Cash & Liquidity ManagementInvestment & FundingCapital MarketsThe Securitization Spectrum

The Securitization Spectrum

In 1996, the major Canadian banks began in earnest to securitize their balance-sheet assets. Today, securitized assets represent about 6.8% of loans and bankers’ acceptances excluding repurchase agreements (loans and BAs) for the big five Canadian banks (Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and The Toronto-Dominion Bank).

Although securitization is an effective way of further diversifying funding sources and reducing the amount of on-balance-sheet leverage, the primary driver to these activities remains regulatory capital arbitrage. By managing down risk-weighted assets, capital ratios are enhanced under the Basel I framework. Originally, lower-risk assets such as government-guaranteed mortgages were pooled and securitized. But as investors and issuers became more comfortable with these transactions, the market gradually moved up the risk spectrum into other asset classes such as credit cards, auto loans, commercial mortgages, and corporate loans. Of the big five Canadian banks that were surveyed last year by Standard & Poor’s, 53% of securitized assets were conventional mortgages, 22% were personal loans and lines of credit, 14% were credit cards, and 9% were corporate loans as of July 31, 2002. These percentages were calculated using securitized assets divided by loans, BAs, and securitized assets.

Of the big five Canadian banks, The Toronto-Dominion Bank (TD Bank) remains the most active in the securitization market, and Royal Bank of Canada (RBC) the least active. As of third-quarter 2002, securitized assets represented 2.2% and 11.9% of loans and BAs, for RBC and TD Bank, respectively. TD Bank’s securitization activities peaked following its C$8.0-billion purchase of TD Canada Trust, which closed in February 2000, to allow the bank to meet the minimum 7% and 10% Tier 1 and total capital ratios required by the Canadian regulators. Historically, RBC has not placed a high reliance on securitization as a source of funding, as it has not found the economics for these types of transactions to be compelling. Currently, we consider RBC the most creditworthy of the major Canadian banks. As of third-quarter 2002, TD Bank and RBC realized around a 70- and 10-basis point pickup to their Tier 1 capital ratios, respectively, from their securitization activities.

Bank of Montreal’s (BMO) use of securitization has hovered around 10% of loans and BAs since 1998, with conventional mortgages making up around 60% of securitized assets. Canadian Imperial Bank of Commerce (CIBC) has reduced its reliance on securitization from a peak of 7.4% of loans and BAs in 1998, to 3.8% in third-quarter 2002, as it was able to reinforce its capital position with the significant capital gains generated from its merchant banking operations, namely Global Crossing Ltd. Currently, Bank of Nova Scotia’s (Scotiabank) regulatory capital ratios and quality of capital are the highest of the big five banks, and the bank remains only a moderate user of securitization, with securitized assets making up 6.0% of loans and BAs. Scotiabank’s quality of capital remains superior to its banking peers as it has a lower reliance on preferred stock and innovative Tier 1 capital instruments (hybrids or trust-preferred securities) within its mix of Tier 1 capital.

National Bank of Canada (National Bank) and Laurentian Bank (Laurentian), which are about one-quarter and one-sixteenth the average size of one of the big five banks, respectively, use securitization to a greater extent, as it proves to be an economical and efficient alternative funding source. As of third-quarter 2002, securitized assets represented 10.5% and 14.3% of loans and BAs for Laurentian and National Bank, respectively. All of Laurentian’s securitized assets are mortgages, and almost 80% of National Bank’s securitized assets are mortgages.

Mouvement des Caisses Desjardins, (Desjardins), a credit union system that has operations based primarily in the Province of Quebec, does not securitize any assets, nor does it have any preferred shares or hybrids within its Tier 1 capital. This reflects Desjardins’ well-established retail deposit base, lower reliance on more expensive wholesale funding sources, and very strong regulatory capital ratios that are well above its Canadian peers.

Impact on the income statement

Along with the boost to capital ratios, GAAP accounting normally causes the originator to book an up-front gain on securitized assets, rather than permitting a gain or loss to be amortized over the life of an asset. The resultant up-front gain immediately flows through the company’s income statement, enhancing the bank’s equity position.

Estimating the risks transferred

The sale of assets through a securitization vehicle does not mean that an originator is free of all responsibilities, should problems occur. Within a structured deal, the originator generally retains a significant subordinated economic interest in the performance of the assets, as these generally do not find a market and must be retained by the originator. These could include a combination of exposures such as first-loss protection positions, excess spread, reserve accounts, retention of a junior or equity tranche, servicing obligations, and overcollateralization. Accordingly, the underlying risk retained from a securitization program would be roughly equivalent to the original on-balance-sheet portfolio that was securitized. Although there is generally no legal obligation to take back assets, a moral obligation is often thought to exist for the originator or sponsor to preserve wide access to the capital markets. This argument is diluted by the view of regulators in various jurisdictions, including Canada, that intervention in a securitization program beyond the contractual obligation of a bank would mean consolidation of all securitized assets back onto the bank’s balance sheet. This would lessen a bank’s incentive to intervene, but would not eliminate the underlying risk retained from securitization activities as discussed above. These conditions have led us to maintain a general policy of adding back securitized assets, unless unequivocal and irrevocable evidence of a complete and true risk transfer can been shown. Although adding back securitized assets would cause a bank to appear more heavily leveraged, this has been accounted for already in past rating decisions.

Aside from securitization, Canadian banks have been able to enhance their regulatory capital ratios by purchasing government guarantees for pools of conventional mortgages that are maintained on a bank’s balance sheet.

Use of preferred shares and hybrids

Standard & Poor’s limit for preferred shares and hybrid securities is slightly different from the Canadian regulators. Rather than applying the limit to net Tier 1 capital, we limit the use of preferred shares and hybrids to 25% of total adjusted equity less general reserves. Total adjusted equity is defined as total common equity, retained earnings, minority interest, acceptable preferred shares and hybrids, and general reserves less investments in unconsolidated subsidiaries, goodwill, and intangibles. For preferred shares or hybrids to be included in total adjusted equity, they must have ongoing and permanent loss absorption features, be deeply subordinated, and perpetual.

The red line in Chart 4 (at 25%) represents the regulatory limit for the use of preferred shares and innovative Tier 1 capital instruments within a financial institution’s net Tier 1 capital. For Canadian financial institutions, identified intangibles (another form of goodwill) can account for up to 5% of net Tier 1 capital. Within our internal capital model, goodwill and identified intangibles are deducted to arrive at total adjusted equity.

Standard & Poor’s capital adequacy model for Canadian banks

In terms of making an assessment of capital adequacy, Standard & Poor’s has developed an internal capital adequacy model that assigns capital on a more refined risk-adjusted basis to all on- and off-balance-sheet assets and, to a limited extent, operational risk. This has allowed for a more refined approach to capital and in many respects, mirrors the framework that currently is being developed under Basel II. A bank’s securitization activities and other capital arbitrage activities are captured by this model, and are ultimately reflected in Standard & Poor’s assessment of a bank’s capital adequacy.

Constraints created by Canadian-style liquidity lines

Standard & Poor’s has, in the past year, raised a number of issues and concerns in the Canadian commercial paper markets. One of the more interesting topics stems from the Canadian market convention of accepting standby liquidity lines for commercial paper securitizations that really are only callable in circumstances of wide market disruption.

Canadian institutional investors continue to purchase and support this type of liquidity support, which attracts no capital charge from the regulators. In contrast, U.S. investors will not purchase asset-backed commercial paper (ABCP) if global-style liquidity lines are not in place, irrespective of their cost – either economic or regulatory. As is evident from Chart 5, some of the Canadian banks, namely CIBC, RBC, and Scotiabank, carry out a significant portion of their conduits activities south of the Canadian border. Ironically, although unable to rate ABCP in Canada (due to the nature of these liquidity lines not meeting our global criteria), Standard & Poor’s rates the Canadian banks’ conduits in the U.S. As investors, why do Canadians accept less protection? As issuers, why is the playing field so different? If it is truly a Canadian market convention, then the onus is on investors to change it. As a rating agency, we can only rate what is put forward for our review and opinion. Standard & Poor’s continues to wonder when this gap will narrow and when Canadian investors will start asking the questions and require liquidity commensurate with the type that is provided worldwide. In the interim, Standard & Poor’s will continue to rate the Canadian banks’ securitization activities in the U.S.

Future evolution

The eventual implementation of Basel II will impose a capital discipline that is more in line with economic reality, lower risk loans will be less onerous to hold on-balance-sheet, and it will reduce the opportunity for regulatory arbitrage. Although the regulatory capital arbitrage incentive might be diminished or disappear with the implementation of Basel II, securitization of bank assets in future is expected to remain, as it provides a viable alternative funding source.

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