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This is a question that has bothered me for a long time – and I’ve never been able to get a satisfactory answer.

What is the seniority of Bankers’ Acceptances?

Finally, through the magic of the Internet, I’m a bit further forward with this inquiry and think – think! – I have a good answer with respect to US Law.

According to DRAFT COPY: PRINCIPLES AND CONDITIONS PRECEDENT FOR THE CREATION OF A LATIN AMERICAN BANKERS ACCEPTANCES MARKET, creditted to Matilde Carrau, Constantino Flores and Manuel Renato Martínez Quezada of the University of Arizona College of Law:

To recuperate the funds invested by the bank in the discount of the acceptance, the bank generally rediscounts the facility in the New York bankers acceptance market. To be able to participate in this market the acceptances have to meet the eligibility requirements established by 12 USC § 372 and § 373. The result of compliance with eligibility requirements also causes that the acceptances not to be considered a deposit subject to reserve requirements or FDIC assessment(155) under regulation D. Hence if the bankers acceptance is eligible for discount and purchase the bank will offer a better rate for this facility as compared to what it would offer in a traditional lending since these “savings” will partially be passed on to the customer.(156)

[155] Under FDIC regulation, banks are required to pay a premium over deposits; hence, if the bankers acceptance complies with eligibility requirements and is therefore not considered a deposit, no prime will be paid for said transaction and the operation will be cheaper.

[156] Professor Boris Kozolchyk comments that off balance sheet credit operations will always be preferred by bankers to get involved with. Bankers acceptances are regarded when backed by premium banks in the moneyness scale as one of the private instruments closest to the currency status; and for practical purposes, they may be regarded as money. Negotiable Instruments class, spring 1997 semester, University of Arizona College of Law, Master of Laws In International Trade Law Program (hereinafter NI Class comment).

Which seems to mean, according to these authors’ interpretation of US law (as of 1997!) that BAs are junior to DNs.

It is my (limited!) understanding that BAs in Canada are regulated by the Bills of Exchange Act … the fact that this is not the Bank Act leads me to believe that:

• BAs are not considered deposits
• BAs are not insured
• BAs will be wiped out before insured deposits lose a dollar

But, I’m still trying to get something definitive from the CDIC and OSFI!

There’s more questions, too! Say the recipient of the proceeds of the BA (the issuer, whose note has been accepted by the bank) does, in fact, pay back his money while the bank is going down the drain. Will this repayment lose its identity in the bankruptcy, becoming part of the general assets of the bank and go towards paying its liabilities in order of seniority? Or does the payment retain its identity and be used to honour THE PARTICULAR BA that was issued against this payment?

Update, 2008-2-7: I have explicit confirmation from the CDIC that: “A Bankers’ Acceptance is not an insurable product with CDIC.”

Update, 2008-2-19: I asked the OSFI:

What is the status of Bankers’ Acceptances should the guaranteeing bank become bankrupt?

a) If the original issuer repays the debt, does this payment retain its identity (and become payable to the holder of those particular BAs), or do such repayments lose their identity and become undifferentiated assets of the bank?

b) If the original holder does not repay the loan, and the bank is not able to honour its guarantee, what is the seniority of the BA in the bankruptcy process? Are BAs junior to Deposit Notes, or parri passu?

c) Has the status of dishonoured BAs been tested in court?

and received the following answer:

OSFI does not have the authority over the day-to-day business operations of financial institutions, such as the issue you raise in your e-mail.

As you may know, a Bankers’ Acceptance note is a short-term promissory note issued by major corporations, backed by a Canadian Chartered Bank, and repayable on a specified date.   

Therefore, in order to determine the guarantee behind the note, you may wish to contact the financial institution from which the agreement originates.

Update, 2008-2-20: I have received the following answer from the Bank of Canada:

In response to your inquiry, I wish to inform you that the Bank of Canada, as the country’s Central Bank, does not provide banking services to the public, nor does it legislate the rules and regulations applicable to the activities of commercial banks and other financial institutions in Canada. This responsibility falls upon the jurisdiction of the Office of Superintendent of Financial Institutions, which can be reached at http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?ArticleID=18.

There’s still a few arrows in my quiver, but I’m starting to run out of options!

Update #2, 2008-2-20: I have talked to a money market trader at a major bank – who in turn talked to his liquidity desk (who runs the BA book) – and the answer from there is:

• (a) Payments from the underlying borrower would go into a BA pool, and
• (b) BAs are parri passu with deposit notes

He had nothing written down on this matter.

Update, 2008-2-21 I checked Moody’s Guidelines for Rating Bank Junior Securities:

For most unregulated non-financial organizations, it is generally assumed that the probability of default is constant across the various obligations within a typical capital structure.1 (In other words, if the company goes bankrupt, it will default on all of its obligations.) Notching guidelines for these entities are therefore governed solely by differences in the expected severity of loss given default. However, because they are regulated — and their regulators may refuse to support certain junior obligations (or more likely, selectively impose losses on them without placing the entire bank into liquidation) — differences in the probability of default also play a role in bank notching practices.

The interplay between systemic support and selective interference complicates the analysis of banks’ junior obligations.

Moody’s does not notch senior debt issued by banks; they are rated at the same level as deposits. This is because deposits and senior debt have the same probability of default and generally rank pari passu in liquidation.

Here’s what Fitch has to say in its Bank Rating Methodology:

Support ratings are the product of Fitch’s assessment of a potential supporter’s (either a sovereign state’s or an institutional owner’s) propensity to support a bank and of its ability to support it. Its propensity to support is a judgement made by Fitch….

It is assumed that typically the following obligations will be supported: senior debt (secured and unsecured), including insured and uninsured deposits (retail, wholesale and interbank); obligations arising from derivatives transactions and from legally enforceable guarantees and indemnities, letters of credit, acceptances and avals; trade receivables and obligations arising from court judgements.

Update, 2008-2-22: OK, we’re starting to get somewhere! Here’s what a Bank of Canada spokesman had to say on the matter:

I would recommend seeking answers from issuers of these instruments or regulators thereof (securities commissions) or perhaps OSFI.

As for the Bank of Canada: BAs carry the credit risk of the accepting bank and are valued accordingly. If the Bank of Canada were holding (either outright or as collateral) a BA issued or accepted by a bank that becomes insolvent, the market value of the BA would obviously be reduced.

In this situation, the Bank of Canada would demand that the BA it is holding as collateral or in a repo be replaced by other collateral. If the institution that pledged or sold the BA to the Bank of Canada were to default at the same time as the bank that issued or accepted the BA were to become insolvent(a highly unlikely scenario), the Bank would be holding an unsecured claim against the bank, that would rank parri passu with the claims of depositors and other general creditors.

Update, 2008-2-27: Many thanks to the wonderful OSFI, who referred me to Section 369 of the Bank Act:

Insolvency 

369. (1) In the case of the insolvency of a bank, 

(a) the payment of any amount due to Her Majesty in right of Canada, in trust or otherwise, except indebtedness evidenced by subordinated indebtedness, shall be a first charge on the assets of the bank;

(b) the payment of any amount due to Her Majesty in right of a province, in trust or otherwise, except indebtedness evidenced by subordinated indebtedness, shall be a second charge on the assets of the bank;

(c) the payment of the deposit liabilities of the bank and all other liabilities of the bank, except the liabilities referred to in paragraphs (d) and (e), shall be a third charge on the assets of the bank;

(d) subordinated indebtedness of the bank and all other liabilities that by their terms rank equally with or subordinate to such subordinated indebtedness shall be a fourth charge on the assets of the bank; and

(e) the payment of any fines and penalties for which the bank is liable shall be a last charge on the assets of the bank.

(2) Nothing in subsection (1) prejudices or affects the priority of any holder of any security interest in any property of a bank.

(3) Priorities within each of paragraphs (1)(a) to (e) shall be determined in accordance with the laws governing priorities and, where applicable, by the terms of the indebtedness and liabilities referred to therein.

This helps a little … but Paragraph (3) kind of muddles the game, doesn’t it?

Update 2008-3-19: No response at all – not even an acknowledgement – from the thoroughly useless Canadian Bankers Association. I am now contacting the IR departments of the Big 6 Banks individually:

Sirs,

It is my understanding that under Section 369(1)(c) of the Bank Act, your Bankers Acceptances would be considered a third charge on the assets of the bank in the event of insolvency.

Section 369(3) of the Act notes that liabilities within this charge may be further ranked in accordance with terms of the indebtedness and liabilities referred to therein.

I would appreciate receiving information regarding Bankers Acceptances that have been accepted by your firm, regarding their seniority within the third charge.

Sincerely,
HYMAS INVESTMENT MANAGEMENT INC.

James Hymas
President

Update, 2008-03-24: TD is parri passu, according to their IR department:

In the event of the insolvency of The Toronto-Dominion Bank, the obligations of the Bank under any Banker’s Acceptance issued by it would rank against the unencumbered assets of the Bank on a parity with all deposit liabilities of the Bank, other than amounts due to the government of Canada or to a province thereof which shall be a first and second charge on the assets of the Bank. Under the laws of Canada, the obligations of the Bank under any Banker’s Acceptances issued by the Bank are direct liabilities of the Bank and rank at least pari passu with all unsecured, unsubordinated indebtedness of the Bank.

Update, 2008-7-18: Other references

• George Nowlan, 2001 G20 Case Study: Initiatives to Develop Canadian Capital Markets
• Financial Consumer Agency of Canada Act, 2001 – some amendments to Bank Act
• Bank boss hostage pair get their £1m
• BIS Papers No 39, April 2008 Financial Market Developments and Their Implications for Monetary Policy
• Expansion of List of Securities Eligible as Collateral for use in Bank of Canada Standing Liquidity Facility, Bank of Canada, July 2001
• Bank Act (1991, c.46)
• Weekly Financial Statistics, Bank of Canada
• Banking and Financial Statistics, Bank of Canada

Update, 2008-8-12: Daryl Merrett, Bank of Canada Review, 1981: The Evolution of Bankers’ Acceptances in Canada