Potentially damaging NSFR treatment of covered bonds looks set to have been averted, with the latest EU proposals including a lowering of the RSF factor for encumbered cover assets to 85%, in what the EMF-ECBC’s Luca Bertalot told The CBR is a “very important result” for the industry.

Under earlier proposals aligned with the Basel Committee on Banking Supervision framework, covered bonds would from a Net Stable Funding Ratio (NSFR) perspective have come out unfavourably versus unsecured funding, potentially disincentivising covered bond issuance.

Encumbered assets – including those in cover pools – had a required stable funding (RSF) factor of 100%, but unencumbered mortgages a lower RSF of as low as 65%. Since the available stable funding (ASF) factor of covered bonds and senior unsecured issuance (for maturities greater than one year) was the same at 100%, the covered bond part of a balance sheet would have suffered a worse NSFR ratio than unencumbered mortgages funded by senior unsecured debt, and also an NSFR ratio of less than 100% (i.e. below the minimum allowed for the overall balance sheet) given the need for overcollateralisation. The impact would have been greatest for covered bond-intensive institutions.

“The current calibration of the NSFR for covered bonds and their cover assets appears to be too restrictive, especially considering the nature of covered bonds as long-standing successful long term funding instruments,” argued the European Mortgage Federation-European Covered Bond Council (EMF-ECBC) in an October 2017 position paper.

The latest version of planned amendments to CRR and BRRD released by the presidency of the Council of the EU in late May include a lower RSF factor of 85% for “assets encumbered for a residual maturity of one year or more in a cover pool funded by covered bonds”.

This is in line with a compromise solution of an 85% RSF factor lobbied for by the EMF-ECBC and industry.

“Together with LCR, this is one of the most important successes of our organisation in recent years,” Luca Bertalot, EMF-ECBC secretary general, told The CBR. “We had a serious issue because, as designed by the Basel Committee, the NSFR penalised secured funding versus unsecured funding.”

Covered bonds were in one respect treated more favourably than under Basel III back in November 2016 when the CRR/BRRD reform proposals were unveiled, with a lower RSF factor for covered bonds held as assets.

At the same time, a carve-out for “interdependent” covered bond models – mainly the Danish system – was incorrectly drafted such that it implied a wholesale exemption for covered bonds. The latest proposals limit covered bonds treated as interdependent to the Danish model, according to Bertalot, but he said that even if it was obvious that the previous wording was a mistake, it helped open the door for better treatment for the whole asset class.

He said the industry worked more intensively on the issue following last September’s ECBC plenary in Barcelona, exploring different solutions before arriving at the “good and acceptable compromise” of an 85% RSF factor.

“We wanted to find an overarching solution for the asset class,” said Bertalot, “not a solution for any particular jurisdiction, so that the whole industry could get aligned behind it. It was important that we acted as a team, and without making too much noise we were able to achieve a very important result.

“With the characteristics of the Danish model, interdependency absolutely makes sense for that market,” he added. “It would be a bit stretching it to claim it for other systems, so I think the outcome is fair.”

The industry’s united front helped consolidate support and a consensus in Member States, and then the Commission, Council and Parliament (ECON), according to Bertalot, who does not expect fundamental changes before the CRR text is finalised.

He said the European institutions’ move should be seen in the context of the parallel covered bond harmonisation initiative.

“It is useless to have a covered bond Directive, which should boost this asset class, and then create a huge bottleneck in the NSFR,” said Bertalot.

The package is now in a trilogue phase, with a final vote in the plenary of Parliament expected in the fourth quarter.

“It is the final piece of making sure covered bonds are properly treated in the Basel III framework as implemented in Europe,” said Bertalot.

“We believe this could now work as a benchmark for other jurisdictions,” he added, “notably with third country equivalence a consideration in the covered bond Directive.”

Photo: Valdis Dombrovskis, European Commission, and Vladislav Goranov, Bulgarian minister for finance, announcing the proposals; Copyright: EU