The Norwegian FSA may impose higher capital charges on issuers or restrict their issuance if it considers that they are tying up too much collateral in covered bonds, it said today (Tuesday), calling for consideration to be given to limits on encumbrance resulting from covered bond issuance.

“Although covered bonds have made a positive contribution to Norwegian banks’ funding in a period of international financial turbulence, consideration should now be given to possibly curbing the use of such bonds,” said Morten Baltzersen, director general of Finanstilsynet (the Financial Supervisory Authority of Norway), in comments accompanying a report on financial trends in Norway.

Finanstilsynet noted that covered bonds had helped Norwegian banks achieve more robust funding by providing them with better access to long term funding markets. However, the regulator said that the increased use of covered bonds also poses challenges.

Morten Baltzersen

“When the presumptively best secured loans on banks’ balance sheets are mortgaged, banks’ other creditors, who are unsecured or lack a deposit guarantee, perceive an increased credit risk,” it said. “As a result banks may in time experience problems in obtaining funding other than by covered bonds, which may in turn heighten vulnerability and reduce their ability to finance loans carrying higher credit risk than home loans.”

The regulator also said that covered bonds introduce a procyclical element to banks’ funding and lending, by easing funding when house prices are rising and there is demand for loans, but potentially drying up rapidly when other funding opportunities are weakened because the best loans have been mortgaged.

“The fact that home loans can be funded at significantly lower interest rates through covered bonds than is the case with loans to business and industry may, detrimentally, draw bank lending away from businesses towards households,” it added.

The FSA said that the strong emergence of secured bank funding has led to disquiet among authorities in many countries, with some having responded by setting limits on such funding.

Regarding Norway, Finanstilsynet said that the volume of covered bonds has risen to a “very high level” in the space of a few years.

To illustrate the magnitude of Norway’s covered bond market, Bernd Volk, head of covered bond research at Deutsche Bank, pointed out that Norway had Eu107.3bn equivalent of covered bonds outstanding as of 30 June for a population of around 5m compared with Eu250bn of mortgage Pfandbriefe outstanding for Germany’s population of over 80m.

“Finanstilsynet is of the view that consideration should be given to introducing limits on the proportion of assets that can be posted as collateral for covered bond issues,” said the regulator. “Irrespective of the outcome of any such assessment, Finanstilsynet expects Norwegian financial institutions to consider the level of such transfers as part of the Pillar 2 process.

“If, in Finanstilsynet’s view, the level of transfer is too high, an appropriate response may be to impose on individual institutions higher capital charges or restrictions on access to covered bond funding. Any such response would be based both on institution-specific risk and systemic risk.”

If general restrictions are to be introduced, it added, this must be done in a way that does not undermine the established market for covered bonds.

A funding official at a Norwegian bank told The Covered Bond Report that the announcement had come as a surprise.

He said that in some ways any move would be too late given the large volumes that banks have already transferred to their covered bond issuing vehicles. He also pointed out that the Norwegian financial authorities had encouraged Norwegian banks to increase their covered bond issuance through a scheme introduced in 2009 whereby they could swap covered bonds for government securities to ease funding pressures, which prompted heavier issuance of covered bonds by existing issuers and prompted more Norwegian banks to enter the market.

And Florian Eichert, senior covered bond analyst at Crédit Agricole, agreed that it would be very hard to introduce limits to an existing market, noting that the Norwegian FSA would be adopting a similar approach to the UK and the Netherlands by rather focusing on taking increased encumbrance risk into account by asking banks potentially to hold more capital.

The Norwegian bank that has transferred the highest proportion of its residential mortgages to its covered bond vehicle is DNB, which has transferred more than 80% of its book. At the other end of the spectrum, the Terra banks have transferred only 21.5% of their residential mortgages.

The Norwegian FSA’s move comes a week after its Swedish counterpart called for its banks to take a lead in bringing more transparency to encumbrance resulting from covered bonds. However, market participants argue that covered bonds are being unfairly singled out.

“The biggest source of encumbrance in recent history has been central bank funding, not covered bonds,” said Eichert. “Unfortunately covered bonds are the most transparent source of encumbrance and are thus being hit first. Limiting covered bonds will merely lead to other forms of encumbrance by banks (securitising mortgage portfolios and pledging them to the ECB for example).

“And do authorities really want to push banks over the edge by cutting or limiting collateralised funding that stays on for longer than unsecured funding in times of stress? Had we had encumbrance levels in place in the past already, a number of banks that are still alive and kicking today would have had to close their doors by now.”

Deutsche’s Volk, meanwhile, noted that the Norwegian FSA’s concerns were being raised at a time when house prices in Norway have risen strongly relative to other EU countries. However, he said the outlook for the performance of Norwegian covered bonds was likely unchanged.

“Overall, in our view, despite these risks, in the current environment spreads of Norwegian covered bonds are likely to remain driven (and supported) by superior sovereign credit quality,” he said.

Photo: Finanstilsynet/CF-Wesenberg