The European Covered Bond Council reiterated its support for covered bonds’ inclusion as Level 1 assets today (Thursday), in light of fears that the European Banking Authority could exclude them from the most privileged level of LCRs when it reports to the EC later this month.

As reported by The Covered Bond Report last week, the ECBC has urged members to lobby their national regulators to support covered bonds’ case following a meeting of the EBA’s Board of Supervisors at which a majority came out against covered bonds counting as Level 1 assets and in favour of closer alignment of forthcoming EU rules with Basel III. Under Basel proposals sovereign bonds would be the key Level 1 asset, with covered bonds facing haircuts and limits as Level 2 assets – although there are also reports that the EBA could recommend lowering or removing a Basel rating threshold for government bonds. The EBA is due to report to the European Commission (EC) by the end of December, with the commission responsible for taking a final decision by the end of June.

ECBC offices, Brussels

The ECBC cites Recital 100 of the Capital Requirements Regulation (CRR), which says: “When making a uniform definition of liquid assets at least government bonds, and covered bonds traded on transparent markets with an ongoing turnover would be expected to be considered assets of extremely high liquidity and credit quality.”

The industry body then cites the preliminary results of an EBA study, released on 23 October, that it says show that the ranking of covered bonds for liquidity metrics is very similar to that of government bonds, and that there is also a clear differentiation versus other asset classes.

“While the EBA did not draw any conclusions in its study, the ECBC believes the results suggest that covered bonds should qualify as Extremely High Liquid Assets (Level 1), under the definition of the LCR,” said the ECBC. “The EBA also stressed that ‘in covered bonds, variables capturing the existence of regulatory characteristics which reduce credit risk and enhance transparency are significant predictors of liquidity’.”

The ECBC also noted concerns about rating triggers being included in European legislation, with a touted AA- cut-off point for covered bonds to be included as Level 1 assets seen as an obstacle for broader support for them, given that this would exclude many countries’ covered bonds.

The Covered Bond Label was put forward by the ECBC as an alternative criterion. The industry body recently voted to align the Label criteria with the CRR, rather than UCITS, and making it a useful option for regulators was one of the key reasons for the switch – even if the Label has yet to gain official regulatory recognition.

Finally, the ECBC said that covered bonds have proven to be the most reliable source of wholesale funding through adverse market conditions and has contributed to the financial stability of the European economy.

“The inclusion of covered bonds in Level 1 would mitigate against over reliance on sovereign debt by the European banking sector and would facilitate the objective of delinking the sovereign from the banking sector,” said Luca Bertalot, head of the ECBC.

As well as for ignoring covered bonds’ qualities, the likely EBA recommendation regarding LCR asset eligibility has been criticised for placing too great a reliance on government bonds.

“The EBA is obviously free to determine the liquidity of covered bonds for regulatory purposes,” said a leading covered bond investor, “but I just wonder how it will help to break the sovereign-bank link if banks are kindly incentivised by LCR provisions to go for more sovereign bonds because covered bonds are not recognised as the highest form of liquidity despite EBA’s own quantitative findings on that very same topic.”

Jesper Berg, head of regulatory affairs and senior vice president at Nykredit Realkredit, said that it is hard to foresee the outcome of the European Commission’s deliberations, but he fears that, if the rumours are true, an apparent compromise between strict Basel compliance and an “escape clause” for European government debt could create difficulties both for Denmark and the Commission.

“It would be as if we haven’t learned anything from history if it’s alright for Danish banks to hold Greek government bonds as liquidity reserves and not hold Danish covered bonds, which are by now trading at interest rates well below most European countries,” he said. “That would be pretty silly and I think most people would be capable of seeing that that would not enhance financial stability.”

With Denmark seen most threatened by covered bond Level 1 exclusion, the country’s authorities have since last week come out strongly in defence of covered bonds’ claim to Level 1 status. Bloomberg reported Danish prime minister Helle Thorning-Schmidt as having told a press conference that the government would stand by the Danish mortgage system.

“We perceive these bonds as first class and that’s the view we’re trying to purvey to the Commission,” she said.