Further to the 2008 European Central Bank's (ECB) biennial review of its risk control measures for Eurosystem credit operations, banks tapping the European Central Bank to raise liquidity by borrowing central bank funds are now required to post more collateral.
In fact, the so-called "technical refinements" in the ECB risk control framework, announced back in September 2008, have been in full force since February 1 2009. On one hand, the ECB has adopted temporary measures to expand the collateral framework and enhance the provision of liquidity. For example, it expanded the list of assets that are eligible as collateral to debt instruments denominated in currencies other than Euro. But on the other hand, it has tightened access to its lending window by imposing stricter risk control measures.
This is particularly true in respect of asset backed securities (ABS):
- A flat-rate haircut of 12% now applies to all ABS, regardless of their residual maturity and coupon structure. Before, this rate corresponded to the level of haircut assigned to ABS with a fixed coupon and a residual maturity of over ten years. For shorter term maturities the discount could be as low as 2%.
- A valuation markdown of 5%, corresponding to an additional haircut of 4.4%, will apply on top of the 12% base-rate for ABS that are subject to theoretical valuation by the Eurosystem absent determination of market price. In other words, the ABS that are theoretically valued by the Eurosystem in the absence of a market price are subject to a total haircut of 16.4%.
- The credit assessment of all eligible assets must be based on a public rating issued by an eligible external credit assessment institution (ECAI). But in the case of ABS, ratings must be explained in a publicly available credit rating report and ECAIs are required to publish rating reviews for ABS at least on a quarterly basis.
- While the above mentioned temporary measures to further expand the collateral framework the Eurosystem lowered the credit threshold for eligible assets from A- to BBB-, it kept, even if just for the time being, the A- requirement for ABS.
However this single A- requirement for ABS, even if already more demanding than the credit threshold applying to other eligible assets, is about to become insufficient.
In fact, ABS rated A- at issuance will soon cease to qualify as eligible collateral. As the ECB announced on January 20 2009, the Eurosystem will require a rating at AAA level from an ECAI at issuance as an additional eligibility criterion for all ABS issued as of March 1 2009, while requiring the previously A- minimum rating to be retained over the lifetime of the ABS.
Moreover, as of March 1 2010 ABS' underlying pool may not consist, in whole or in part, of tranches of other ABS.
While the ECB refers to all these changes as technical refinements (or complements thereto) of its risk control measures we believe that, in the context of the current financial market conditions, these changes can clearly be seen as a response to the growing concern that ECB's liquidity lines could be misused.
There have indeed been suggestions of abuse, with some banks trying to dump highly illiquid assets of questionable value at the ECB while others would fabricate new ABS purely in order to post them as collateral with the ECB.
This is certainly a sign of the times we are living, where the search for liquidity seems to be absolutely critical for all market participants.
However, no matter what, the truth is that the Eurosystem's collateral framework has proven robust and efficient over the years and has constituted a liquidity stronghold in this financial downturn. We believe this is the feature ECB is trying hard to preserve, namely by imposing stricter ABS risk control measures which ultimately reflect the actual use of eligible ABS by counterparties. This enables the source of liquidity which many have used in the current context to remain open and to correspond to a viable opportunity for those complying with the rules of the game.
From a policy perspective we may say that these measures certainly increase the standard and therefore foster safety and certainty to the benefit of all participants in the Eurosystem.
From a Portuguese perspective, this is how Portuguese banks have been using eligible ABS and therefore, even if ABS ECB eligibility going forward may look harsher and more stringent, we believe we will continue to witness Portuguese banks tapping the ECB and posting ABS as collateral on a regular basis.
Paula Gomes Freire