According to OSFI (1994), a bank providing liquidity protection that embeds protection against other risks, like credit risk, would incur regulatory capital charges that, when passed on to the issuance program, could make the ABCP less economical.

U.S. regulatory charges have, however, been lighter on liquidity facilities that offer some degree of credit protection. Hence, liquidity enhancement for U.S. ABCP programs typically covers more than just general market disruptions, offering some elements of protection against credit risk.10

I was happy to find a definitive reference to the capital requirement for liquidity support – it is OSFI guideline B5:

An eligible liquidity facility that is in compliance with the conditions and scenarios described in sections 4.3.1, 4.3.2, and 4.3.3 is subject to the following capital treatment:
• for a facility that is available in the event of a general market disruption, a 0% credit conversion factor (CCF) applies;
• for a facility with an original maturity of one year or less or that is unconditionally cancellable at any time without prior notice, a 10% CCF applies; or
• for a facility with an original maturity of more than one year, a 50% CCF applies

Update, 2007-10-4: I note that the capitalization rules were mentioned by Dodge in a September, 2007 speech:

Another issue related to securitization concerns the capitalization of banks. If banks are moving securitized loans off their balance sheets, but still providing liquidity guarantees for these securities, how much capital should they be required to set aside? The authorities at the Basel Committee may need to revisit this issue in light of recent experiences.