A proposal drawn up by Danish and German banking associations that would remove a cap on covered bonds in liquidity buffers for only some parts of the asset class is being pursued in spite of objections from several countries, who say the plan would create a two tier market based on flawed criteria.

As well as the Danes and Germans, banking associations in Norway, Poland and Sweden have supported the proposal.

For certain covered bonds, the plan would remove a 40% cap on their use in liquidity buffers envisaged in the Basel Committee’s Liquidity Coverage Ratio (LCR) framework and change the haircuts they face from 15% or more proposed under Basel III to haircuts corresponding to those used by central banks.

However, only some covered bonds would qualify for such treatment, and the criteria proposed by the Danes and Germans for determining which instruments are of a sufficiently high quality and liquidity have been criticised. The Covered Bond Report understands that the proposal was rebuffed at a meeting of the European Covered Bond Council’s steering committee on 2 December.

Key criteria in the proposal relate to the size of a country’s covered bond market. A draft of the plan includes “market level” criteria that:

• “The minimum market size measured by volume of covered bonds issued to be Eu50bn (or euro equivalent) or 25% of total bonds outstanding issued by financial institutions within the jurisdiction,”

and:

• “The minimum market size measured by outstanding covered bond volume being greater than 15% of national GDP as an average over the last five years.”

A market participant described the criteria as “ridiculous” and said that they had been “shot down” in ECBC steering committee discussions.

Fears over spilt cause rift

“There are several criteria in there that really don’t make a lot of sense,” he said. “I can’t see why covered bonds as a percentage of GDP, for example, should be particularly relevant.

“Any differentiation should be done on a bond-by-bond or issuer-by-issuer basis, but certainly not country-by-country.”

The potential divide the proposal could create between “ins” and “outs” in the covered bond market reminded some market participants of a hastily concocted plan to split the asset class into “core” and “non-core” jurisdictions in autumn 2007, when the industry was attempting to rewrite inter-dealer market-making rules. Strong objections from several jurisdictions prevented that plan from being implemented.

However, representatives of the Danish and German associations told The Covered Bond Report that the proposed size criteria are relevant.

“Size tells you something about how much liquidity you have,” said Ane Arnth Jensen, director general and chief executive of the Association of Danish Mortgage Banks (Realkreditrådet), which is supporting the proposal alongside the Danish Bankers Association (Finansrådet) and Mortgage Bank Federation (Realkredit Foreningen). “And how else should you compare it if not with the size of the economy?”

Jens Tolckmitt, vdp: "This is a work in progress"

Jens Tolckmitt, chief executive of the Association of German Pfandbrief Banks (vdp) – one of five German banking groups under the umbrella Zentraler Kreditausschuss body, which is supporting the proposals – said that the size criteria reflect investor considerations that are based on experience.

“We asked ourselves: ‘What are the features of a covered bond that make investors confident that they can really raise money from selling positions in the covered bond market?’” he said. “And it was proven during the crisis from their experience in the French, German, Danish and also Swiss markets that a very good approximation for the depth of a market is its size compared with the overall bond market in a country, and with its GDP. Investors have told us that in these markets it was always possible to get in and out of positions at reasonable prices.

“The size of a market has more implications, such as the level of support from the respective government.”

However, a market participant said that France’s absence from the countries supporting the proposal, in spite of its status as an unquestionably high quality and liquid jurisdiction, was a result of serious doubts about the criteria and underlined the lack of consensus around the Danish-German plan.

Countering suggestions that an ulterior motive for the criteria is to give the Danish and German markets an advantage, the two chief executives pointed to Polish support for the plan: the Polish Mortgage Credit Foundation has put its name to the proposal even though the size of its market means that it would not meet the criteria.

According to data from the ECBC’s Fact Book 2010, the only countries where covered bond outstandings met the requirement to average at least 15% of GDP over the past five years (measured over 2005-2009) were Denmark, Germany, Ireland, Luxembourg, Spain and Sweden (see table below). Of those, Luxembourg had less than Eu50bn of covered bonds outstanding (as of 2009), but should pass the alternative threshold of covered bonds comprising more than 25% of bonds issued by financial institutions. France, Norway and the UK pass the Eu50bn-plus test and the 15% threshold appears to be within their reach in the coming two to three years.

The original proposal was a combined Danish and German effort beginning last summer, and it was amended as associations of the other three countries came on board. Norway is represented by Finance Norway (FNO) and Sweden by the Association of Swedish Covered Bond Issuers, which is part of the Swedish Bankers’ Association.

Ane Arnth Jensen, Realkreditrådet: "We need really strict criteria"

Work on the proposal began when the final Basel III plan was still under discussion, but industry bodies are now lobbying for changes to CRD IV, with the European Commission’s position due to be finalised by the summer. A covered bond banker said that in order to influence the EC’s framework, any pressure needs to be applied by March-April.

Although the European Covered Bond Council and its parent, the European Mortgage Federation, are lobbying for improved treatment of covered bonds in CRD IV, there is not yet an alternative formal proposal to that of Denmark and Germany. The two countries are therefore continuing to lobby for their changes, even if support is not as broad as they would have preferred.

“When we saw that there was a problem with the LCR and with the leverage ratio, we knew that we had to act quickly and convincingly to get a foot in the door,” said Tolckmitt, “and that was the aim of this proposal. That was also why we worked on an alliance basis, rather than waiting for a common understanding among everybody, as that way we would have missed the deadline.

“And I would still say that this is a work in progress,” he added, “so everybody is invited to join and we are open to discussing any issues of major concern to everybody else, as long as the proposal is not watered down to something that would be irrelevant from a regulator’s point of view.”

Jensen echoed this final point.

“If we want covered bonds to be recognised on the same level as government bonds, we need to have really strict criteria,” she said. “You cannot argue that on the one hand you should make sure that these bonds should be harmonised to government bonds, and then on the other say that every kind of covered bond can be eligible for that.”

Jensen said that the proposal does not harm the interests of other jurisdictions as they would still benefit from being eligible for liquidity buffers as Level II assets. She also said that countries that do not satisfy the criteria could work towards eligibility.

“It depends on their priorities, but if they really want to expand their markets there are the means to do that,” she said.

Some market participants have said that there are other ways in which covered bonds could be categorised that would avoid excluding whole jurisdictions. One suggested ratings as well as standards of pool disclosure and price transparency – while ratings are cut from the Basel III criteria under the Danish-German proposal, pool disclosure and price transparency have been added.

Alternative criteria could form the basis of an alternative proposal, said some bankers.

Covered bonds outstanding as a percentage of GDP