Reforms to Basel III published yesterday (Thursday) include improved risk weights for covered bonds in line with EU treatment in a major achievement for the market, holding out the promise of better future treatment and improved prospects in respect of non-EU/EEA markets and products.

Discussions on the long-awaited reforms, which come into force from 2022 and have been dubbed “Basel IV”, had proven controversial, with the introduction of an output floor for mortgage risk weights a major sticking point.

Yesterday, the Basel Committee on Banking Supervision’s oversight body, the Group of Central Bank Governors & Heads of Supervision (GHOS), endorsed the Basel III post-crisis regulatory reforms.

The final text includes new risk weights for exposures to covered bonds. Covered bonds rated AAA to AA- will have a risk weight of 10%, A+ to BBB- 20%, BB+ to B- 50%, and below B- 100%. Under the current Basel rules, covered bonds rated AAA to AA- have a risk weight of 20%, in line with similar unsecured bank debt, A+ to BBB- 50%, BB+ to B- 100%, and below B- 150%.

The new risk weights are in line with those for covered bonds in the EU under the CRR.

“This is one of the major achievements that the covered bond market has reached in recent years,” Luca Bertalot, secretary general of the EMF-ECBC, told The CBR. “Of course, implementation in Europe will be important to secure this, but this is clearly one of our most important achievements in a global context.”

The EMF-ECBC noted that the announcement comes after several years of discussion and consultation in which the industry body has actively participated. It said it is particularly delighted that “the macro-prudential characteristics of the covered bond asset class have been formally recognised at global level, and that the BCBS recommendations capture the key qualitative features already intrinsic to the Covered Bond Label”.

Bertalot said that the cause of this breakthrough for covered bonds was that, although the product has long had strategic importance for countries across Europe, most non-European countries have changed their view on the asset class after years of discussion with industry stakeholders.

“The covered bond is part of the solution to these countries’ funding problems – this is true for developed economies and emerging countries,” he said. “Since 2010, there has been a radical modification of the view of this asset class.”

Bertalot noted that covered bond markets have developed in Australia, New Zealand and Singapore, that a covered bond legislation has recently been finalised in Brazil and that discussions are ongoing about the possibility of introducing the asset class in South Africa.

“All these countries were reluctant just a few years ago,” he said.

He said the new treatment of covered bonds was also a recognition that the product contributes to financial stability, which is the aim of Basel III rules.

The EMF-ECBC said the agreement paves the way for a broad international investor base to further develop in the covered bond market – something that bankers highlighted will be beneficial once the ECB’s covered bond purchase programme comes to an end.

Bertalot said it also underlines the importance of the Covered Bond Label, “which remains the only platform by which banks can demonstrate to the global market, in the interests of transparency, their compliance with the provisions of the recommendations”.

Ralf Grossmann, head of covered bond origination at Société Générale and incoming ECBC deputy chairman, said the decision was a surprise.

“It is a good starting point,” he said. “Recognition from Basel for covered bonds is something we really needed.

“However, there are other areas where the Basel Committee is still more defensive on covered bonds.”

Grossmann listed two such fronts – the first being LCR, noting that the Basel Committee, when reporting on the progress of LCR, has noted in reports that the EU is deviating from Basel rules in respect of covered bonds’s treatment. The second front is the NSFR, which, he said, is “unfortunately quite punitive” for covered bonds.

“This turnaround is a good signal, and I’m confident that when we have a harmonised EU covered bond framework in place that will also have a positive impact on the treatment in Basel, then as Europeans we can make strong arguments that this product is very well regulated and deserving of more privileges,” he said. “But unfortunately this is some way down the road, and it is not a done deal that we will get a better deal on NSFR.”

Analysts and market participants said demand for non-EU covered bonds from bank treasuries will be boosted by the new rules, but expect the impact on performance to be limited in the near term due to the long wait for the reform to be introduced.

“Once implemented in European legislation this will be a major positive for covered bond regimes outside the EEA, which currently are not eligible for preferential risk weight treatment under the EU’s CRR,” said Maureen Schuller, head of financials research at ING. “Furthermore, this also paves the way for covered bonds issued by banks within the EEA to obtain a favourable risk weight treatment in jurisdictions outside the bloc.”

Joost Beaumont, senior fixed income strategist at ABN Amro, added that the announcement of changes to the non-EU treatment of covered bonds is also “very timely” given Brexit negotiations.

The EMF-ECBC said it will now examine the BCBS recommendations to fully assess their impact, and begin a dialogue with EU institutions in anticipation of the implementation of the recommendations into EU law.

“Our priority now is to assess the other elements of the agreement and their impact on EU mortgage lenders and covered bond issuers, and ensure that future implementation in Europe responds to market realities and specificities so that a level-playing field is secured globally,” said Bertalot.

The new rules will come into force on 1 January 2022 and will be phased in over five years.

To be eligible for the 10% risk weight treatment, covered bonds must meet a 10% nominal overcollateralisation requirement, which analysts noted is higher than legal OC requirements under many covered bond frameworks around the world. If the regulatory framework does not include an OC requirement of at least 10%, the issuer must show that their cover pool meets the 10% requirement in practice.

Risk weights for unrated covered bonds will be derived using the issuer’s risk weight.

Photo: Basel Committee on Banking Supervision Chair Stefan Ingves, Group of Central Bank Governors & Heads of Supervision Chair Mario Draghi, and Basel Committee Secretary General William Coen; Credit: BIS