Thursday, May 7, 2009

ABCP: Accumulate Bank of Canada Power!

Posted on Prefblog:

The Canadian Press reports that Mark Carney has proposed yet another regulator (while, I suspect, coughing and pointing at himself):
The central bank governor told a Senate committee that the country’s regulatory fiefdoms need a new mechanism to ensure individual financial watchdogs do not have blinders on that prevents them from seeing the bigger picture.

Carney said the central bank had warned years in advance about the risks involved with the $32-billion non-bank asset-backed commercial paper market, but its cautions were ignored.

“We view ourselves as having an advocacy role identifying problems and making them known,” he said.

“The advice has not always been followed, and in some cases problems have been repeatedly identified.

“In one case, the issue was really the only serious capital market problem we have had in this crisis (and) had been identified by the bank some years in advance.”

Carney’s argument for what he called a new “mechanism” that would require individual regulators to consider the wider implications of their actions came at the conclusion of a two-hour hearing with the Senate banking committee.

Unfortunately, there is no mention of such a thing in the Official Opening Remarks.

Let’s recapitulate, shall we?

The seeds of the ABCP fiasco were sown long ago, when OSFI required that banks put up capital for undrawn, guaranteed lines of credit (”Global Liquidity”). They did not require capital for undrawn vague committments, such as the General Market Disruption clause. I consider this to have been an entirely prudent ruling. For this reason, the ABCP market in Canada relied on GMD agreements, since Global Liquidity cost too much extra.

In the States, the Fed did not require capital for Global Liquidity; since it did not require capital it was cheap; since it was cheap that’s what ABCP issuers chose.

Later, the Fed changed their rules to be more consistent with the Canadian approach. At that time, the US ABCP market was sufficiently well-established that the extra costs were absorbed. Canadian issuers did not change their ways because there was no point: there would have been extra costs for whoever went first with no competitive advantage.

In 2003 the Bank of Canada published a warning about ABCP - well done BoC and I hope Paula Toovey and John Kiff get bonuses!

By 2007, the market was a little bit rigged: an enormous fraction of outstanding Canadian ABCP was held by accounts controlled/advised by entities that also had ownership interests in producers. There has never been a satisfactory explanation - public and satisfactory to me, anyway - of whether the portfolio managers responsible for the accounts holding the paper were motivated solely by concerns about the best interests of the accounts they were managing.

In mid/late 2007 the market collapsed. It became apparent that there were many holders of ABCP who were enormously concentrated in the asset class, if not a single name within that asset class. As far as I know, not a single PM has lost his license due to over-concentration. The regulatory response has concentrated on investment suitability, which I don’t understand at all. Even with hindsight, I consider non-Bank Canadian ABCP to be a suitable money-market investment that, unfortunately went bad. Please note that the word “suitable” means “on the list”. It means “sure, consider this stuff for inclusion in a diversified portfolio”. It does not mean “back up the trucks, guys, and load up 100% in this paper”. If that’s what the word “suitable” meant, NOTHING would be “suitable”.

I have not yet heard of anybody losing their license - or even being charged - for concentration risk.

Some people got burned and got burned badly, sure. That’s what happens when you load up on a single sure-fire can’t-miss investment. The only systemic implications I have seen is that some financial institutions were forced for reputational reasons to take the defaulted paper onto their books at par, without this reputational risk having been accounted for as part the financial institutions’ capital requirements.

This reputational risk needs to be addressed in Basel 3, if not sooner. As I have urged, for instance, the assets held by bank-sponsored money market funds should be included in Risk-Weighted Assets for capital calculation purposes. I have not yet heard any argument as to why such a course of action is not both necessary and sufficient.

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