Covered bonds are becoming an increasingly important funding option for mid-sized Czech banks, according to Moody’s, as favourable currency swaps provide access to attractive funding levels and allow them to compete with their larger peers, which have a firm hold on the depositor market.

In a sector comment published on Thursday of last week (16 February), Moody’s noted that against a backdrop of recent rapid loan growth that is outpacing the growth of deposits, the Czech Republic’s tier of three mid-sized banks have largely used up their deposit base for lending.

Raiffeisenbank a.s., UniCredit Bank Czech Republic & Slovakia (UCS) and Moneta Money Bank, formerly GE Money Bank, had an average consolidated loan-to-deposit ratio of 101% as of end-June 2016, according to the rating agency.

The three banks have found themselves crowded out of the depositor market by larger banks (CSOB, Česká spořitelna and Komerční banka), Moody’s said, making Czech mortgage covered bonds (hypoteční zástavní list) an increasingly attractive option to fill shortfalls in financing and improve their asset-liability mismatch.

The rating agency noted that the cost of new deposits to banks is currently around 20bp, between 50bp and 70bp lower than the coupons payable on Czech covered bonds. However, spreads on koruna-euro currency swaps have been negative since 2012, mitigating much of the cost difference when banks issue euro-denominated bonds – which make up more than half of issuance.

“This means that, for now, the use of covered bonds puts the mid-sized banks on a par financially with their larger purely deposit-funded peers, enabling the mid-sized banks to comfortably fund their growth and support their profitability,” said the rating agency.

Raiffeisenbank a.s. and UCS are already established issuers in the Czech covered bond market, which totalled some Eu11.656bn equivalent as of the end of 2015, comprising bonds denominated in euros and koruna and Eu5.5bn of private placements, according to ECBC figures.

Issuance has steadily increased since the European sovereign debt crisis, having peaked in 2007, but only two public, syndicated deals have so far been sold from the jurisdiction, a Eu500m five year for Raiffeisenbank a.s. in October 2014 – of which half was retained – and a Eu250m five year for UCS in April 2015. UCS has said it could issue its first benchmark covered bond this year, having acquired collateral from its former Slovak sister bank.

Moody’s said, however, that the potential investor base for Czech covered bonds is reduced by the country’s legal framework. The Czech Republic’s covered bond laws, which stem from 1992, differ from European best practices. Moody’s highlighted “numerous weaknesses and anomalies” that it said could unsettle investors, including automatic acceleration in the event of an issuer’s bankruptcy, LTV caps that are out of line with other European frameworks, and a lack of provisions to allow derivatives in cover pools.

Furthermore, the typically small size of issuance disqualifies most Czech covered bonds from preferential treatment under LCR.

Changes to the country’s framework that will bring it in to line with more accepted European standards are widely expected to take effect in 2018, and analysts expect issuance and investors’ interest in the market to increase thereafter.

“Besides Poland, where we have already seen euro benchmark issuance, the Czech Republic is the most promising candidate for euro-denominated issuance out of Eastern Europe,” said Franz Rudolf, head of financials credit research at UniCredit.