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Rethinking 4%

18 February 2016
Richard Kemmish


Homer Simpson described Canada as ‘our goody-two-shoes brother’. He many have had a point, regulations there frequently seem to be about not upsetting anyone, not rocking the boat by letting anyone do anything offensive. The 4% limit on covered bond issuance was designed to make absolutely sure that no unsecured creditors got upset by those nasty covered bonds.

So the news that OSFI is considering dropping the 4% limit might come as something of a shock. The real shock though was the language that accompanied the announcement. OSFI Deputy Superintendent Zelmer introduced the topic by saying that it was “designed to promote the viability of banks in times of stress”. He went onto say that ‘underpinning’ the work was a desire to make sure that there were enough unencumbered assets to support collateral requirements and provide secured funding in times of stress.

The reference to collateral requirements in times of stress was perhaps (finally) a covered bond regulator acknowledging the vast sources of contingent encumbrance that can emerge (in repos, clearing house requirements, derivatives, etc) and which, by the way, will dwarf covered bond encumbrance.

The reference to secured funding in times of stress is similarly an unusual recognition of the reality that when banks get into trouble, secured funding - whether repos at the central bank, covered bonds into the market or the combination, covered bond repos to the central bank – is often the only life line available. As Keynes said, central banks should provide unlimited liquidity but only to “solvent banks with high quality collateral”. So they need collateral.    

But here’s the problem: an ex ante requirement for a minimum amount of assets that can be used to raise funding in an existential crisis rapidly becomes meaningless. As soon as it becomes an issue, the rule will be dropped, No regulator would prefer a bank to fail than breach a rule designed to stop it failing (someone tell the people who set bank capital requirements. Minimum levels of going concern capital were originally introduced to ensure that banks wouldn’t fail, defined as when a bank runs out of its own funds. The definition of failure now seems to be when a bank breaches the minimum capital rules. You set capital rules mainly to make sure that you don’t breach capital rules). 

For the record, Mr Zelmer did also refer to the ‘traditional’ reason for limiting covered bond issuance: the need to ensure that there would be enough unencumbered assets in place to satisfy the claims of unsecured creditors. The emphasis of the speech though suggests that this concern was secondary to the need to ensure emergency funding. Perhaps he has done the maths on the actual impact of being subordinated to 4% of covered bonds on the loss given default for other creditors (to save you the maths: its negligible).

And yes, I have just managed to get quotes from both of my heroes: John Maynard Keynes and Homer Simpson into the same piece.

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