An increasing reliance on secured funding by European banks makes it important to improve disclosure of which of a bank’s assets have been pledged as collateral, said Fitch yesterday (Tuesday). UK authorities last week stated their confidence in being able to gain such visibility.

Fitch said that secured funding, be it via covered bonds or repo transactions with the European Central Bank and other counterparties, has been one of the few forms of wholesale funding available to some banks in the second half of the year.

The rating agency in the second quarter of the year carried out a European fixed income investor survey where 87% of respondents expressed concern about an increased use of secured funding by banks, potentially leading to structural subordination. Fitch said yesterday that a reliance on secured funding in the second half of the year has probably added to unsecured investors’ concerns.

Asset encumbrance is also on the agenda of financial regulators, with the UK’s Bank of England and Financial Supervisory Authority (FSA) addressing the issue only last Thursday.

Hector Sants

The FSA recently completed a survey of major UK banks’ levels of asset encumbrance, and Hector Sants, chief executive of the FSA, on the occasion of the release of the Bank of England’s December Financial Stability Report on Thursday, said that asset encumbrance is a potential risk.

“It’s clearly an area that we both [FSA and Bank of England] need to look at closely, and the FPC [Financial Policy Committee] will engage with,” he said. “The position at the moment is we can get data, so you should be reassured that we can get visibility of the issue.

“We will be asking the banks to put work into improving their systems, improving their management information, to ensure that we can get at the data, and indeed they can get the data, and if necessary communicate it to investors in a more timely and efficient way than they currently do it.”

Adverse funding feedback loops

The Bank of England’s Financial Stability Report said that there are market concerns about asset encumbrance, and that higher levels of, or greater uncertainty about, encumbrance increase the probability of a credit run, making the institution more vulnerable to liquidity risk.

“That may have contributed to the increase in unsecured funding costs,” it said. “It can lead to the emergence of adverse funding feedback loops, whereby funding-constrained banks seek to tap secured markets only to see their access to unsecured funding markets reduced further.”

Also speaking on Thursday, Andy Haldane, executive director, financial stability at the Bank of England, said that the central bank and the FSA were led to look closely at the degree of asset encumbrance at banks because some banks believe that funding will remain skewed towards the secured form in 2012.

“What the Report says is that we want to get underneath how much of the balance sheet is secured now, how much prospectively might be encumbered tomorrow, with a view to shedding a little light on that,” he said. “And that might in turn help reduce uncertainty and cheapen the cost of unsecured funding looking forward.”

Fitch said that there is a lack of transparency over which assets have been pledged as collateral because banks generally do not disclose such details on a consistent basis and estimating them from other sources can be difficult.

Encumbrance is a key issue, it said, even though whether a bank obligation is collateralised only matters to an investor if a bank defaults, and bank defaults are still extremely rare, with the five year cumulative default rate for banks rated by Fitch over the past 20 years standing at less than 1%. The rating agency also said that additional access to funding provided by having readily mobilised collateral tends to reduce bank default risk.

“However, when assessing banks’ senior unsecured debt ratings, Fitch can take account of the level of secured funding and notch down the unsecured ratings to reflect below average recovery expectations if we believe that asset encumbrance is particularly high,” it said.

The rating agency said that it is difficult to set a specific trigger point for such a move in terms of the percentage of assets used as collateral because the amount of encumbrance a bank can bear varies widely depending on its business model and the quality of its assets. “Banks that are purely focussed on low risk residential mortgages, for example, should be able to accommodate a higher level of encumbrance than banks with a broader range of assets with higher overall potential loss rates,” it said.

Profile of major UK banks’ term debt funding