The Dutch central bank has identified disclosure as a means of mitigating risks associated with asset encumbrance, and said that prudential limits on covered bond issuance have helped keep Dutch encumbrance levels below the European average.

The comments were made by De Nederlandsche Bank (DNB) in a financial stability report published on Thursday.

It is the latest regulator to put forward transparency as a means of tackling asset encumbrance. The Swedish financial authorities have urged issuers to take the lead on asset encumbrance by releasing relevant information and the European Banking Authority has highlighted asset encumbrance reporting as integral to regulators’ supervision of the financial markets.

In its report DNB said that secured funding has increased in importance, with the use of covered bonds increasing in particular, although there are other sources of encumbrance, such as central bank liquidity support. The rise in secured funding can have a self-reinforcing effect, said the central bank, noting that asset encumbrance brings with it certain risks, such as pro-cyclicality and threats to deposit guarantee schemes as well as greater interconnectedness and complexity in the financial system.

It said that Dutch banks have increasingly turned to secured funding, mainly via issuance of long dated covered bonds as opposed to ECB funding. Dutch covered bonds are highly overcollateralised, leading to relatively high asset encumbrance when they are issued, DNB noted, mainly due to the interest-only profile of many Dutch mortgages backing covered bonds, with high LTV ratios also playing a role.

However, average asset encumbrance at large Dutch banks, at 14%, is below the European average of 25%, said the Dutch central bank, and is partly due to DNB setting prudential limits on the volume of covered bonds that individual institutions may issue. The Dutch central bank takes a case-by-case approach to banks’ covered bond issuance.

In addition, it said that provision by banks of “sufficient information” can mitigate the risks of asset encumbrance, by helping keep encumbrance levels low and reducing the risk of surprises.

“If banks report frequently on which portion of their balance sheet is encumbered, unsecured financiers can make better risk assessments,” it said. “This increases the incentives for banks to keep asset encumbrance low.

“Providing frequent information reduces the risk of surprises for investors, thus avoiding the threat of a sudden increase in risk premiums or funding risks, for example.”

A new housing market policy in the Netherlands will also help limit asset encumbrance, said DNB. Two aspects of this, the introduction of annuity-based mortgages and the gradual imposition of a 100% LTV ratio limit, will help lower the level of overcollateralisation required in future, according to the central bank.

As concerns the risk of asset encumbrance jeopardising the stability of the broader financial system by potentially necessitating deposit insurance payments and, ultimately, a government bail-out of banks, DNB said this could be countered by pricing the risks for the deposit guarantee scheme (DGS).

“In the future ex-ante deposit guarantee scheme, which is expected to be introduced in 2015, the banks will pay a risk-based premium,” said the central bank. “Making this premium partly dependent on the level of asset encumbrance will prevent banks from seeking to lower their funding costs by pushing the risks onto the DGS.”

Funding of Dutch banking sector split by main funding categories June 2012 (Eu bn)

Source: DNB