The ECBC has cautioned the EBA, ECB, and ESMA against relying too heavily on quantitative measures in coming up with definitions of assets counting toward liquidity buffers, with covered bonds justified a Level 1 LCR slot, and argued against a flat haircut for Level 2 assets.

The points were made in a position paper submitted by the European Covered Bond Council (ECBC) last Friday (28 September) on the treatment of covered bonds in liquidity coverage ratios (LCR) proposed under the Capital Requirements Directive (CRD) IV, which will implement Basel III regulations in the EU.

ECBC, Brussels

Basel III splits liquidity buffers into two parts, Level 1 and Level 2, with Level 2 assets counting towards a maximum of 40% of the buffer and subject to a 15% haircut. Covered bonds were included in the Basel III LCR framework as Level 2 assets, although a CRD IV proposal from the European Commission (EC) last summer did not specify which asset classes would be eligible for liquidity buffers. Instead, the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Central Bank (ECB) have the mandate to develop definitions of Level 1 and Level 2 assets by the middle of 2013.

In this context, noted the ECBC, the industry body is responding to a request from the EBA to provide it with a list of parameters and numerical evidence that could prove the liquidity of the covered bond asset class, using as a starting point items listed in Article 481(2) of CRD IV.

The position paper is the culmination of work carried out by a group of covered bond specialists – Florian Eichert of Crédit Agricole, Fritz Engelhard at Barclays, Kim Laustsen of Nykredit, and Frank Will of RBS – with a draft having been distributed and discussed during a ECBC plenary in Munich mid-September.

The paper introduces qualitative and quantitative criteria to showcase the liquidity of covered bonds, with the ECBC welcoming the CRD IV text voted by the European Parliament’s Economic and Monetary Affairs Committee (ECON) for adding qualitative criteria that were not included in a mix of quantitative, turnover-focussed, factors specified for review in the EC’s proposal.

“[W]e want to stress that putting a lot of focus on current turnover figures that are very hard to obtain in the first place is in our view not fully reflecting the purpose of the LCR,” said the ECBC. “Relying too heavily on quantitative liquidity measures may actually result in a distorted assessment of the actual liquidity of a financial instrument.”

The LCR-linked review of liquid assets should therefore only focus on one side of the “liquidity definition”, according to the ECBC, namely a bank’s ability to sell an asset in a stress scenario, with its ability to buy assets in such a context irrelevant to the purpose of the LCR.

Although the ECON’s CRD IV text is subject to the conclusions of a trialogue process bringing in the Commission and Council proposals, the ECBC position paper puts forward that it introduced qualitative criteria that help show that covered bonds have strengths worthy of being deemed as assets of “extremely high liquidity and credit quality” (Level 1).

These are, according to the industry body: credit quality steps, additional quality criteria on top of those set by central banks, and support financing for the European economy.

Evidence cited by the ECBC as supporting covered bonds’ strength in the context of these criteria includes a stable recent evolution of Moody’s collateral scores, a metric measuring the underlying credit quality of cover pools, the dedicated legal frameworks that back most covered bonds, the asset class’s repo eligibility, and the importance of covered bonds to finance European mortgage lending.

In addition, only allowing government and government-related debt to count as Level 1 assets, without limits on their contribution to meeting the LCR or haircuts, is too restrictive, said the ECBC.

“The ECBC believes that it would be potentially hazardous to build up a ratio relying largely, if not only, on public debts which have also shown some shortcomings over the recent years,” it said in a note to members. “We believe it is necessary, in order to build a sound and sustainable ratio, to diversify the eligible assets and broaden the scope of the Level 1 category to private sector investments, such as covered bonds, which have proved to be resilient and adapted to financial turmoil.”

CRD IV should also move away from a flat haircut on Level 2 assets irrespective of their maturity, said the ECBC, with this approach out of line with that of central banks, for example.

“We would argue that the risk on shorter dated assets is lower than for longer dated ones,” said the industry body. “Consequently, we would rather expect that haircuts are lower for shorter dated assets and increase the longer maturities.

“The collateral framework of the Eurosystem has been reflecting this fact for many years.”