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The Great Accounting Debate:Conduits – ‘on or off’ balance sheet under IFRS
European Securitisation
The Great Accounting Debate: Conduits – ‘on or off’ balance sheet under IFRS • PricewaterhouseCoopers 1
A typical multi-seller conduit has the following structure
Introduction
ConduitOriginatorsIssuesCommercialPaper
Originators
Deferred consideration
Assets sold at discount
Originators
Liquidityprovider
Programme-wideenhancement
Assets are sold by various originators at a discount to cover both primary creditenhancement and interest. The conduitring fences these assets and theoriginator receives deferred considerationwhere losses do not exceed the creditenhancement.
It is assumed in this paper that no assetsof the ‘sponsoring’ bank are included.
A liquidity provider is put in place foroccasions when commercial paperissuance is not possible due, for instance,to market disruption. In somecircumstances it can also cover credit losses.
A programme-wide credit enhancement(‘PWE’) is also put in place to ensure the conduit receives a high short-termrating. This often takes the form of a letter of credit.
In practice the liquidity provider andprogramme wide enhancement may be provided by the ‘sponsoring bank’. This sponsoring bank may also receivefees either from the conduit or direct from the originators. The conduit fundfunds its purchases usually usingCommercial Paper (‘CP’).
Accounting issue
The accounting issue that arises underIFRS is whether any party shouldconsolidate the conduit? The primaryaccounting pronouncement thataddresses this is IFRS 27 and itsinterpretation SIC 12 but consideration of IFRS 39 is also required.
SIC 12 deals specifically with when aspecial purpose vehicle (‘SPV’) should be consolidated. It will in due course be subsumed into IFRS 27(R). Thefundamental concept of IFRS 27 is thatyou consolidate those companies orvehicles that you control. A key control
Source: PricewaterhouseCoopers
2 The Great Accounting Debate: Conduits – ‘on or off’ balance sheet under IFRS • PricewaterhouseCoopers
test of IFRS 27 is who controls thefinancial and operating policies of the company.
SIC 12 has four tests of when a SPVshould be consolidated which expandthese concepts. In outline, a companyshould consolidate an SPV if:
(i) it is undertaking activities on itsbehalf and it benefits from this
(ii) it effectively controls the SPV
(iii) it has the majority of the risks of the SPV
(iv) it receives the majority of the benefitsof the SPV
These tests are indicators of control andneed to be considered together, forinstance it might make no sense toconsolidate a vehicle under tests (i) and(ii) if a company has absolutely noeconomic interest in the vehicle.
The risk criteria
We will first consider criterion (iii) the ‘risktest’. To understand and analyse the riskmatrix of the conduit we first have toanalyse the position of the originators. To do this we need to consider IFRS 39.Under this standard each originator needs
to consider if they can derecognise theassets transferred to the conduit or not.To do so the originator would need to show that it has not retained‘substantially’ all the risks and rewards of the assets. Given the high rating of the conduit and the level of creditenhancement required to support this, it will, in practice, be very rare for theoriginator not to have retainedsubstantially all the risk and rewards andhence maintain the assets on its balancesheet. The corollary to this is the conduitrecognising a loan to the originator ratherthan the assets legally acquired.
To return, therefore, to the conduit and ananalysis of its risks. The conduit has aseries of high quality loans to a variety oforiginators, funded by CP and supportedby PWE and a liquidity facility. In thisanalysis risk will generally occur if theloans default and the key question is whobears the majority of this risk.
Clearly in the first instance it will not bethe CP holders. On the face of it the PWEwill bear the risk and the provider of thePWE should consolidate the conduit. Inpractice the liquidity provider may takesome risk share and the exact terms ofthis facility should be considered.
Turning briefly to the other SIC12 criteria
Criterion (iv) looks at who has the majorityof the benefits of the conduit. Benefitsarise in the form of interest payments tothe CP holder, possibly derivativepayments and various fees. How youassess and compare benefits is complexbut in many cases will show a‘sponsoring bank’ receives the majority of the variable benefit.
Criteria (i) and (ii) are more judgemental. If you ask the question why is the conduitin operation you might well conclude thatit is there to enable the sponsoring bankto lend to its clients. Therefore theconduits activities are carried out onbehalf of the sponsoring bank, it benefitsthrough fees and should consolidate.
Again in practice the sponsoring bank willmanage the conduit on a day-to-day basisand it will be difficult to demonstrate thatde facto it does not control the conduitunless the conduit has the unlimitedpower to ‘kick out’ the sponsor.
Therefore, where the sponsoring bankalso provides liquidity support and PWE,it almost certainly will need to consolidatethe conduit. If, however, these roles are
The Great Accounting Debate: Conduits – ‘on or off’ balance sheet under IFRS • PricewaterhouseCoopers 3
shared with third parties the analysisbecomes more difficult and it may bepossible to demonstrate nobody controlsthe conduit.
Does the accounting matter?
For many sponsoring banks theaccounting will only matter if it affectsregulatory capital. This will depend onindividual country regulators. To date theFrench regulator seems to have decidedto adopt an accounting approach andrequire full capital backing against theconsolidated assets. On the other handthe Dutch regulator appears to beadopting a Basel II approach, ignoring theaccounting and requiring capital backingagainst the PWE and liquidity facility.
To facilitate this the rating agencies aredeveloping rating methodologies to rateliquidity facilities. This latter approach isthe one adopted in the short term by theUS authorities when FIN 46 wasimplemented.
Restructuring possibilities
A number of European conduits sponsorswho do not want to consolidate theirconduits are looking to see if somethingakin to Expected Loss Notes (‘ELN’) helpsin this regard.
ELNs were developed by US companiesto avoid consolidation under FIN 46 andthere are a number of potential investorsin such notes active in the market.
These notes would be structured so thatthe PWE does not take the majority of the risks as analysed using FIN 46 typetechnology. Using the analysis it canusually be shown that, by issuing arelatively small level of ELNs, the majorityof the risk moves away from the PWE asdoes enough benefit to bring the sponsorbelow 50 per cent.
Two important warnings should, however,be given to this approach:
• Whilst ELNs may work within the rigidrules of FIN 46, SIC 12 is a much more‘substance’-based standard and issuing a small level of ELNs may not pass the‘sniff test’ of SIC 12.
• ELNs will only handle the risk criteria of SIC 12 and possibly some of thebenefit criteria. The activity and controlcriteria of IFRS 27 and SIC 12 willremain a real challenge.
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Roland JeanquartBelgium32 2 710 [email protected]
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