The Basel Committee published final standards for banks’ counterparty exposures yesterday (Tuesday) that were revised from an initial proposal to recognise certain covered bond features, with an RBS analyst noting “novel” elements of an OC requirement.

The final standard supercedes a 1991 standard and set outs a supervisory framework for measuring and controlling large exposures, which is scheduled to take effect from January 2019.

The supervisory standards are designed to limit the losses a bank could face in the event of a sudden failure of a counterparty or group of connected counterparties, and contribute toward the reduction of system-wide contagion risk.

The Basel Committee on Banking Supervision proposed initial standards in March last year, in response to which the European Covered Bond Council (ECBC) raised concerns about their impact on European covered bond issuers and called for a full or partial exemption of the asset class from the large exposure limits.

The Basel Committee yesterday said that its initial proposal was revised to, inter alia, include “a treatment that recognises particular features of some covered bonds”.

This involves allowing covered bonds meeting certain conditions to be assigned an exposure value of no less than 20% of the nominal value of the bank’s covered bond holding, with other covered bonds requiring a 100% exposure value.

Initial reactions from some covered bond specialists suggested the final standard was positive to neutral, with the partial exemption of covered bonds “a sign of the recognition of the value of the asset class”, according to one industry source, but the prevailing framework in Europe already reflecting the Basel standards, with the addition of national discretions.

Jan King, covered bond analyst at RBS, pointed out that the deadline is some way off, in 2019, and that how the rules are transferred into European standards will be decisive, with the Basel standards stating that member jurisdictions have the option to set more stringent standards and apply standards to a wider range of banks.

According to King, under the prevailing rules in the EU Capital Requirements framework, exposures to CRD-compliant covered bonds can be fully or partially exempted by regulators.

“The BIS framework implements additional rules for covered bonds in order to be eligible for favourable treatment,” he said.

One of the conditions is that covered bonds fulfil requirements in line with the UCITS definition of the asset class, according to King, without limiting the geographical scope. In addition, the cover pools must exclusively consist of public sector claims, residential mortgage loans with a 80% LTV limit that qualify for a 35% risk weight and/or commercial mortgages, subject to a 60% LTV limit and a 100% risk weight. Subsitution assets and derivatives are acceptable additional collateral.

Another condition for a lower exposure value is minimum overcollateralisation of 10%, although this does not need to be a legal requirement. If this is the case, then the issuer needs to publicly disclose on a regular basis that the cover pool meets the 10% requirement in practice.

“While the OC rules look strict at first glance, the novelty is that it explicitly includes voluntary OC and furthermore reverses the burden of proof from the investor to the issuer that (where applicable) it sticks to stricter requirements than required by law,” said King. “This can also be seen as a positive for issuers who can themselves remove uncertainties about whether or not their bonds fulfil the requirements for preferential treatment.

“In practice, many issuers already hold substantially more OC than is required by law in order to support the ratings of their bonds.”