The International Monetary Fund said yesterday (Wednesday) that policymakers should encourage covered bond issuance as a way of addressing a shortage of safe assets, a problem it highlighted on releasing a new chapter of its Global Financial Stability Report.

The IMF said that while heightened uncertainty, regulatory reforms and crisis-response measures by central banks are increasing demand for safe assets, supply has declined and is set to fall further. The IMF forecast a $9tr (Eu6.87tr) fall in the supply of safe assets by 2016, equivalent to roughly 16% of the projected total.

In the report’s key conclusions and policy implications, the IMF said that “the production of safe assets by the private sector is an important source of supply and should not be impeded”. The IMF noted that securitised instruments and covered bonds generate safety synthetically by “combining the payoffs of risky instruments” rather than having the “intrinsic” safety of government debt.

It said that to ensure such products fulfil their safety role, there is a need to introduce: intensive supervision, better incentives for issuers (aligning issuer’s compensation with the longer term performance of the created securities); a robust legal framework; and improved public disclosure to ensure that securitised products are well understood and market participants have the resources and information to price and manage the risks.

“Well conceived and regulated covered bond structures of mortgages (with overcollateralisation and the ability to replace impaired loans) are one good example,” said the IMF.

Covered bonds were earlier highlighted as being particularly interesting among safe assets that could be created by private issuers.

“Two critical aspects differentiate covered bonds from typical securitisations: the unobstructed access they provide to asset pools in case of an issuer default and, perhaps most importantly, the ongoing substitutability of asset pools that underlie these bonds,” said the IMF. “The latter feature ensures that the quality of asset pools is kept high at all times, as issuers are required to substitute or add collateral in case of credit quality deterioration (thus ensuring overcollateralisation).”

The IMF also said that “sound” securitisation can play a role in growing the supply of safe assets. However, it noted that poor securitisation in the US had tainted the asset class and said that “investors are generally still unwilling to invest much in these types of assets.”

Outstanding amounts of marketable potentially safe assets (US$ trillion)