Extension of LCR eligibility to certain unrated issues in the EC’s Delegated Act has been welcomed as reducing reliance on ratings. Meanwhile, those who lobbied for covered bonds have welcomed the overall outcome and a feared OC problem is now said to be a non-issue.

The European Commission’s announcement on Friday that EEA covered bonds rated AA- or higher and subject to other criteria can constitute up to 70% of liquidity buffers as restricted Level 1 assets with 7% haircuts, and that those rated AA- or higher – as well as certain non-EEA covered bonds – and subject to other criteria qualify as Level 2A (up to 40% with 15% haircuts) were in line with leaked drafts and, although welcome, came as little surprise to most market participants.

However, late in the process a new band of eligibility was added for covered bonds, in Level 2B, for “unrated high quality covered bonds”, as revealed by the Commission’s releases on Friday. These covered bonds can constitute up to 15% of LCRs – like securitisations in Level 2B – and are subject to 30% haircuts.

Regarding the quality requirement these unrated covered bonds face, they are outlined by virtue of criteria coming on top of some of those faced in Level 1 and Level 2A: cover pools must comprise exclusively EEA public sector loans, residential mortgages or guarantee home loans (by reference to CRR Article 129(1), all qualifying for a risk weighting no higher than 35% under the Standardised Approach, and must meet at all times a minimum overcollateralisation (OC) requirement of 10%.

Some market participants said that a reference to “national laws” in relation to the latter OC and other requirements would mean that minimum OC levels would have to be enshrined in legislation – thus requiring changes in various jurisdictions – but Luca Bertalot secretary general of the EMF-ECBC, said that in his understanding this interpretation is incorrect.

“I understand that the details of the methodology on how OC is calculated should be embedded in the covered bond law,” he said, “but not the percentage.”

Bertalot said that the inclusion of unrated covered bonds in LCRs is welcome and reflects the Commission’s intention to avoid over-reliance on ratings.

“This was already the direction they had taken by introducing transparency and removing the issuer rating requirements,” he added.

A covered bond investor in Frankfurt also welcomed the direction of travel.

“If that is the way forward for modern banking regulation to deal with shortcomings within rating agency methodologies, why not?” he said. “At least it is somewhat consistent with the approach of further harmonising covered bonds across Europe – see the EBA’s best practises, for example.

“To be fair, I currently do not believe that unrated covereds are more liquid than rated paper, but it gives a confidence boost to covereds in that I cannot imagine unrated corporate debt being eligible for LCRs.”

The inclusion of unrated covered bonds is also understood to have been made as a concession to countries that have suffered worst in the sovereign debt crisis and who might otherwise have faced greater exclusion from LCRs.

The European Covered Bond Council’s Bertalot meanwhile welcomed the overall result.

“We welcome the European Commission’s recognition of the macro-prudential value of covered bonds and its efforts to reduce the LCR’s over-reliance on ratings by introducing specific requirements relating to transparency,” he added. “This can be seen as recognition of the importance of further enhancing disclosure in the covered bond market through initiatives such as the Covered Bond Label.”

Covered bonds’ role in LCRs under the Commission’s regulation is greater than that detailed under the Basel III framework but, explaining the Commission’s thinking on Friday, Mario Nava, director of the financial institutions directorate, DG Internal Market and Services, said that the Delegated Act “takes fully the spirit of Basel”, but is adapted to reflect European specificities.

“Covered bonds is a particular European specificity,” he said. “This is something of which the Europeans should be proud. They have an excellent track record. They are in several cases of very comparable quality to the top quality liquid assets (sovereigns), and therefore we have included them in the Level 1.”

He noted that they are nevertheless subject to both a cap and a haircut, “so we have taken everything in consideration, and it is truly ceinture et bretelles (belt and braces)”.

Ane Arnth Jensen, managing director of the Association of Danish Mortgage Banks (Realkreditrådet), said that the outcome was as had been expected recently and was satisfactory.

“There has been a lot of struggle to get this result,” she said. “There was the report from the EBA in October that stated on an evidence-based analysis that covered bonds were actually under certain circumstances fully liquid, but after this the board of supervisors took the opposite decision in December. So it has been a hard job and many people have been involved in fighting to get this result.

“You have always to judge the result in light of what was at risk,” she added, “and any other result would have been a huge challenge for the Danish financial sector and would have cost a lot in terms of expenses and higher interest rates.”

Jens Tolckmitt, chief executive of the Association of German Pfandbrief Banks (vdp), said that the result was broadly in line with what had been expected ahead of the announcement, with some recent unwelcome additions – for example, reference to issuer ratings – having been dropped, and the Commission having come a long way since the process started.

“We can be very happy with the result,” he said. “This treatment reflects properly the resilience of our product throughout the financial crisis.

“They have acknowledged that there are other safe assets than government bonds, which is important. Given the different treatment of government bonds and private sector bonds in other areas of regulation, it might not have been realistic to achieve treatment for covered bonds on a par with government bonds, even if it would have been justified.”

The European Parliament can reject but not amend the Commission’s Delegated Act in the coming six months, although this is understood to be very unlikely, with part of the delay in its release said to be the result of efforts to ensure that none of the EU bodies had objections to its contents. Implementation is due on 1 October 2015.

Image: Capture of EC stream of LCR briefing, with Mario Nava (left)