Commercial Paper

A company or group of companies looking to enhance liquidity may sell receivables to a bank or other conduit, which, in turn, will issue them to its investors as commercial paper. The commercial paper is backed by the expected cash inflows from the receivables. As the receivables are collected, the originators are expected to pass the funds to the bank or conduit, which then passes these funds on to the note holders.

In practice, most commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less constant amount of their assets using commercial paper.
Commercial paper is issued by a wide variety of domestic and foreign firms, including financial companies, banks, and industrial firms.

Money market mutual funds (MMFs) and commercial bank trust departments are the major investors in commercial paper. MMFs hold about one-third of the outstanding commercial paper, while bank trust departments hold between 15 and 25 percent.7 Other important investors, holding between 5 and 15 percent, are nonfinancial corporations, life insurance companies, and private and government pension funds.

Commercial paper entails credit risk, and programs are rated by the major rating agencies. Because commercial paper is a rolling form of debt, with new issues generally funding the retirement of old issues, the main risk is that the issuer will not be able to issue new commercial paper. This is called rollover risk.

Asset Backed Commercial paper (ABCP) programs provide cost-effective funding to a sponsoring bank’s customers. They allow
receivable sellers that otherwise cannot directly access the commercial paper market to finance
their receivables at favorable rates. Even sellers that are able to access the commercial paper
markets participate in ABCP programs because they provide alternative sources of funding and
the seller generally remains anonymous in a multi-seller conduit; investors are protected through
various program enhancements built into the structure of ABCP programs.
A bank also benefits from ABCP programs. Instead of lending to its customers through its own
balance sheet, the bank is able to refer its customer to the ABCP conduit, avoiding higher
regulatory capital charges. A bank earns fees for the services it provides to its customers and the
ABCP conduit.
An ABCP program functions similar to a term securitization. Each seller transfers receivables to
the conduit, which is typically a variable interest entity (VIE), usually in a two-step transfer.
(The accounting for the transfer is outside the scope of this paper.) The seller receives cash at a
discount to the receivables’ face values in order to provide credit support to the conduit and to
cover payment of the conduit’s funding costs. Each seller is provided a facility limit and term.
Many ABCP programs are revolving in nature. For example, interests in new receivables or
other financial assets meeting pre-determined eligibility criteria can be sold to the conduit when
previously transferred interests are repaid by their related obligors. Other ABCP programs
involve static amortizing pools of assets.

When new paper is not sold to roll over the matured paper, the bank must pay the investors of the maturing paper and hold the unsold paper in its own account until sold. This requires the bank to record the outstanding paper it holds on its balance sheet, increasing its liability, which raises reserve and capital requirements, and lowering its profit margin.