Danish covered bonds issued under the country’s balance principle look set to become the only covered bonds in relation to which banks can book unrealised gains and losses due to changes in their own credit risk, according to EBA technical standards released on Monday.

The European Banking Authority published the final draft Regulatory Technical Standards (RTS) on “close correspondence between the value of an institution’s covered bonds and the value of the institution’s assets relating to the institution’s own credit risk” under Article 33 of the EU Capital Requirements Regulation (CRR).

That article specifies the criteria that must be met in order for an institution to be allowed to include the amount of unrealised gains and losses on its liabilities in own funds. This, according to analysts, captures the practice of generating capital by writing down one’s own liabilities, and vice-versa, which banks have been able to do in the past but the EBA frowns upon.

“In general, changes in gains and losses on its liabilities following changes in own credit risk should not lead to changes in the capital position,” it said. “The reason for the rule is that it is not considered prudent for the regulatory capital to strengthen when the fair value of a liability decreases due to an increase in own credit risk (own credit standing).”

However, under CRR Article 33, an institution may include gains and losses on its liabilities in its own funds if the following four conditions are met:

• The liabilities are UCITS 52(4) compliant covered bonds,
• The changes in the value of an institution’s assets and liabilities are due to the same changes that institution’s own credit standing,
• There is a close correspondence between the value of the covered bonds and the value of an institution’s assets, and
• It is possible to redeem the mortgage loans by buying back the bonds financing the mortgage loans at market or nominal value.

The EBA’s final draft RTS further specify what constitutes close correspondence between the value of the covered bonds and the value of the assets. The existence of such a close correspondence, according to the CRR and the EBA, would justify gains and losses on liabilities following changes in own credit risk to be taken into account. In such special cases, however, noted the EBA, the change in asset value offsets the change in liabilities, leaving the capital position unchanged.

Maureen Schuller, head of covered bond strategy at ING Bank, notes that the EBA has set out three conditions for close correspondence to be deemed to exist:

• Changes in the fair value of the covered bonds issued will at all times result in equal changes in the fair value of the assets underlying the covered bonds.
• Mortgage loans underlying the covered bonds issued may at any time be redeemed by buying back the covered bonds at market/nominal value (exercise of the delivery option).
• There is a transparent mechanism for determining the fair value of mortgage loans and covered bonds, which includes fair valuing the delivery option.

A close correspondence does not exist however, she noted, when a net profit or loss arises from changes in the value of either the covered bonds or the underlying mortgage loans.

Analysts said that the conditions specified by the CRR and EBA mean that only Danish covered bonds issued under the country’s balance principle will benefit, and the EBA itself refers to this system in the rationale for its RTS.

“For example, due to the nature of the Danish mortgage system, at some banks, there is a direct link between a mortgage loan provided to a borrower and the corresponding covered bond financing that same loan – so-called match funding – and a connected special option for the borrower,” said the EBA. “This option allows the customers to buy back the specific covered bond financing the mortgage loan in the market and deliver the covered bond to the mortgage bank as an early prepayment of the loan.

“The value of the mortgage loan is thus directly connected to the value of the corresponding covered bond. An increase in the value of the bond means a corresponding increase in the value of the mortgage loan, and a decrease in the value of the corresponding covered bond means a similar decrease in the value of the mortgage loan.”