The Basel Committee has relaxed its liquidity coverage ratio requirement for banks, delaying its full introduction and broadening the range of high quality liquid assets making up the LCR. Covered bonds took a backseat in the news, with market participants saying that the implications for covered bonds are unclear but could be positive.

Bank for International Settlements, Basel

The Basel Committee on Banking Supervision yesterday (Sunday) announced that it has made several amendments to the Liquidity Coverage Ratio as a minimum standard for banks, including to the definition of high quality liquid assets (HQLA) and net cash outflows (the numerator and denominator of the ratio) and the timetable for the requirement.

A summary description of the revised LCR was published yesterday and a full text incorporating the changes is due to be published sometime today (Monday).

Covered bond market participants said that the committee’s announcement was not surprising and played down any implications for covered bonds, at least on the basis of the summary documents released yesterday.

“Based on the studies that have been made about how far away we are from hitting the LCR targets it was always going to be the case that they would have to relax it,” said a covered bond banker. “The implication would have been horrible on the real flow of funds into the economy so there is no great surprise that they’re going to relax it, and doing so effectively in three ways: via the numerator, denominator, and timing.”

Full implementation of the LCR requirement has been postponed until 2019, with banks only having to comply with the ratio to 60% from 2015, with compliance moving up to 100% in steps of 10% per annum.

The Basel Committee also expanded the range of HQLA by introducing a new category of second tier HQLA, splitting the second level into Level 2A and Level 2B assets. Level 2 assets continue to be subject to an overall cap of 40% on the proportion of the LCR that they can comprise.

It appears that one of the appendices accompanying the Basel Committee press release on the Bank for International Settlement (BIS) website has been slightly changed, with an initial version of the document not mentioning covered bonds in the list of assets that count as Level 2A assets, and a later version doing so. According to the summary description of the revised LCR available at the time of writing, “Level 2A assets include, for example, certain government securities, covered bonds and corporate debt securities”.

The announcement did not refer to haircuts on Level 2A assets, but covered bond market participants said that the treatment of covered bonds with a rating of at least AA-, which under an earlier proposal were eligible as Level 2 assets, has not changed as a result of the committee’s changes to the Level 2 HQLA range, besides being known as Level 2A rather than Level 2 assets.

A new Level 2B category has been introduced, however, to expand the definition of HQLAs to include, subject to higher haircuts and a limit: corporate debt securities rated A+ to BBB-, with a 50% haircut, certain unencumbered equities, also subject to a 50% haircut, and certain residential mortgage backed securities (RMBS) rated AA or higher, with a 25% haircut.

The aggregate of Level 2B assets, after haircuts, is subject to a cap of 15% of the total HQLA stock.

Although covered bonds were not explicitly mentioned by the Basel Committee as Level 2B assets, one analyst suggested covered bonds in the A+ to BBB- rating range would be included, based on interpreting the committee’s use of the term corporate debt as referring to non-government debt, with the inclusion of less secure financial instruments such as equities as a Level 2B asset also suggesting that covered bonds in the A+ to BBB- rating range would likely be included in the new category.

However, many analysts were waiting to read the full text of the changes before commenting further, with one initially saying that the Basel Committee’s announcement was not a covered bond specific topic, and that relatively little information had been provided.

Included in one banker’s reactions to the changes was a comment noting that the 25% haircut on RMBS in the Level 2B bucket was “not much” compared with a 15% haircut on covered bonds, and that the differential was much larger under Solvency II.

“It massively understates the difference in liquidity,” he said, adding that covered bonds continue to be treated much more favourably than RMBS under the ECB’s collateral framework.

Florian Eichert, senior covered bond analyst at Crédit Agricole, said that the changes announced by the Basel Committee do not necessarily constitute the final set of rules, at least when it comes to the details, citing as support for this interpretation the committee’s statement that it “will continue to explore the use of market-based indicators of liquidity to supplement the existing measures based on asset classes and credit ratings”.

“We read this a bit similar to the way Europe is approaching its liquidity rules,” said Eichert. “The technical details, which define which asset will be treated how and what exactly the parameters are for this, are still under construction.

“Similar to the CRD and EBA [European Banking Authority], the Basel Committee is also thinking about alternative indicators away from ratings to determine LCR treatment,” he added. “In essence this could mean that despite the rating limits things could still move around.”

The aforementioned banker echoed this sentiment, noting that the Basel Committee’s announcements did not contain any details defining a covered bond.

“That’s an area of uncertainty that is up to the EBA and the European Commission,” he said.

Wolfgang Kälberer, head of EU affairs at the Association of German Pfandbrief Banks (vdp) in Brussels, said that the Basel Committee’s announcement is likely to have an impact on EU level negotiations on CRD IV.

“The compromise process is still ongoing, and there was a willingness to wait for a decision from the Basel Committee,” he said. “It could be that the EU ends up with an even more flexible approach than Basel but that remains to be seen.”

The extension of LCR eligible assets at the Basel Committee level is a positive development, said Kälberer.

“If you go for other asset types that are less secure than covered bonds, such as asset backed securities or corporate bonds, then this is going to be positive for covered bonds’ eligibility,” he said. “The EBA appears to be leaning toward distinguishing between covered bonds from different jurisdictions rather than accepting the asset class as a whole, but the Basel Committee move to extend the range of eligible assets could have the effect of pushing the boundary in favour of covered bonds from member states that were perhaps not as liquid as those from other countries during the crisis.”

Should covered bonds rated A+ to BBB- be eligible as Level 2B assets, this could allow a broader range of issues to be included, particularly issuance from peripheral countries where covered bonds have been downgraded in the wake of sovereign and bank downgrades.