A one-size-fits-all approach to the “mythical” issue of asset encumbrance is not supported by research and any absolute encumbrance limit would “catastrophically” impact dedicated covered bond banks, the ECBC argues in an EBA consultation response today (Monday).

ECBC offices, Brussels

In its submission to the European Banking Authority’s consultation on asset encumbrance reporting, the European Covered Bond Council says that asset encumbrance issue needs to be addressed through a holistic and gradual approach, taking into consideration all different sources of encumbrance.

“The ECBC believes that establishing hard limits on covered bond issuance would be a short term and one-size-fits-all solution,” it says. “These limits would be detrimental for this essential asset class and, therefore, for the European banking industry as a whole.

“We, therefore, invite European regulators to further investigate other potential solutions and we would like, in particular, to draw their attention to the recent initiative launched by the industry – the Covered Bond Label initiative – which aims to improve information disclosure and transparency in this market.”

The ECBC argues that a large part of encumbrance is hard to measure and that this can lead to a focus on the most visible and transparent part of encumbrance, such as covered bonds, with biased conclusions reached because of this.

It says that according to recent studies, including one from the European Central Bank, there is no evidence of correlation between the covered bond encumbrance of a bank and its senior unsecured spread levels

“The existence of different business models implies in our view a case by case interpretation of the level of asset encumbrance,” says the ECBC. “For specialised issuers for instance, the level of encumbrance – given a broad definition – is close to 100%.

“For those financial institutions which do not take any deposits, all senior investors are institutional investors who are well aware of their position in the priority ranking in case of insolvency. For such institutions, the high level of encumbrance is only a consequence of their business model and cannot be interpreted differently.”

The ECBC says that an absolute limit would endanger existing stable business models in traditional covered bond markets.

“There are long established covered bond markets in several countries including Denmark, France, Germany and Sweden,” it says. “In these jurisdictions, dedicated covered bond banks often exist that do not take in retail deposits and that provide a key service to the economy, but which would be catastrophically impacted by any absolute encumbrance limit.

“Therefore, we consider that an issuance soft cap established on a case-by-case basis might be more relevant in this area, especially as this could be easily implemented thanks to the licence systems already in place in several jurisdictions. Such system is already in place in the Netherlands. The breach of a soft cap should result in an increase in incremental capital required rather than a strict ban to issue new covered bonds.”

The ECBC further argues that specialised issuers that do not take deposits should be exempt from the more burdensome reporting requirements proposed by the EBA. It also says that institutions should only be requested to report on covered bonds if their asset encumbrance level triggered by covered bonds is equal to or larger than a 5% threshold put forward by the EBA.

The ECBC also argues that the strict supervision of covered bonds and their restrictive cover pool eligibility criteria are a mitigating influence and make covered bond encumbrance more stable and less sensitive to market conditions in times of turmoil than other forms of encumbrance arising from repo haircuts or derivative collateral.

The covered bond market’s average growth of 7.5% since 2007 is also sustainable, says the ECBC, compared with other forms of encumbrance and given that some countries have seen issuance for the first time. It says this growth has often been misinterpreted because senior unsecured and securitisation issuance has been shrinking.

In its response, the industry body also stresses positive role of covered bonds in crisis and historically.

Regarding a consultation question on what the appropriate asset encumbrance ratio should be, the ECBC argues for an alternative to those put forward by the EBA.

“The ECBC considers that asset encumbrance should not be reduced to a simple encumbered assets to total assets ratio,” it says.

The ECBC argues that most important to senior unsecured creditors is the ratio of unencumbered assets to unsecured liabilities, rather than the share of encumbered assets to total assets, which it says has been more commonly cited.

“In particular for specialised institutions, as is the case for many covered bond issuers, the ratio of unencumbered assets to unsecured liabilities provides a fairer picture than the pure encumbrance ratio (encumbered assets/total assets), which is usually very high for such issuers,” it says. “Instead, their lower dependence on unsecured funding corresponds to a high ratio of unencumbered assets to unsecured liabilities, indicating a comfortable level of protection for senior unsecured bondholders.”

Given the challenge of coming up with an appropriate regulatory response to asset encumbrance, the ECBC argues that a straightforward way to increase market discipline and lower excessive encumbrance is by enhancing transparency, and it cites its Covered Bond Label initiative in this regard.

“This transparency tool provides very detailed asset and liability side information and facilitates the investors’ due diligence when comparing different issuer models, products in different markets and national supervision,” it says.

The ECBC paper can be found on its website.