Standard & Poor’s has highlighted that increasing asset encumbrance is by no means a negative influence on its bank ratings given a focus in its ratings on the probability of default, something that covered bond financing and funding support from central banks often decreases.

In research discussing the influence of asset encumbrance on its bank ratings published on Thursday, the rating agency noted an increase in covered bond issuance over the past four years and that this could affect banks’ funding and liquidity positions and, in turn, S&P’s ratings.

This trend and the negative rating possibilities it carries have caused concern among many observers, but S&P noted other aspects of encumbrance and the way this is treated in its methodology that suggest such fears may be overdone.

Most immediately, the rating agency said that other financing, in particular collateralised central bank borrowing, can be a more significant contributor to the overall degree of encumbrance on a bank’s balance sheet and, consequently, to its analysis and ratings.

“Looking at Europe, we see that increased covered bond issuance is not the most striking development in bank funding markets over the past few years,” said S&P. “Rather, it is the spike in funding via the long-term refinancing operation (LTRO) of the European Central Bank.

“EU banks’ use of LTROs had rocketed to more than Eu1tr by August 2012 from Eu120bn at year-end 2006, significantly reducing the likelihood of a liquidity driven default for European banks in the short term. Some European banks even received additional long term funding from their national central banks under other schemes, and continued to use medium and short term facilities.”

The rating agency also said that banks have been pledging more assets than previously partly due to concerns about European Commission bail-in proposals, and that senior unsecured issuance has fallen.

“We expect that banks will pledge more of their assets to obtain funding as they manage through a period of restructuring or a change in capital market conditions, with governments still providing funding and liquidity support,” said S&P. “Asset encumbrance typically increases during such a transition and we see this trend in Europe through the fall in senior unsecured funding relative to other asset-backed or secured funding.”

The rating agency went on to say: “Temporary increases in encumbrance can, we believe, support a bank’s creditworthiness.”

S&P detailed several ways in which encumbrance influences different parts of its rating process.

One way is in a system-wide funding assessment in its Banking Industry Country Risk Assessment (BICRA) methodology, where it looks at the stability of funding sources in a country. With regard to this, S&P said: “Covered bond markets tended to be more stable sources of funding during the financial crisis, although we note that this can differ by jurisdiction and the nature of the covered bond product. A large and mature covered bond market, like that in Germany, Scandinavia, or France, is in our view more stable than smaller less-established markets, such as those in Portugal, Greece, Italy, and Ireland.”

Regarding bank-specific funding assessments, where it compares a bank’s funding profile with the average profile for banks in a country, S&P said: “Issuing covered bonds has typically afforded banks longer dated funding profiles and relatively stable funding sources in stressed financial markets. This type of secured funding is therefore an important part of many banks’ financing strategies and can reduce the risk of default.”

S&P also stressed that a holistic approach needs to be taken when considering what impact a bank’s encumbrance might have on its ratings.

“Increasing asset encumbrance is a common feature in banking systems that are restructuring or when funding markets change,” it said. “We therefore do not use specific point-in-time thresholds for measuring when asset encumbrance becomes a rating weakness.

“Instead, we focus on the impact of asset encumbrance on a bank’s overall funding and liquidity.”