Mr. Chairman, members of the committee, I am pleased to appear before you today to discuss this very important issue. There were many factors at play that caused the problems which occurred in the asset-backed commercial paper, also called ABCT, market, and I believe a full discussion and review are vitally important.
Before I speak to some of the questions related to the ABCP issue, let me touch briefly on OSFI's role in the Canadian system.
The Office of the Superintendent of Financial Institutions Act notes that OSFI shall strive to
||protect the rights and interests of depositors, policyholders and creditors of financial institutions, having due regard to the need to allow financial institutions to compete effectively and take reasonable risks
Institutions under OSFI's regulatory oversight include banks, federally registered trust and loan companies, property and casualty insurance companies, life insurance companies, and federally regulated private pension plans. Thus for banks, OSFI's primary role or job is to protect the interests of depositors. This is important, since banks hold the life savings of many Canadians.
Because OSFI was created to help contribute to public confidence in the financial system, some have assumed this means we are responsible for public confidence in the financial system. However, our act makes it clear that our role in contributing to public confidence in the financial system is concentrated on the banks' safety and soundness.
Today I would like to focus on what OSFI is doing as a result of the non-bank ABCP issue. Before doing that, I would like to reiterate a few key points regarding the non-bank ABCP market.
First, OSFI's capital rules are designed to help protect the safety and soundness of Canadian banks in the interest of depositors. The capital rules that apply to Canadian banks did not drive the widespread adoption of general market disruption liquidity lines by non-bank firms in Canada. This topic is covered at length in an OSFI backgrounder dated April 22, 2008, copies of which were provided to you on Friday.
Second, there was no consensus that the ABCP market posed a significant risk to investors. Indeed, the market had worked very well for the previous 17 years. Further, some developments had occurred and were reported on that were seen as being positive, such as DBRS's decision to change its rating methodology in January 2007.
Third, much more is known today than before about the factors that were important for investor safety. For example, after the events of last August, it became apparent that the strength of the sponsor—in other words, whether the conduit was set up by a bank or non-bank—was extremely important.
OSFI has taken a number of actions in response to the ABCP issue. First, we assessed early on the impact of the turmoil in the ABCP markets on all federally regulated institutions that we oversee. Very few of the institutions we oversee had material exposure to non-bank ABCP. It's important to note that financial institutions are considered to be sophisticated investors. The private pension plans that OSFI oversees had virtually no exposure.
We also began a review of guideline B-5, which requires Canadian banks to delineate their roles and responsibilities in creating ABCP vehicles, as well as capital requirements for loans to such vehicles. We are focusing on the roles and responsibilities of banks, especially when they deal with ABCP conduits created by unregulated entities like Coventree. We are looking at whether bank involvement with such conduits can create the impression that ABCP issued by unregulated entities is sponsored by banks.
Third, we are focusing on how banks determine which products they add to their approved product list for ultimate sale. Our focus is on risk that may result in large, unexpected payouts or losses by a bank. From our perspective, Canadian banks are at risk if they unexpectedly repurchase products they had sold to clients. We want to determine best practices in developing approved product lists, so that the likelihood of future losses is minimized.
Fourth, OSFI has been very involved in the work of the Financial Stability Forum to assess the causes of the turmoil and to formulate recommendations to enhance system resilience. I've worked with international colleagues to draft the FSF report on enhancing market and institutional resilience. The report includes more than 60 recommendations that have been accepted by G-7 finance ministers and covers key issues, such as capital and liquidity for banks, as well as the need for more transparency in ABCP conduits, and various changes that should be made by rating agencies.
This is the reason I have to leave at 4:30. There is an FSF working group meeting tomorrow in Europe.
Lastly, OSFI, as well as our international counterparts via the Basel Committee, are increasing capital charges for liquidity lines to support ABCP. This will further enhance bank safety and soundness.
The freezing of the non-bank ABCP market has rightfully led to a lot of questions, and it is important to identify and understand what happened. OSFI fully supports the efforts being made by all parties in this regard and will continue to provide input into these deliberations.
I would be pleased to take your questions.
I will try to get in a few quick questions and then pass the microphone to Mr. Del Mastro.
Thank you for coming, Ms. Dickson.
I think you will find this a very non-partisan issue around this table, unlike many others. Everyone is here trying to find out what went wrong. Our role, as parliamentarians, is to make sure our investors, both large and small, are protected.
I'm sure you're aware that we started out with some witnesses from a variety of sizes of investors who were frankly very critical of you and some of the others. I think they were looking at the role the Minister of Finance played in this, which was nothing other than encouraging everybody to sit down and get together.
But a lot of them suggested they didn't know what they were buying. That, to us, is very troubling. Maybe you can comment on that, whether or not you can play any role in that.
One accusation was that we've abandoned seniors, and that seniors were allowed to invest in these unprotected, which has hurt their future savings, if you will.
The other major accusation was that international banks should not be permitted to operate schemes in Canada that expose billions of Canadian dollars.
I don't know if that's your role, but can you comment on those accusations to at least get the record straight on that?
Thank you, Mr. Chairman and members of the committee. The Department of Finance and the Minister of Finance welcome these important hearings on Canada's asset-backed commercial paper--ABCP--market, specifically the non-bank sector of this market that was subject to the Montreal Accord and a court-supervised restructuring under the Companies' Creditors Arrangement Act.
I am pleased to have the opportunity to appear before this committee on behalf of the Department of Finance.
The restructuring of the non-bank-sponsored ABCP market under the Montreal Accord has been a market-led initiative with no public money or government guarantees. The restructuring provides a good example of how the private sector can sort out a market issue, and its success has been admired internationally. This, however, does not detract from the reality that the process has been long, complex, and very difficult for everybody involved.
Before I take your questions, I'd like to share with you the Department of Finance's perspective on the ABCP market and events leading up to the freezing of the non-bank sector market, including the global context in which this happened, some of the lessons learned, and the response of policy-makers.
The regulation of securities markets in Canada is the responsibility of provincial securities commissions. The regulatory framework specifies, among other things, the level of disclosure required of issuers and investment dealers selling securities to the public. In Canada, commercial paper, including ABCP, is sold under a short-term debt provincial securities regulations exemption. This exemption allows short-term debt maturing not more than one year from the date of issue and having an approved credit rating from an approved credit rating agency to be sold without the need for a prospectus.
In Canada, there are two distinct ABCP market segments: bank- sponsored conduits, representing about $80 billion Canadian of outstanding ABCP as of last August, and non-bank-sponsored conduits, which accounted for around $35 billion Canadian.
In all ABCP programs, there is an inherent mismatch between the term of the assets—normally several years—and the term of the ABCP—normally three months or less. ABCP conduits therefore require standing liquidity lines from financial institutions that can be accessed under conditions where the sale of new ABCP is difficult or impossible.
In most jurisdictions, ABCP programs are backed by “global style” liquidity lines that can be accessed under a wide variety of market circumstances, including a credit event. An unique feature of the Canadian market as it existed prior to August, was that most ABCP, including all conduits in the non-bank sector, were supported by “general market disruption” lines, which were only accessible to issuers when the inability to issue new ABCP relates to a general disruption in the Canadian ABCP market, rather than the deterioration of creditworthiness of the issuer or its assets. This left the Canadian ABCP market more exposed to risk, so that investors would be unwilling to roll their paper at maturity.
The Canadian marketplace, including investors and the rating agency, accepted “general market disruption” lines. This was not a decision made by regulators. The Superintendent of Financial Institutions has already addressed you on this issue.
The key trigger of the global turmoil was the rise in the default rate in U.S. subprime mortgages. This immediately affected structured assets that were backed by such mortgages. What is clear now is that in the rapidly growing U.S. subprime mortgage market, originators of loans had loosened their standards of lending considerably. This created a pool of questionable assets that found their way into structured finance products around the world through the process of securitization.
Investors' concern quickly spread to a broad range of complex products with potential exposure to subprime securities, owing to their complexity and to a general lack of transparency. This included structured securities rated highly by rating agencies. One example was the global market for ABCP.
Against this evolving global backdrop last summer, Canadian investors came to question the quality of the assets underlying Canadian ABCP. In mid-August, the non-bank market froze, as investors refused to roll their paper. Domestic banks, to their credit, supported their own ABCP programs, but for non-bank ABCP, liquidity providers did not provide funds for the most part. The failure of the non-bank conduits to meet their maturing commercial paper obligations raised the spectre of a fire sale of assets and significant losses of capital.
On August 16, a group representing major investors in non-bank-sponsored ABCP and the main international bank asset providers agreed to a standstill under the Montreal Accord. This accord laid the basis for a market-led restructuring of the non-bank ABCP market, with a view to preserving investors' money. The restructuring process, led by the Pan-Canadian Investors Committee under the leadership of Mr. Purdy Crawford, has been a market-led initiative.
Since the standstill began, the Department of Finance and the Bank of Canada have encouraged a market-led restructuring as a better course of action for investors, other participants, and capital markets than a fire sale of assets. We are not a member of the investors committee. However, we have monitored developments closely through an observer on the committee, and we have encouraged all parties to work constructively toward an orderly resolution. The Minister of Finance has issued statements supporting the restructuring process at key milestones.
On June 5, the Superior Court of Justice of Ontario approved the plan for restructuring asset-backed commercial paper, developed by the Pan-Canadian Investors Committee. This marks a decisive step in what has been a long and difficult process. Since last August, the Government of Canada has supported this market-led restructuring as a preferred course of action for investors and for the ongoing stability of the overall Canadian financial system. Small investors' interests have been accommodated in the final plan. Its successful resolution removes an overhang of uncertainty and should help restore greater stability in our money markets.
While the Montreal Accord is a good example of the market sorting out a market issue, there are clearly lessons to be learned for market participants and for policy-makers, both domestically and internationally. The Canadian market is already adjusting; investors are demanding greater transparency and disclosure from issuers and are stepping up their own due diligence. Since last August, all bank-sponsored ABCP programs have adopted global-style liquidity lines, and sponsors are making efforts to increase the transparency of the underlying assets of these programs. Financial institutions are also strengthening their risk management policies and practices.
Many of the lessons learned are global in nature, requiring a coordinated global response. In April, G-7 ministers and central bank governors endorsed a report of the Financial Stability Forum, which provides detailed recommendations to address the weaknesses that contributed to the global market turmoil and to enhance market and institutional resilience going forward. The Minister of Finance has indicated that Canada is fully committed to implementing these recommendations, which include specific timelines and priorities.
A number of these recommendations apply to the asset-backed commercial paper market. In particular, recommendations deal with the need for improved transparency in the securitization process, changes to the role and quality of the ratings process, and the appropriate use of ratings by investors and regulators.
The FSF has made a number of other relevant recommendations related to improving accounting and valuation processes for complex products and enhanced disclosure for financial firms. The Department of Finance, the Office of the Superintendent of Financial Institutions, the Bank of Canada, securities regulators, market participants, and credit rating agencies are all engaged in these issues, as are international standard setters.
For example, within its purview, securities regulators are reviewing the conditions under which commercial paper backed by structured credit products may be sold to Canadian investors. Prudential regulators, including ours, for their part must assess the appropriate capital treatment and risk management policies and practices respecting structured credit products.
The FSF also called on countries to review and strengthen their financial regulatory frameworks. In Canada, the priority is a common securities regulator with a more principles-based regulatory framework.
The Minister of Finance announced in February 2008 the establishment of an expert panel on securities regulation to advise on enhancing the content, structure, and enforcement of securities regulation in Canada. Under the chairmanship of the Honourable Tom Hockin, the panel is currently consulting across Canada with a broad range of market participants, including investors and their representative groups. The panel will deliver to the Minister of Finance and provincial and territorial ministers responsible for securities regulation a final report by the end of 2008. The minister applauds this committee's decision to hold hearings on these matters. There are a number of important issues that you could usefully explore.
With those words of introduction, let me open it up to your questions.
Let me put this into the global context and then come back to the specific issue.
I think it's fair to say that in the global context, if you go back a year or a year and a half ago, many people saw that the risk spreads were very low. They seemed unsustainably low and needed to widen. I think it was recognized that there was even a possibility that this wouldn't be an entirely smooth process. But I think it's fair to say that nobody foresaw the kind of global financial turbulence we have been going through in the last 10 months. Nobody foresaw the potential for contagion from subprime mortgages into a whole broad spectrum of complex products. Nobody foresaw the contagion effects this could have in the money markets at the core of the financial system.
This has certainly precipitated a great deal of reflection, a great deal of work on what needs to be done to prevent this type of crisis from happening again. The reality is that credit cycles are not new. They're not going to go away. So we also have to be prepared to manage these situations in the future.
With respect to this specific market, as the superintendent indicated, this is not a new market. It's been around for some time. It had been working successfully. With respect to the issues around global or general market-style liquidity, this was known in the market. As the superintendent indicated, the bulk of the investors in this market were highly sophisticated and very big investors. These were contracts issued in the private sector between relatively sophisticated players, by and large.
In terms of the regulatory oversight of this, as I indicated, securities regulation is in the domain of the provincial securities commissions. This was issued in the exempt market because it was a short-term instrument with an accredited credit rating. The scope of the exempt market is something the provincial securities commissions are looking at.
Thank you, Mr. Chairman.
In most cases I've been hearing that we have to look to see what went wrong; we can't necessarily look to the past; and we have to look to the future to see how we can correct this. But in order to find a solution, we have to blame somebody--I don't know if I necessarily want to use the word “blame”.
I understand the complexity. I don't want to make it too simplistic, but we're going around in circles, in a sense. We have OSFI coming forward and saying they're here to protect depositors. You just said that investors should be more sophisticated and understand. But investors have advisers, and advisers didn't advise properly. The advisers rely on the credit agencies, and the credit agencies didn't do their job.
Then all of a sudden investors wanted a higher return. So the banks, or whoever bundled up these products, made it so the returns would be higher. There was a market that was fulfilled and there were people willing to buy. Those were the forces. I don't think we can ever change that.
It's not a securities regulator issue, because they'll look at what happened prior to this. There is no mechanism to prevent this from happening in the future, because this has to be prevented prior to it ever happening.
In the end, I don't even know if anybody is going to report or say they're going to fix it, because it's not anybody's job. The securities regulators will look at their end. OSFI will look at its end. You'll look at your end. Mr. Purdy Crawford is only making sure the investors get their money--and that's a separate arrangement for what happened in the past. I feel like we're going around in circles.
The answer always seems to be that it's very complex. But people were involved who put these products together and invested. We see now that the little investors are probably being protected, whereas some of the investors who are more sophisticated, like TransAd, that have the proper individuals to analyze these products, didn't do it. Jean Coutu and numerous other corporations in Canada invested in these products. I'm not sure if they're going to be protected. They had the ability to look at this. They relied on somebody, and somebody relied on somebody else.
Is there an answer? Is there something we could do? Is there something that somebody could do?