A potential increase in banks’ minimum reserve requirements is widely cited as a major unknown for 2024 euro benchmark covered bond supply, while analysts’ differing opinions on the extent of deposit outflows and level of lending nudge their forecasts higher or lower.

The potential for a minimum reserve requirement (MRR) increase was flagged in ECB discussions around September, with some policymakers said to be in favour of a move higher from 1% to 3% or 4%, but others advocating a more modest or no change.

Citi’s Jussi Harju – whose 2024 euro benchmark forecast of €155bn is the lowest of 17 surveyed – does not anticipate “any meaningful impact” on euro covered bond issuance if the ECB would increase the MRR for Eurozone banks. He highlights plentiful levels of “free” excess liquidity (the amount of excess liquidity less MROs and (T)LTROs outstanding) and says that even if the ECB would raise the MRR from today’s 1% to 10%, current free excess liquidity would be sufficient to absorb this in major European jurisdictions.

Harju notes that an increase in MRR could have indirect implications for covered bonds, hurting Eurozone banks’ P&L through lower net interest income (since required reserves do not earn any interest, meaning banks would be forced to hold more non-earning assets), and lowering their LCR ratios (as MRR does not count towards LCR requirements). But he argues that while this, in turn, could increase their funding needs, overall any impact would be limited and in any case not immediate, with Citi not expecting a decision on MRR “anytime soon”.

But several analysts expect a significantly greater impact from any MRR moves on the part of the ECB.

Natixis’s Jennifer Levy – whose €185bn forecast was the highest – says that a decline in banks’ excess reserve liquidity and LCRs resulting from an increase in the MRR to even 2%, coupled with TLTRO repayments, could lead to some banks deciding to issue more debt instruments to mitigate the impact. Noting that European banks all have LCRs above the required 100% level, she highlights that for them to maintain their current LCR ratios under a 2% MRR scenario, and taking into account TLTRO repayments, Italian, French and German banks would need to add €194bn, €182bn and €176bn of liquidity, respectively.

Natixis: Additional liquidity needs to maintain the current LCR

Source: ECB, EBA, Natixis

Crédit Agricole’s Florian Eichert acknowledges that a materially higher MRR would be “a big shock” to supply prospects. Given a lack of clarity as 2024 approaches, some banks have indicated that they are adopting a cautious approach, he says, contributing to a theme of precautionary pre-funding also being driven by potential deposit outflows (see below for more on deposits).

“The ECB will likely discuss this as part of its operational framework review sometime in the spring of 2024,” adds Eichert.

“Despite some comments calling for a materially higher MRR, we would be surprised if the ECB were to move to beyond the pre-Covid level of 2% MRR. Should this indeed be the case, it would be better than the scenario some banks currently model for and should as a result eventually reduce their funding needs.”

The impact of TLTROs themselves – which have hitherto loomed large over the covered bond market – is widely expected to decline significantly in the coming year. BayernLB’s Emanuel Teuber, for instance, notes that only 20% of TLTRO III funds are left versus the peak of €2.3tn, and of this €491bn outstanding at the end of Q3 2023, 50% mature this coming March.

BayernLB: Maturing TLTRO III funds lead to increased demand for capital market funding

Note: Outstanding TLTRO III funds per country in EUR bn (left-hand scale); outstanding TLTRO III funds per country in EUR bn compared to the peak in %, outstanding TLTRO III funds per country in EUR bn compared to outstanding ECB deposits and excess reserves (right-hand scale); as at 30/09/2023; Source: BayernLB Research, ECB

“While TLTRO repayments in 2024 could lead to some replacement financing via covered bonds, the fact that around 80% of this facility has already been repaid provides the market with much more clarity in terms of a potentially lower refinancing requirement compared to the uncertainty we had a year ago,” he says. “Issuance activity in the current year, which is weaker than in the previous year, also shows that while some of the TLTRO funds due are being refinanced through syndicated covered bond issues, the majority is being refinanced by melting down excess liquidity at the central banks.”

However, Teuber notes that the Italian banking system is particularly heavily burdened, with its €155bn outstanding accounting for 90% of total Italian excess reserves, against a Eurozone average of 14%. he says this probably indicates a “more urgent” liquidity/funding need for Italian banks than for other countries.

“This therefore underlines the need for Italian banks to make greater use of capital market financing, including covered bonds, in the future.”

Fifty shades of funding gap

When it comes to the asset and liability sides of issuers’ balance sheets, muted or negative loan growth is somewhat offset by concerns over deposits outflows to result in positive pressure, with the net effect of analysts’ individual views determining to what degree this could boost supply.

There appears to be more of a consensus among analysts on the deposit situation being a clearly supportive factor in supply expectations. JP Morgan analysts, for example, highlight accelerated deposit outflows in 2024 as “a notable risk” for heightened covered bond funding pressure. They nevertheless suggest that pre-funding in anticipation of this risk has contributed to 2023’s high supply and caution against overestimating any potential impact in 2024.

BayernLB’s Teuber takes a similar stance, also attributing part of the past two years’ extensive issuance to addressing potential deposit outflows, noting that new lending business has been weak over the period.

“As long as deposit outflows do not increase significantly more than banks already expect, the dynamic between loan and deposit growth is likely to be less volatile overall, which should not prompt issuers to play it safe by ‘overfunding’,” he says. “In other words, we do not see the same impetus for banks to plan for increased funding needs as in 2022/23, when they had to proceed cautiously and balance the dynamics between loan growth and expected deposit outflows.”

DZ: Deposit growth has been partly negative recently – annual growth rate of bank deposits (household and corporate deposits) as of August 2023

Source: ECB, Bank of Canada, Statistics Sweden, DZ BANK Research

DZ Bank’s Thorsten Euler says that, on balance, a further decline in deposits and slight credit growth in 2024 should have a positive impact on the volume of new covered bond issues. While noting that growth rates in residential mortgage lending are declining, he points out that they have remained positive recently, with portfolios hence growing, and paints a rosier picture than some of his peers for the year ahead.

“Our economists assume that the currently weak economic growth in the euro area will brighten somewhat in the second half of 2024,” says Euler. “In the fourth quarter of 2024, our interest rate analysts also expect the first cautious interest rate cuts by the ECB, which should also benefit slight credit growth.”

Citi’s Harju meanwhile highlights the combination of prevailing higher interest rates and slowing residential lending as a negative in his downbeat forecast. He notes that on an annualised basis lending growth has already turned negative in nine Eurozone countries and that loan growth is declining in the rest, with Eurozone residential mortgage interest rates being higher than at any time except the global financial crisis. Harju nevertheless sees a potential silver lining in the form of forward-looking indicators of housing loan demand not being as bleak as last year, with the ECB’s October 2023 bank lending survey showing a reverse from a record-deep slump.

An exogenous variable in the loan-deposit mix is sovereign retail issuance, with a few analysts highlighting its impact on household deposit balances in Italy, Portugal and, most notably in 2023, Belgium.

“We will continue to monitor whether other sovereigns will jump on the bandwagon of retail issuance,” says Credit Agricole’s Eichert. “Wherever this starts to become a theme, we can expect wholesale funding needs to go up.”

Another factor widely expected to support issuance is the funding cost differential between covered bonds and senior unsecured instruments – even if this narrowed in 2023. Covered bonds underperformed senior preferred and senior non-preferred by 24bp and 46bp, respectively, over the past 12 months, according to iBoxx indices cited by Citi’s Harju, reversing 2022’s trend. But he notes that senior preferred remains historically expensive versus covered bond funding, with the differential around 15bp above its long term average.

“Remaining MREL shortfalls hold relatively little significance for covered bond issuance in 2024,” he adds.”

Photo: October ECB governing council meeting, Athens; Credit: Andrej Hanzekovic/ECB/Flickr