DBRS has said that a change to the way regulator OSFI calculates issuance limits for Canadian banks will lead to “no material increase” in capacity, in contrast to widespread bullish forecasts for existing and potential issuers – although the rating agency’s analysts still see the potential for future change.

The Office of the Superintendent of Financial Institutions Canada (OSFI) on 23 May wrote to Canadian deposit-taking institutions (DTIs) alerting them that it is changing the way it calculates the limits for how much covered bonds they can issue.

Most notably, the numerator has been changed from covered bonds outstanding to “total assets pledged for covered bonds”, and the limit changed from 4% of total assets to 5.5%. (The denominator measure of total assets was also updated.) OSFI said that the update to the numerator was taken “to better reflect the amount of assets encumbered through covered bonds by capturing the overcollateralization associated with these instruments”.

With Canadian issuers currently maintaining overcollateralisation (OC) levels of 104% to 110%, analysts and some other market participants calculated that the change will result in a large increase in issuance capacity. One covered bond analyst, for example, said the new limit calculation could increase issuance capacity by some C$85bn (EUR56bn, US$63bn) – equivalent to more than half of the currently outstanding volume of Canadian covered bonds – and others were similarly bullish. They further suggested that other Canadian mortgage lenders, such as Laurentian Bank of Canada and Canadian Western Bank, would henceforth find covered bond issuance more viable and be more likely to enter the market.

However, DBRS analysts argue that there will be no material increase in capacity, highlighting that OC requirements may increase and the need for issuers to meet the covered bond limit on an ongoing basis.

“Consequently, when issuers determine the amount of covered bonds to issue, OSFI expects them to specifically take into account the pledging of additional collateral to meet potential higher overcollateralization requirements,” they said in a report on Tuesday.

They point out that the Canadian Registered Covered Bond Programs Guide issued by Canada Mortgage & Housing Corporation (CMHC) requires issuers to establish a maximum level of OC and that issuers have all set this at 25%. A 25% OC level then implies an issuance limit equivalent to 4.4% of total assets, rather than the 5% implied by, for example 10% OC, with capacity increasing from $226bn only around $30bn rather than $75bn.

DBRS-estimated covered bond issuance capacity based on current and revised calculation* (C$ billions)

* Assets for covered bond issuance capacity calculation are as of January, 2019 except for Fédération des caisses Desjardins du Québec, which is based on March, 2019. ** Estimates assume the Autorité des marchés financiers — the regulatory body that supervises the issuance of covered bonds by Federation des caisses Desjardins du Québec from a prudential standpoint — adopts OSFI’s revised calculation and limit. Source: Company Reports, DBRS Analysis.

The analysts then argue that the need to maintain a buffer against potential fluctuations in total assets means the increase in capacity is lower still.

They further calculate that the limit will continue to constrain smaller banks’ interest in covered bonds.

“Canadian banks tend to be conservative when adhering to regulatory requirements set by OSFI,” said the rating agency. “DBRS expects the banks to maintain a cushion to avoid breaching the 5.5% covered bond limit. Furthermore, the revised calculation ensures that banks maintain enough unencumbered assets to readily meet higher collateral requirements.

“OSFI has clearly indicated that the revised calculation does not constitute an effective increase in the covered bond issuance capacity for financial institutions. Thus, the question of whether the limit will be increased to make it less cost prohibitive for smaller banks to issue covered bonds remains under consideration.”

A market participant suggested the excitement around OSFI’s announcement was partly the result of Superintendent Jeremy Rudin (pictured) having “fanned the flames” in April 2018 when he said OSFI was taking “a hard look” at the limit.

However, he stressed at that time that any revisions must encourage banks to maintain enough unencumbered, high quality assets when times are good to be able to meet higher collateral requirements “if times turn sour”.

Paul Bretzlaff, senior vice president, Canadian ABS and pension funds, at DBRS, told The CBR that had OSFI been intending to increase issuance capacity, it would have put out a public consultation paper.

His colleague Maria-Gabriella Khoury, senior vice president in DBRS’s global financial institutions group, said that such a consultation could yet be the next step for OSFI.

“The entire spirit of this letter was to clean up the calculation before they go ahead and put out a consultation paper on changing the limit,” she said. “The smaller issuers, who are not able to keep up with the reporting requirements as fast as the larger issuers, needed something that is both dynamic and transparent, and would include OC, because most likely if the smaller issuers start issuing, their OC requirements will probably be higher than the large banks.”

She also noted that the move increases transparency around assets encumbered by covered bond issuance for unsecured creditors, something that has become more important following the introduction of Canada’s bail-in regime in September 2018.