European Commission bail-in proposals provide for a flexible limit on asset encumbrance, according to a BaFin official writing in the German regulator’s latest quarterly, with absolute limits potentially endangering existing business models of covered bond issuers, particularly those of mortgage Pfandbriefe.

BaFin, Bonn

In an article published yesterday (Tuesday) examining the impact of asset encumbrance on unsecured creditors, Steffen Meusel, senior advisor at BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht), notes that since the start of the crisis investors’ confidence in banks has fallen and this has led to an increase in secured funding via covered bonds, repos and ECB LTROs. According to the article, Eu1.1tr of loans mature in 2012 at euro-zone banks, 80% of which are unsecured, but only 20% of current 2012 refinancing is unsecured. On top of this, adds Meusel, increasing amounts of collateral being provided in derivatives transactions will further diminish the insolvency estate available to creditors.

“If there were to be insolvency, higher levels of asset encumbrance would also have a detrimental effect on the (few remaining) investors in unsecured forms of funding,” he says. “The reason for this is that there are only a few remaining freely disposable assets and these are typically of lower quality than collateral for covered bonds or for repos.

“Thus rising encumbrance levels mean that there is a disproportionately large increase in the loss for unsecured creditors during insolvency.”

Meusel says that a negative cycle of more secured funding and even more expensive unsecured funding could become even more pronounced due to bail-in plans.

“For this reason, efforts are taking place at national and international levels to limit asset encumbrance as a whole or, for example, to limit the emission of covered bonds or the size of the cover pool,” he says.

However, Meusel says that proposals made during negotiations over CRD IV are unlikely to be implemented or will only be implemented in part.

“An absolute limitation seems particularly critical, as they would endanger existing stable business models, particularly for issuers of mortgage Pfandbriefe,” he says. “The banks would also lose operational options, particularly for refinancing shortfalls and rating downgrades.”

Meusel notes that in new jurisdictions such as Australia, Canada and New Zealand limits on covered bond issuance have been put in place and that “this appears to make sense” so as to improve acceptance of the asset class by unsecured creditors and avoid an overly sharp increase in encumbrance.

According to Meusel, EC proposals setting out the basis for bail-ins provide for a more flexible limit on asset encumbrance.

“Amongst other matters, the stipulation by national authorities that ‘sufficient’ amounts of liabilities be made available for restructuring should be ensured,” he says. “This expressly excludes secured liabilities to the extent of the value of the collateral; a national option is currently planned for covered bonds within the meaning of Article 22 (4) of the UCITS Directive (also includes Pfandbriefe under the Pfandbrief Act).”

While noting that limited data is available, Meusel says that asset encumbrance has increased significantly in most European countries since 2005, and that for some European banks it increased strongly in 2011.

“An important cause of this increase in asset encumbrance is the increased use or legal introduction of covered bonds as a form of refinancing,” he says. “Only Germany, Ireland and Luxembourg – the three countries where public covered bonds dominate – registered a decrease.”

Meusel notes that while German outstandings fell, the overcollateralisation ratio of Pfandbriefe increased, from 20% to 29% for mortgage Pfandbriefe and 11% to 21% for public sector Pfandbriefe.

“Internationally, the proportion of overcollateralisation is in some parts rising even more strongly,” he says. “The reason for this is the increasing requirements of rating agencies on the cover pool, in order to maintain high bank ratings (AAA ratings where possible) for the covered bonds.”

The European Central Bank’s LTROs also anticipate a relatively high level of overcollateralisation, says Meusel, particularly in peripheral euro-zone countries, with their ECB eligible assets having been expanded to include more risky assets with higher haircuts.

“According to the ECB, many German banks have also participated in the three year ECB tenders,” he adds. “The Bundesbank and BaFin are monitoring whether risks might arise from the use of the LTROs by German banks.”

The article can be found here in English and here in German.