Any limits on asset encumbrance that might result from ongoing European regulatory discussions may make sense as part of a bail-in regime but should be dynamic and flexible to avoid risks such as pro-cyclicality, according to DBRS.

The rating agency last Tuesday (11 September) said that recent actions and comments from European regulators and industry bodies foreshadow the introduction of asset encumbrance limits, citing moves on behalf of organisations such as the European Banking Authority (EBA) and the European Systemic Risk Board (ESRB).

Encumbrance limits make sense in the context of bail-in regulations in order to protect deposit holders and unsecured creditors, said DBRS, adding that covered bonds represent an obvious target.

“Given the popularity of the covered bond instrument, one can easily forecast a limit to issuance as part of a headline-making strategy to control asset encumbrance,” it said.

However, any imposition of encumbrance limits should be carefully considered, added DBRS. The introduction of a hard cap should be avoided, according to the rating agency, as this risks pro-cyclicality and the possibility of otherwise secure banks being sent over a liquidity cliff toward bankruptcy.

“As a result, debate over any proposed limit on encumbrance should include flexibility and allow for the ability to further encumber an elevated proportion of assets in times of stress,” said DBRS.

It cited the example of Belgium’s covered bond legislation, which allows the country’s central bank to grant exceptions to a covered bond issuance limit – 8% of a bank’s assets – when assets are needed to maintain contractual obligations of the covered bond programme or when the bank’s credibility on the market is affected. It can also impose a lower limit to protect depositors if the bank has pledged a large amount of collateral in other forms, noted DBRS.

Any encumbrance limits would have a large impact on heavy issuers of covered bonds, with areas such as Germany, Spain and certain Nordic countries likely to be more severely affected, according to the rating agency. It suggested that differentiation be made between banking models, so that non-retail deposit taking institutions, for example, would be allowed to have higher levels of encumbered assets. Otherwise, issuers such as specialised mortgage banks would need to access new markets for funding, potentially increasing overall funding costs.

In addition to being flexible and differentiated, any encumbrance limits should also be introduced gradually, said DRBS, as some banks will need time to diversify their funding sources.

“There is a risk of decreasing supply from regular covered bond issuers in the market and a further slowdown in their lending activities as they adjust their funding models,” it said. “A drive to implement bail-in legislation by 2015 will likely prove detrimental to large covered bond issuers.”

In contrast, covered bond issuance from new or previously quiet jurisdictions is likely to increase, according to the rating agency, as a result of the combination of investor demand for high quality collateral and appetite for non-bail-inable debt, and the appeal of low cost funding.

The rating agency also warned that asset encumbrance limits could inject an element of risk to covered bonds in the context of issuers’ management of overcollateralisation. In extreme cases, it said, encumbrance limits may limit issuers’ capacity to add collateral to shore up a given rating and “may be used as justification not to support the covered bonds rating”.

Overall, DBRS said that it finds that the issue of asset encumbrance is of “some but not immediate concern” to covered bond investors and ratings.

“However, it is difficult to say at this stage what the impact will be as several factors need clarification,” it said.