The Office of the Superintendent of Financial Institutions Canada (OSFI) on 23 May wrote to Canadian deposit-taking institutions (DTIs) alerting them that it is changing the way it calculates the limits for how much covered bonds they can issue.

Most notably, the numerator has been changed from covered bonds outstanding to “total assets pledged for covered bonds”, and the limit changed from 4% of total assets to 5.5%. (The denominator measure of total assets was also updated.) OSFI said that the update to the numerator was taken “to better reflect the amount of assets encumbered through covered bonds by capturing the overcollateralization associated with these instruments”.

With Canadian issuers currently maintaining overcollateralisation (OC) levels of 104% to 110%, analysts and some other market participants calculated that the change will result in a large increase in issuance capacity. One covered bond analyst, for example, said the new limit calculation could increase issuance capacity by some C$85bn (EUR56bn, US$63bn) – equivalent to more than half of the currently outstanding volume of Canadian covered bonds – and others were similarly bullish. They further suggested that other Canadian mortgage lenders, such as Laurentian Bank of Canada and Canadian Western Bank, would henceforth find covered bond issuance more viable and be more likely to enter the market.

However, DBRS analysts argue that there will be no material increase in capacity, highlighting that OC requirements may increase and the need for issuers to meet the covered bond limit on an ongoing basis.

“Consequently, when issuers determine the amount of covered bonds to issue, OSFI expects them to specifically take into account the pledging of additional collateral to meet potential higher overcollateralization requirements,” they said in a report on Tuesday.

They point out that the Canadian Registered Covered Bond Programs Guide issued by Canada Mortgage & Housing Corporation (CMHC) requires issuers to establish a maximum level of OC and that issuers have all set this at 25%. A 25% OC level then implies an issuance limit equivalent to 4.4% of total assets, rather than the 5% implied by, for example 10% OC, with capacity increasing from $226bn only around $30bn rather than $75bn.

DBRS-estimated covered bond issuance capacity based on current and revised calculation* (C$ billions)

* Assets for covered bond issuance capacity calculation are as of January, 2019 except for Fédération des caisses Desjardins du Québec, which is based on March, 2019. ** Estimates assume the Autorité des marchés financiers — the regulatory body that supervises the issuance of covered bonds by Federation des caisses Desjardins du Québec from a prudential standpoint — adopts OSFI’s revised calculation and limit. Source: Company Reports, DBRS Analysis.

The analysts then argue that the need to maintain a buffer against potential fluctuations in total assets means the increase in capacity is lower still.

They further calculate that the limit will continue to constrain smaller banks’ interest in covered bonds.

“Canadian banks tend to be conservative when adhering to regulatory requirements set by OSFI,” said the rating agency. “DBRS expects the banks to maintain a cushion to avoid breaching the 5.5% covered bond limit. Furthermore, the revised calculation ensures that banks maintain enough unencumbered assets to readily meet higher collateral requirements.

“OSFI has clearly indicated that the revised calculation does not constitute an effective increase in the covered bond issuance capacity for financial institutions. Thus, the question of whether the limit will be increased to make it less cost prohibitive for smaller banks to issue covered bonds remains under consideration.”

A market participant suggested the excitement around OSFI’s announcement was partly the result of Superintendent Jeremy Rudin (pictured) having “fanned the flames” in April 2018 when he said OSFI was taking “a hard look” at the limit.

However, he stressed at that time that any revisions must encourage banks to maintain enough unencumbered, high quality assets when times are good to be able to meet higher collateral requirements “if times turn sour”.

Paul Bretzlaff, senior vice president, Canadian ABS and pension funds, at DBRS, told The CBR that had OSFI been intending to increase issuance capacity, it would have put out a public consultation paper.

His colleague Maria-Gabriella Khoury, senior vice president in DBRS’s global financial institutions group, said that such a consultation could yet be the next step for OSFI.

“The entire spirit of this letter was to clean up the calculation before they go ahead and put out a consultation paper on changing the limit,” she said. “The smaller issuers, who are not able to keep up with the reporting requirements as fast as the larger issuers, needed something that is both dynamic and transparent, and would include OC, because most likely if the smaller issuers start issuing, their OC requirements will probably be higher than the large banks.”

She also noted that the move increases transparency around assets encumbered by covered bond issuance for unsecured creditors, something that has become more important following the introduction of Canada’s bail-in regime in September 2018.

Gita Salden, deputy director general of the treasury and director of financial markets, Dutch Ministry of Finance, made the remarks in a keynote speech at a European Covered Bond Council plenary being hosted by the Dutch Association of Covered Bond Issuers at ABN Amro’s headquarters in Amsterdam.

Explaining the backdrop to the Dutch market, she noted that the country’s real estate market is very specific, with high mortgage debt levels being maintained for tax reasons. With deposits unable to fund this, a funding gap opened up that Salden said explained the development of securitisation, which was initially the preferred funding instrument, with Dutch RMBS achieving a leading position globally. Covered bonds, meanwhile, originally played a more modest role.

However, securitisation became “contaminated” in the financial crisis, she said, even if losses hardly increased. This necessitated the establishment of a Eu200bn guarantee programme to help the market, according to Salden, something she said no-one in a finance ministry wants to have to do. Covered bonds were affected, but recovered much more quickly, she noted.

Salden said that three lessons had been learned from this experience. Firstly, there is a need for a diversity of funding instruments, she said, noting that an overreliance on securitisation leaves one vulnerable.

The second lesson, according to Salden, regards transparency. She said that a lack of transparency leads to the miscalculation of risk and can lead to panic. Work to improve transparency in covered bonds and also securitisation is therefore welcome, said Salden.

The third lesson she cited concerns collateral. Salden said that while collateral is a help, it is not a silver bullet in a crisis, as its quality can be affected and more can be required. In relation to this, she said that the ministry has some concerns about encumbrance and she said this needs to be monitored, particularly its interplay with the new bail-in framework.

Looking ahead to the Capital Markets Union, Salden said that creating a framework for high quality securitisation – one of the goals of the European Commission – is a priority. She cited remarks by European Central Bank president Mario Draghi regarding how asset-backed securities are discriminated against, and agreed with his comments, citing capital treatment and Liquidity Coverage Ratios as areas in which this is an issue.

Regarding harmonisation of covered bonds – another workstream of the Commission under its CMU goals – Salden said that there had already been a lot of movement in this direction and that she would probably take a critical view on harmonisation. However, she said that she would welcome her aforementioned encumbrance concerns being addressed in a manner similar to the “healthy ratio” approach taken in the Netherlands.

The country updated its covered bond framework at the beginning of this year.

Thomas Östros, Swedish Bankers' Association managing director

The consultation was on draft guidelines released by the EBA on 20 December on disclosure of encumbered and unencumbered assets aimed at providing transparent and harmonised reporting.

As noted by Fitch in a commentary on Thursday of last week (20 March), when the consultation ended, the EBA proposals include specific dispensation such that emergency liquidity assistance (ELA) given by central banks would not be disclosed.

In its response, the Swedish Bankers’ Association (Svenska Bankföreningen) says that liquidity assistance by central banks must be disclosed and that, as proposed, the guidelines mean any reporting will lose all credibility.

“The argument that financial stability is achieved by concealing that information is unreasonable, and instructions from authorities not to disclose facts will undeniably result in greater market uncertainty,” says the association. “In particular, this proposal will seem irrational in the context of increased regulation on liquidity disclosure and requirements in liquidity buffers.

“The objective of the EBA guidelines is ‘to enable the market participants to compare with institutions in a clear and consistent manner’ since ‘disclosure by institutions about encumbrance is of vital importance for market participants to better understand and analyse the liquidity and solvency profiles of institutions’. This objective is completely contradicted by the explicit proposal to conceal information regarding encumbrance related to central bank funding.”

Fitch echoed this, saying that the absence of disclosure on emergency liquidity assistance is likely to encourage investors to withdraw funds sooner than they would do if transparency was provided at a time of crisis because they would be forced to make conservative assumptions.

“The proposals also allow for timing delays and do not require frequent reporting,” said the rating agency. “It would help to boost confidence in bank disclosure if additional reporting could be reconciled to reported financial statements. But this is not part of the EBA’s proposal.

“In addition, information disclosed may not be sufficiently granular to answer all of the questions that investors might have.”

The Swedish association also commented on the reporting of unencumbered assets, saying that information on the quality of these is crucial information for senior bondholders.

It said that there are problems with using ratings to categorise unencumbered securities, and said that with regard to covered bonds securities could be divided into “labelled and not labelled”.

A final version of the guidelines is expected by June, noted Fitch.

The rating agency last Tuesday (11 September) said that recent actions and comments from European regulators and industry bodies foreshadow the introduction of asset encumbrance limits, citing moves on behalf of organisations such as the European Banking Authority (EBA) and the European Systemic Risk Board (ESRB).

Encumbrance limits make sense in the context of bail-in regulations in order to protect deposit holders and unsecured creditors, said DBRS, adding that covered bonds represent an obvious target.

“Given the popularity of the covered bond instrument, one can easily forecast a limit to issuance as part of a headline-making strategy to control asset encumbrance,” it said.

However, any imposition of encumbrance limits should be carefully considered, added DBRS. The introduction of a hard cap should be avoided, according to the rating agency, as this risks pro-cyclicality and the possibility of otherwise secure banks being sent over a liquidity cliff toward bankruptcy.

“As a result, debate over any proposed limit on encumbrance should include flexibility and allow for the ability to further encumber an elevated proportion of assets in times of stress,” said DBRS.

It cited the example of Belgium’s covered bond legislation, which allows the country’s central bank to grant exceptions to a covered bond issuance limit – 8% of a bank’s assets – when assets are needed to maintain contractual obligations of the covered bond programme or when the bank’s credibility on the market is affected. It can also impose a lower limit to protect depositors if the bank has pledged a large amount of collateral in other forms, noted DBRS.

Any encumbrance limits would have a large impact on heavy issuers of covered bonds, with areas such as Germany, Spain and certain Nordic countries likely to be more severely affected, according to the rating agency. It suggested that differentiation be made between banking models, so that non-retail deposit taking institutions, for example, would be allowed to have higher levels of encumbered assets. Otherwise, issuers such as specialised mortgage banks would need to access new markets for funding, potentially increasing overall funding costs.

In addition to being flexible and differentiated, any encumbrance limits should also be introduced gradually, said DRBS, as some banks will need time to diversify their funding sources.

“There is a risk of decreasing supply from regular covered bond issuers in the market and a further slowdown in their lending activities as they adjust their funding models,” it said. “A drive to implement bail-in legislation by 2015 will likely prove detrimental to large covered bond issuers.”

In contrast, covered bond issuance from new or previously quiet jurisdictions is likely to increase, according to the rating agency, as a result of the combination of investor demand for high quality collateral and appetite for non-bail-inable debt, and the appeal of low cost funding.

The rating agency also warned that asset encumbrance limits could inject an element of risk to covered bonds in the context of issuers’ management of overcollateralisation. In extreme cases, it said, encumbrance limits may limit issuers’ capacity to add collateral to shore up a given rating and “may be used as justification not to support the covered bonds rating”.

Overall, DBRS said that it finds that the issue of asset encumbrance is of “some but not immediate concern” to covered bond investors and ratings.

“However, it is difficult to say at this stage what the impact will be as several factors need clarification,” it said.

ECBC offices, Brussels

In its submission to the European Banking Authority’s consultation on asset encumbrance reporting, the European Covered Bond Council says that asset encumbrance issue needs to be addressed through a holistic and gradual approach, taking into consideration all different sources of encumbrance.

“The ECBC believes that establishing hard limits on covered bond issuance would be a short term and one-size-fits-all solution,” it says. “These limits would be detrimental for this essential asset class and, therefore, for the European banking industry as a whole.

“We, therefore, invite European regulators to further investigate other potential solutions and we would like, in particular, to draw their attention to the recent initiative launched by the industry – the Covered Bond Label initiative – which aims to improve information disclosure and transparency in this market.”

The ECBC argues that a large part of encumbrance is hard to measure and that this can lead to a focus on the most visible and transparent part of encumbrance, such as covered bonds, with biased conclusions reached because of this.

It says that according to recent studies, including one from the European Central Bank, there is no evidence of correlation between the covered bond encumbrance of a bank and its senior unsecured spread levels

“The existence of different business models implies in our view a case by case interpretation of the level of asset encumbrance,” says the ECBC. “For specialised issuers for instance, the level of encumbrance – given a broad definition – is close to 100%.

“For those financial institutions which do not take any deposits, all senior investors are institutional investors who are well aware of their position in the priority ranking in case of insolvency. For such institutions, the high level of encumbrance is only a consequence of their business model and cannot be interpreted differently.”

The ECBC says that an absolute limit would endanger existing stable business models in traditional covered bond markets.

“There are long established covered bond markets in several countries including Denmark, France, Germany and Sweden,” it says. “In these jurisdictions, dedicated covered bond banks often exist that do not take in retail deposits and that provide a key service to the economy, but which would be catastrophically impacted by any absolute encumbrance limit.

“Therefore, we consider that an issuance soft cap established on a case-by-case basis might be more relevant in this area, especially as this could be easily implemented thanks to the licence systems already in place in several jurisdictions. Such system is already in place in the Netherlands. The breach of a soft cap should result in an increase in incremental capital required rather than a strict ban to issue new covered bonds.”

The ECBC further argues that specialised issuers that do not take deposits should be exempt from the more burdensome reporting requirements proposed by the EBA. It also says that institutions should only be requested to report on covered bonds if their asset encumbrance level triggered by covered bonds is equal to or larger than a 5% threshold put forward by the EBA.

The ECBC also argues that the strict supervision of covered bonds and their restrictive cover pool eligibility criteria are a mitigating influence and make covered bond encumbrance more stable and less sensitive to market conditions in times of turmoil than other forms of encumbrance arising from repo haircuts or derivative collateral.

The covered bond market’s average growth of 7.5% since 2007 is also sustainable, says the ECBC, compared with other forms of encumbrance and given that some countries have seen issuance for the first time. It says this growth has often been misinterpreted because senior unsecured and securitisation issuance has been shrinking.

In its response, the industry body also stresses positive role of covered bonds in crisis and historically.

Regarding a consultation question on what the appropriate asset encumbrance ratio should be, the ECBC argues for an alternative to those put forward by the EBA.

“The ECBC considers that asset encumbrance should not be reduced to a simple encumbered assets to total assets ratio,” it says.

The ECBC argues that most important to senior unsecured creditors is the ratio of unencumbered assets to unsecured liabilities, rather than the share of encumbered assets to total assets, which it says has been more commonly cited.

“In particular for specialised institutions, as is the case for many covered bond issuers, the ratio of unencumbered assets to unsecured liabilities provides a fairer picture than the pure encumbrance ratio (encumbered assets/total assets), which is usually very high for such issuers,” it says. “Instead, their lower dependence on unsecured funding corresponds to a high ratio of unencumbered assets to unsecured liabilities, indicating a comfortable level of protection for senior unsecured bondholders.”

Given the challenge of coming up with an appropriate regulatory response to asset encumbrance, the ECBC argues that a straightforward way to increase market discipline and lower excessive encumbrance is by enhancing transparency, and it cites its Covered Bond Label initiative in this regard.

“This transparency tool provides very detailed asset and liability side information and facilitates the investors’ due diligence when comparing different issuer models, products in different markets and national supervision,” it says.

The ECBC paper can be found on its website.

Fitch, Canary Wharf

The rating agency’s survey took in 135 entities (101 banking groups) that it rates.

For the first time the ranking in Fitch’s report was based on cover pool size, rather than covered bond funding, as a proportion of a bank’s assets, which the rating agency said was possible given better disclosure. It noted that initiatives are underway to improve encumbrance disclosure further.

Cover pool encumbrance was broadly stable from 2011 to 2012, averaging 10% last year, according to Fitch. It said that trend drivers vary.

“Growing use of covered bond funding for some banks is based on necessity, borne from limited access to unsecured funding,” said Fitch. “More stable use comes from banks in countries where covered bonds have accounted for a large share of financing for a long time.”

The rating agency highlighted developments such as the cancellation of securitisations leading to higher encumbrance in Spain, and deleveraging in Germany including cover pools, often leading to slight decreases in encumbrance.

Newly opened markets are unlikely to witness high levels of encumbrance resulting from covered bonds given issuance limits, Fitch said.

“Banking authorities in countries that have adopted covered bonds more recently have put in place regulatory limits on cover pool size or covered bond issuance,” it said. “Covered bond issuers in these countries unsurprisingly remained in the lowest bucket (0%-10%).”

For example, Fitch noted that in Australia legislation introduced in late 2011 specifies that assets in the cover pool cannot exceed 8% of domestic assets.

For coverage of previous Fitch research on asset encumbrance and covered bonds, which explains the rating agency’s views on the importance of the issue and how it tends to vary across issuers and countries, please see here for its last report, in June 2012, and here for earlier research.

Fitch, Canary Wharf

The comments were made in response to a bank recovery and resolution framework proposal from the European Union Economic & Monetary Affairs Committee (ECON) last week, under which depositors would be ranked ahead of senior unsecured creditors. The proposal also introduced the possibility of covered bondholders’ residual claim being bailed-in, although market participants appear hopeful that this will not feature in the final directive. (See here for previous coverage.)

Depositor preference has a far greater influence on subordination risk than balance sheet encumbrance, said Fitch, which previously flagged the issue last August (see here). Regulatory reforms may also lead to a rise in encumbrance by increasing secured funding and collateral posting, but the risk is lower.

A preference for retail depositors over senior unsecured bondholders could substantially increase subordination risks for senior creditors, said the rating agency, pointing to figures released by the Bank for International Settlements on Monday. According to these the introduction of depositor preference can raise the median asset encumbrance ratio for European banks by about three times, noted Fitch.

“This is consistent with our findings last year that deposits raise the median encumbrance of funded banking assets to around 72% compared to 28% when only secured funding is included,” it said. “This shows how the relative size of a bank’s deposit base compared to other funding sources could limit recoveries for senior unsecured bondholders.”

However, policymakers’ views on which deposit categories should come under protection are likely to vary, said Fitch, especially because the definition of a deposit can include instruments that resemble capital markets investments. A narrow application would have a less marked impact on the encumbrance ratio.

Asset encumbrance could also increase if banks use more long term secured funding to comply with the Basel III net stable funding ratio, with regulatory reforms and market pressure adding to momentum for banks to increase balance sheet encumbrance. Collateral for OTC derivatives, for example, is increasing.

“However, these factors are unlikely to have as great an impact on subordination risks compared to depositor preference,” said Fitch. “In any case, they are being at least partly offset by a receding euro-zone sovereign crisis, collateral optimisation and enhanced capital buffers and liquidity.

“Weaker European banks that are able to restructure and improve their financial profile will see balance-sheet encumbrance decline if their need for central bank funding reduces.”

Ulrich Bindseil, ECB

At the event, organised by the ICMA Covered Bond Investor Council and The Covered Bond Report, investors and a representative of the European Banking Authority (EBA) discussed covered bonds’ position in macroprudential regulation, with Nordic and Spanish experiences colouring the debate.

Georg Grodzki, head of pan-European credit research at Legal & General Investment Management, said that overuse of covered bonds can fuel a rise in property prices — citing Ireland and Spain as examples — and said that it is important “to be honest” about this potential impact. Regulatory authorities are entitled to monitor overall leverage in an economy, and, as a funding tool contributing to this, covered bonds would legitimately come under their focus.

“There should not be a ban on lateral thinking” about the big picture implications of use of an asset class that has many strengths and weaknesses, he said.

“If there is a property bubble it won’t be covered bonds’ fault,” added Grodzi, “but covered bonds are not a guarantee that things will remain under control.”

Claus Tofte Nielsen, head of position management allocation strategies at Norges Bank Investment Management, said that investors should be “relaxed” about the possibility of regulators turning to covered bonds in a bid to try to dampen house prices. However, he noted that politics can also influence how regulators go about tackling overheating property markets and said that investors should be mindful of this, as well as the role played by the availability of sources of cheap funding. He gave as an example the introduction of legislation in Denmark that allowed interest-only mortgages, which, he added, some would say turned out to be a mistake.

Other panellists pointed out that covered bonds are only one piece of the puzzle. Christian Moor, policy advisor, securitisation and covered bonds at the European Banking Authority, said that loose underwriting standards and poor risk management are other contributing factors.

Mónica Trastoy, senior credit analyst at Santander Asset Management, noted that several factors were behind the property bubble in Spain, such as a growing population, high employment and high per capita salaries, and that the growth of the cédulas market only came later.

Meanwhile, Morten Bækmand, head of investor relations at Nykredit Realkredit, gave a mixed prognosis on the wider regulatory front. He said that whereas a previous examination of pending regulations had thrown up 10 potential ways for the group to be put out of business, recent encouraging developments suggested that “we can only be killed three or four times”.

Florian Eichert, senior covered bond analyst at Crédit Agricole CIB, said that regulation remained uppermost among issues that investors are grappling with based on his conversations with them.Jens Tolckmitt, chief executive of the Association of German Pfandbrief Banks (vdp), noted that the regulatory scene was developing.

“Some of the big elephants are out of the room,” he said. “Others are coming.”

He cited mention of covered bond harmonisation in a recent EC green paper on long term finance.

Bækmand noted that a “key” decision would be the final outcome over what assets are eligible as top level LCR assets after the EBA has completed its work on this. Bækmand was optimistic about Danish covered bonds’ fate, noting that the industry had a lot of data to back up its case.

Tolckmitt said that a major issue that needs to be tackled is the way in which European-level regulatory initiatives can be contradictory, and he called for greater examination of the interaction of different regulations. In particular, he said that were covered bonds to become subject to haircuts in the event of a bail-in this would “kill” the idea of covered bonds.

Nykredit’s Bækmand agreed with this, citing two examples. He said that CRD IV induces banks to raise more longer term funding, but that Solvency II penalises insurance companies buying long term assets, and that the authorities want liquid markets but are introducing the Financial Transactions Tax, which Bækmand said “will kill liquid markets”.

Indeed, the transaction tax has many market participants worried, and a trader in the conference audience took the opportunity to ask Ulrich Bindseil, director general, market operations, at the European Central Bank and one of the keynote speakers, for the ECB’s views on the proposal.

Bindseil said the transaction tax needed to be thought about very carefully, and that, as currently proposed, it risks undermining liquidity in the bond markets, including in covered bonds.

Nykredit’s Bækmand warned that such muddled banking regulation would “sow the seed for the next piece of trouble”, which he said was likely to be activity being driven into the shadow banking sector.

Investors also had warnings for regulators. Grodzki criticised a trend of political interventionism and regulatory overreach and inconsistency, saying that this undermines investors’ trust, and that regulators and politicians were playing into the hands of old-fashioned securitisation.

“Regulators should rein in their ambitions to fix the world,” he said. “They are not wiser than the markets.”

Encumbrance, SME preoccupations

Another topic on the investor-driven conference agenda was asset encumbrance, and whether covered bonds were being unfairly singled out as a contributor.

Bindseil at the ECB said that covered bonds have not been a driving factor of intensifying asset encumbrance, but that the issue will become more relevant for the market because of a general trend toward collateralised transactions, in part due to regulatory drivers. There needs to be scope for collateralised and unsecured bank liabilities, he said.

For L&G’s Grodzki, senior unsecured investors should be more worried about depositor preference than asset encumbrance via covered bonds when it comes to their spot in the payback queue and recovery prospects. And Moor at the EBA defended the way covered bonds were dealt with in the EBA’s asset encumbrance reporting consultation, saying that the asset class was not singled out and that the proposed data reporting requirement is “quite reasonable”.

It is right that regulators pay attention to asset encumbrance, which has increased over the years, he added, to determine to what extent it is a real problem or not.

When an investor warned of the implications of changes recently put forward to the proposed EU bail-in framework, Moor said that uncertainty about the fate of covered bonds in a bail-in situation should not be exaggerated, questioning how certain investors can really be about how covered bonds would ultimately fare in an insolvency situation under national covered bond laws.

The conference would not have been complete without a discussion of SME backed covered bonds, as controversially spearheaded by Commerzbank via the launch of the first such deal at the end of February, with use of the “covered bond” term being a major concern for several large investors.

Rainer Mastenbroek, head of covered bond funding at Commerzbank, was once again pressed to explain why the issuer introduced the SME backed programme and why it referred to it as a covered bond.

“We chose the covered bond brand because that it is how people referred to it during the preparation and because it has typical covered bond features,” he said. “It was the natural thing to do to call it a covered bond, and I don’t think the name affected the pricing.”

The latter point was an answer to a question posed by Andreas Denger, senior portfolio manager at MEAG, about how much pricing power could be attributed to the deal being called a covered bond, as opposed to a collateralised SME bond, for example.

He welcomed the innovation and SME funding tool, but said that it is missing traditional covered bond assets as collateral and that is one of the reasons he believes it should not be referred to as a covered bond.

Thorsten Jegodtka, portfolio manager at Union Investment, said that the Commerzbank SME bond came under the remit of the ABS team at Union Investment, and criticised the use of the covered bond term in connection with the deal, saying that it amounted to abuse of a good name for the product.

Mastenbroek played down the take-up of covered bonds backed by alternative assets on a bank’s balance sheet. He said that the SME programme made sense for Commerzbank because it corresponded to one of the bank’s core business areas, and that the issuer wanted all of these to have access to covered bond financing.

The comments were made by De Nederlandsche Bank (DNB) in a financial stability report published on Thursday.

It is the latest regulator to put forward transparency as a means of tackling asset encumbrance. The Swedish financial authorities have urged issuers to take the lead on asset encumbrance by releasing relevant information and the European Banking Authority has highlighted asset encumbrance reporting as integral to regulators’ supervision of the financial markets.

In its report DNB said that secured funding has increased in importance, with the use of covered bonds increasing in particular, although there are other sources of encumbrance, such as central bank liquidity support. The rise in secured funding can have a self-reinforcing effect, said the central bank, noting that asset encumbrance brings with it certain risks, such as pro-cyclicality and threats to deposit guarantee schemes as well as greater interconnectedness and complexity in the financial system.

It said that Dutch banks have increasingly turned to secured funding, mainly via issuance of long dated covered bonds as opposed to ECB funding. Dutch covered bonds are highly overcollateralised, leading to relatively high asset encumbrance when they are issued, DNB noted, mainly due to the interest-only profile of many Dutch mortgages backing covered bonds, with high LTV ratios also playing a role.

However, average asset encumbrance at large Dutch banks, at 14%, is below the European average of 25%, said the Dutch central bank, and is partly due to DNB setting prudential limits on the volume of covered bonds that individual institutions may issue. The Dutch central bank takes a case-by-case approach to banks’ covered bond issuance.

In addition, it said that provision by banks of “sufficient information” can mitigate the risks of asset encumbrance, by helping keep encumbrance levels low and reducing the risk of surprises.

“If banks report frequently on which portion of their balance sheet is encumbered, unsecured financiers can make better risk assessments,” it said. “This increases the incentives for banks to keep asset encumbrance low.

“Providing frequent information reduces the risk of surprises for investors, thus avoiding the threat of a sudden increase in risk premiums or funding risks, for example.”

A new housing market policy in the Netherlands will also help limit asset encumbrance, said DNB. Two aspects of this, the introduction of annuity-based mortgages and the gradual imposition of a 100% LTV ratio limit, will help lower the level of overcollateralisation required in future, according to the central bank.

As concerns the risk of asset encumbrance jeopardising the stability of the broader financial system by potentially necessitating deposit insurance payments and, ultimately, a government bail-out of banks, DNB said this could be countered by pricing the risks for the deposit guarantee scheme (DGS).

“In the future ex-ante deposit guarantee scheme, which is expected to be introduced in 2015, the banks will pay a risk-based premium,” said the central bank. “Making this premium partly dependent on the level of asset encumbrance will prevent banks from seeking to lower their funding costs by pushing the risks onto the DGS.”

Funding of Dutch banking sector split by main funding categories June 2012 (Eu bn)

Source: DNB

The EBA said that the development of reporting templates for asset encumbrance will fulfil tasks mandated by the European Commission, Parliament and Council under CRD IV/CRR, and also a recommendation of the European Systemic Risk Board (ESRB) in February when it published a Report on Bank Funding.

The ESRB noted then that asset encumbrance for a sample of large European institutions had increased substantially between 2007 and 2011, with the median ratio of encumbered assets over total assets rising from 7% to 27% and the average asset encumbrance ratio, weighted by total assets, increasing from 11% to 31%.

The EBA said today that asset encumbrance reporting will provide supervisory authorities with the necessary information on the level of asset encumbrance on institutions.

“Firstly, it will allow a harmonised measure of asset encumbrance across institutions, which will allow supervisory authorities to compare the reliance on secured funding and the degree of structural subordination of unsecured creditors and depositors across institutions,” it said. “Secondly, it will allow supervisors to assess the ability of institutions to handle funding stress, by providing an assessment of the ability of switching to secured funding.

“Thirdly, it can be incorporated into crisis management, as it will allow for an assessment of the assets available in a resolution situation.”

Financial authorities such as Sweden’s FSA and central bank have called for greater transparency from banks about their levels of asset encumbrance, with regulators and other market participants having bemoaned a lack of useful data.

The implementing technical standards (ITS) include a reporting template for covered bond programmes.

“Specific monitoring related to covered bonds is deemed necessary in order to ensure an effective and harmonised supervision of asset encumbrance and cover bond issuance,” said the EBA.

In the EBA’s words, it listed as the main reasons for this:

• Covered bonds programmes constitute one of the main drivers of assets encumbrance.
• Asset encumbrance in covered bonds programmes is mainly a long term encumbrance, as opposed to encumbrance generated by repo financing and securities lending, and mainly involves loans assets.
• Asset encumbrance profiles, due to covered bonds programmes, are particularly heterogeneous, and hence difficult to compare, across institutions and Member States, due to the fact that the extent of overcollateralisation varies not only as a function of varying national regulatory minimum requirements but also as a function of rating agencies requirements and the issuer’s strategies in terms of voluntary collateralisation buffers.

The ITS consist of three parts:

• A legal text which introduces the definition of asset encumbrance and outlines both the frequency and the proportionality criteria in the reporting;
• Reporting templates and instructions which, in the future, will be used for regulatory reporting on asset encumbrance;
• A data point model (DPM) and validation rules providing a structured representation of the requested data. The DPM contains all the relevant technical specifications necessary for developing an IT reporting format.

The EBA said that following the end of the consultation period on 24 June, and to the extent that the final CRR text changes before adoption of the ITS, the EBA will adapt the draft ITS accordingly to reflect any developments.

The EBA consultation can be found here.