Imposing a limit on asset encumbrance as part of bail-in legislation, an idea floated by the IMF, would interfere with covered bond markets and be resisted by authorities in several European countries because of the established role they play, said Fitch today (Tuesday).

IMF HQ, Washington, DC

The idea of limiting encumbrance, or requiring banks to maintain a minimum amount of unsecured debt, was highlighted in an International Monetary Fund (IMF) staff discussion paper on bail-ins of systemic financial institutions last week.

Amendments tabled to the Capital Requirements Directive by European Union MEPs also address asset encumbrance. UK Conservative MEP Vicky Ford, for example, has proposed an amendment citing a “total unencumbered assets ratio” that would require the European Commission, after consultation with the European Banking Authority (EBA), to report on the amount and composition of financial institutions’ unencumbered assets and on whether and how it would be appropriate to set a legislative limit on these. A proposal by two MEPs from the Greens/European Free Alliance, would require deposit taking institutions to hold a capital cushion against issuance of covered bonds above a threshold of 4% of total assets.

Fitch today said that authorities in several European countries may be unwilling to impose a fixed limit on asset encumbrance as part of any future bail-in legislation because of the deep-rooted role covered bonds play in their markets, and that such a limit would most affect specialised covered bond issuers in France, Germany and Scandinavia as well as banks in southern Europe that have become dependent on central bank financing.

It considers covered bonds sold into the market less of a concern than some other forms of secured funding encumbering balance sheets, with increasing reliance of banks in the more troubled euro-zone countries on secured funding, most notably via the ECB’s three year longer term refinancing operations (LTROs) and market repo funding, a more negative ratings driver.

“Covered bonds in northern Europe have an established role in financial markets and are a key component of local pension funds, being seen as the safest holdings available in countries where sovereign debt issuance is low,” said Fitch. “However, covered bonds are also issued internationally.

“While it’s unclear where any potential encumbrance limit would be set, it would be difficult for European authorities to impose a limit if it interferes with the broader operations of these markets.”

Encumbrance levels are difficult to measure and compare, noted the rating agency, because of inconsistent and even poor disclosure by banks, although some banks have improved their disclosure in 2011 financial statements.

The rating agency expects to publish special reports on the encumbrance of European banks’ balance sheets and the use of covered bond funding over the next few months.

High encumbrance levels are not necessarily a sign of stress, said Fitch, and can instead be due to the structure of a country’s banking and investment sector, with Scandinavian and German banks, for example, among the biggest issuers of covered bonds as a percentage of their total balance sheet.

“However, when a bank starts to increase encumbrance, this is often a sign of stress,” it said.

The number of banks issuing covered bonds has increased in recent years because of the high cost of, and reduced demand for, unsecured funding, it said, with Spanish banks, for example, increasing issuance, which is usually retained as collateral to repo with the ECB.