A new EC legislative proposal for a bank recovery and resolution framework published yesterday (Wednesday) is positive for covered bonds, according to analysts, as it excludes secured liabilities from bail-ins, grants covered bonds a further explicit exemption, and carries other benefits.

Commissioner for internal market and services, Michel Barnier, who announced the proposals

The proposal, which was well flagged and widely anticipated, is aimed at creating a crisis management framework that will remove the need for government bail-outs by shifting the burden of any restructuring and resolution of failing banks to a bank’s shareholders and creditors.

Leef Dierks, head of covered bond strategy at Morgan Stanley, said that the legislative proposal is largely in line with discussion papers and other past communication on the framework, and that it confirms covered bonds are benefitting from regulatory treatment compared with other asset classes.

“The news is largely positive,” he said, “although it has largely already been priced in.”

According to the European Commission, the costs associated with the introduction of a bail-in tool should be moderate, “far outweighed by the expected macro-economic benefits associated with a far-reduced likelihood of systemic financial crises and economic disruption”.

It said that funding costs for banks are expected to increase on average by around 5bp-15bp, and that when subtracted from the expected benefit in GDP terms of a lower probability of systemic crises this translates into a net yearly benefit of 0.34%-0.62% of EU GDP. The commission also published an impact assessment, which provides a much more detailed breakdown of the impact of bail-in on banks’ cost of funding in different situations, based initially to a large extent on a JP Morgan survey that estimates an 87bp increase in funding costs of bail-inable liabilities.

The legislative proposal empowers the relevant authorities to employ resolution tools ranging from those for prevention, early intervention, and/or resolution, with intervention by the authorities becoming more intrusive as the situation deteriorates.

Preparation and prevention tools include the requirement that banks draw up recovery plans and authorities prepare resolution plans, while in the event of incipient problems early intervention powers allow authorities to take steps such as requiring the institution to implement measures set out in the recovery plan, draw up an action programme and a timetable for its implementation, and require the institution to draw up a plan for restructuring of debt with its creditors.

In addition, supervisors will have the power to appoint a special manager at a bank for a limited period when there is a significant deterioration in its financial situation and other tools are not sufficient to reverse the situation.

A third pillar, dedicated to resolution of a failing bank that preventative or early intervention measures were not able to stabilise, grants four main resolution tools:

• a sale of business;
• separating good assets or essential functions to be allocated to a new bank to be sold to another entity and liquidating the old bank (bridge institution tool);
• allocating bad assets to an asset management vehicle (asset separation tool, only to be used in conjunction with another tool);
• recapitalising the bank by wiping out or diluting shareholders and reducing or converting into shares the claims of creditors (bail-in tool)

With respect to the bail-in tool, the commission’s proposal states that the resolution authorities should have the power to bail-in all the liabilities of the institution, but that some would be excluded ex-ante, such as secured liabilities, covered deposits, and liabilities with a residual maturity of less than one month.

Bernd Volk, head of covered bond research at Deutsche Bank, said that the proposal is broadly positive for covered bonds, with covered bonds, as part of “secured liabilities”, exempted from bail-in.

“Hence, besides authorities finding specific ways or arguments (which is unlikely particularly in countries with long covered bond history) covered bonds seem fine,” he said. “It is not clear though if a loss due to lack of refinancing (i.e. high asset-liability mismatch) after cover pool segregation in case of bank resolution can be excluded, i.e. if covered bond holders would be limited to pool assets, and actually have to bear the risk of the cover pool.”

Volk highlighted that the EC proposal specifically states that the hierarchy of claims is crucial and that it is largely covered bonds’ ranking that works in the asset class’s favour.

While Article 38 on the bail-in tool also states that with respect to secured liabilities and guaranteed deposits resolution authorities should be entitled to exercise bail-in powers “in relation to any part of a secured liability or a liability for which collateral has been pledged that exceeds the value of the assets, pledge, lien or collateral against which it is secured”, covered bonds are explicitly exempted from this provision.

To make possible and effective the application of bail-ins, financial institutions need to have a sufficient amount of bail-inable liabilities, and the commission said that the minimum amount will be proportionate and adapted for each category of institutions on the basis of their risk or the composition of its sources of funding (Article 39).

By way of example and on the basis of evidence from the recent financial crisis and of performed model simulations, the Commission said that an appropriate percentage of total liabilities which could be subject to bail in could be equal to 10% of total liabilities (excluding regulatory capital).

Deutsche’s Volk said that activating resolution before insolvency is positive for covered bonds as it reduces substitution risk or the risk of taking out OC shortly before insolvency, and that refinancing risk for covered bonds can also be reduced by the introduction of resolution tools and powers such as the creation of a “bridge” institution to continue the operation of critical functions of a failing bank, or the separation of “bad” assets into an asset management vehicle.

With respect to the drawing up of recovery and resolution plans he noted that the commission’s proposal requires these to be agreed by a banking group’s home regulator and designated “resolution authority” as well as new “resolution colleges”, which include other relevant national regulators and the EBA.

“Particularly regarding countries with long covered bond history, the direct involvement of national regulators should be a home-run regarding ongoing covered bond support,” said Volk.

He also suggested that, assuming that resolution becomes the standard way of managing financial institution problems, an exemption of most employee claims from resolution under the proposed bail-in provisions (article 38) could lead to a greater acceptance of and focus on universal bank covered bond issuers, away from specialist issuers with limited or no employees, as in the case of obligations foncières-issuing SCFs.

“This in turn suggests the need for limits regarding asset encumbrance via covered bonds, which are not mentioned at this stage,” he said.