A leaked EC paper on LCRs includes new issuer rating eligibility criteria for covered bonds that, if implemented, could result in some double-A issues not being Level 1 eligible, and some single-A issues excluded entirely. Another clause has raised hopes for non-EU issuers.

The document – which is expected to be the basis for discussions at the European Commission on Monday as the body nears a final decision on eligibility criteria for Liquidity Coverage Ratios – was first highlighted by Bloomberg yesterday (Thursday), although many of the details merely confirmed the content of previous Commission documents.

However, the document includes clauses that would require not only minimum ratings for covered bonds as a precondition for eligibility, but also minimum issuer ratings, and a market participant told The Covered Bond Report that these are new and were not anticipated.

The clauses say that for covered bonds to be eligible for Level 1, not only do they need to be credit quality step 1 (i.e. rated Aa3 or AA- or equivalent or higher), but they also need to be from issuers that are rated at least credit quality step 2 (A3 or A- or equivalent or higher), or as the document puts it:

“The issuer is assigned a credit assessment by a nominated ECAI which is at least credit quality step 2 in accordance with paragraphs (1) and (2) of Article 120 of Regulation (EU) No. 575/2013.”

This would mean that double-A rated covered bonds from issuers rated Baa1 or BBB+ or equivalent or lower would be excluded from Level 1.

It is not clear from the wording of the text whether the relevant issuer ratings are those that are taken into account for the covered bond rating criterion, and it is also not definite what ratings will be taken into account – although an analyst has suggested that it could be the same as for risk weighting purposes, which is the lower rating in the case of two ratings, the middle in the case of three, and the better of the two lowest in the case of four.

This suggests that double-A rated covered bonds of issuers such as Austria’s Bawag and Kommunalkredit Austria, Germany’s Deutsche Hypothekenbank and Deutsche Pfandbriefbank, and the UK’s Clydesdale Bank and Yorkshire Building Society, which would otherwise be eligible for Level 1, could now be excluded.

Recent documents from the Commission have also indicated that a Basel requirement for a double-A rating for eligibility as Level 2A assets has been relaxed to single-A, but some covered bonds that would benefit from that might now miss out if the issuer rating criteria are included: not only do covered bonds have to be credit quality step 2 to be eligible for Level 2A, but issuers have to be investment grade rated (the wording is the same as for Level 1, as above, except that “step 2” is replaced by “step 3”).

As a result of this, the Level 2A eligibility of the covered bonds of several issuers from peripheral jurisdictions appears to be under threat, but a greater difference between the ratings assigned by different rating agencies for such issuers and the lack of clarity on the exact criteria for defining the ratings clauses makes it difficult to pin these down.

The market participant noted that the relaxation of the rating criteria for covered bonds had been key to winning support from a broader range of countries for covered bonds’ status in LCRs, and that this might now be an issue again, while the threatened narrowing of eligibility for Level 1 could be just as sensitive a development.

The document is more encouraging for non-EU issuers, as it includes a dedicated section in the definition of Level 2A assets regarding the inclusion of covered bonds from “third countries”. This broadly reflects the Level 2A requirements for EU covered bonds, with the main difference being a clause defining legislative covered bonds without reference to EU regulations:

“They must be covered bonds in accordance with the domestic law of the third country which must define them as debt securities issued by credit institutions and secured by a cover pool of assets, in respect of which bondholders shall have direct recourse for the repayment of principal and interest on a priority basis in the event of the issuer’s default.”

The market participant said that this is good news for the likes of Australian and Canadian issuers, as it holds out the promise of their covered bonds being eligible as Level 2A assets, which was not clear before. [Incorrect reference to domestic treatment of Australian covered bonds relative to Canadian covered bonds removed.]

Another aspect of the document highlighted by the market participant is that the relevant authority may apply a higher haircut to covered bonds under certain conditions relating to illiquidity, concentration risk and correlation risk that are to be defined. This raises the prospect of Level 1 assets facing higher haircuts than 7% and Level 2A assets haircuts higher than 15%.

A covered bond analyst cautioned today that many such details are still subject to change during the Commission’s finalisation of its decision.

“It ain’t over till the fat lady sings,” she said.