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

Before Erste’s inaugural issue, only three Hungarian institutions had sold covered bonds – OTP Bank and UniCredit Bank Hungary through specialist mortgage bank subsidiaries, and FHB Mortgage Bank, a standalone issuer. However, new names are joining the market, encouraged by regulation in the vein of the Net Stable Funding Ratio (NSFR).

The Hungarian National Bank (MNB) announced in June 2015 that it would from 1 October 2016 require banks to fund at least 15% of their residential mortgage loans through long term liabilities, under the Mortgage Funding Adequacy Ratio (MFAR).

“There are quite big changes taking place in the Hungarian market, and this is the most important,” said András Botos, deputy CEO of Erste Mortgage Bank. “This is why we will have three new mortgage banks – one of them ours – alongside the three old mortgage banks.”

Erste Mortgage Bank, the issuing entity of Erste Bank Hungary, commenced operations on 1 July before launching a debut covered bond offering on 17 October. The bank printed a HUF20bn (Eu65.2m) issue comprising two HUF10bn tranches, a three year and a five year, after taking combined orders of HUF72bn.

MKB Bank, a former BayernLB subsidiary that was nationalised in 2014 before being sold to a consortium of investors this summer, is obtaining licenses for a specialist subsidiary. MKB Mortgage Bank is expected to begin operations and issue its first covered bond in early 2017, a spokesperson told The CBR.

K&H Bank, a subsidiary of KBC Bank, is also understood to be in the process of establishing an issuing entity.

The MFAR was introduced to reduce a maturity mismatch that resulted from the conversion of households’ foreign currency mortgage loans into forints last year, as such loans – mainly denominated in Swiss francs – were phased out.

The MNB said banks that did not already have specialised mortgage banks, which are required for the issuance of covered bonds under Hungarian law, would be given time to establish issuing entities. According to Botos, the central bank has informed the banking community that the mortgage financing requirement will be raised to 20% in 2018.

The MNB expects the MFAR to encourage the issuance of around HUF300bn (Eu973m) of mortgage bonds.

Botos said the requirements could also lead Hungarian issuers to consider euro-denominated issuance.

“For now this size and this volume was the right thing to do,” said Botos. “However, along with the raising of the MFAR up to 20% in 2018 and the possible pooling of partner banks’ cover assets, the investor base in Hungary might be quite narrow for us to meet the regulatory requirement.

“I would guess that Hungarian issuers will eventually have to return to the European markets again.”

The established issuers of OTP – Hungary’s largest bank – and FHB sold the country’s only euro benchmark covered bonds before the financial crisis, and issuance post-crisis has been limited to the domestic market.

Botos added that if they go back to the European market, Hungarian issuers will likely opt for benchmark-sized trades.

“We cannot properly tap the European market otherwise,” he said. “We will need large and frequent issuances.”

Photo credit: Erste Bank

The European Mortgage Federation-European Covered Bond Council (EMF-ECBC) initially published a position paper on NSFR in July 2015, but since then the European Banking Authority (EBA) in December published a report to the Commission recommending the introduction of the framework but highlighting some EU specificities not addressed in Basel Committee on Banking Supervision proposals in October 2014.

The Commission last month asked the EBA for further guidance on topics such as the treatment of derivatives in the NSFR and the application of the principle of proportionality. The Commission is due, if it considers it appropriate, to submit a legislative proposal to the European Parliament and Council by the end of this year, with implementation envisaged around 2018.

The EMF-ECBC said in its final position paper – which it submitted to the Commission and EBA today (Wednesday) – that it welcomes the EBA recommendation that certain EU specificities should be taken into account in the transposition of the NFSR into the EU banking framework, including pass-through models.

“The EMF-ECBC supports the option for national supervisors to identify assets and liabilities which are interdependent and set the Required Stable Funding (RSF) and the Available Stable Funding (ASF) to zero for such assets and liabilities,” it said.

Such a move could effectively neutralise the impact of otherwise negative consequences of the NSFR on covered bond funding, given that the EMF-ECBC further argues that a wider range of models should be covered than envisaged by the Basel Committee or EBA.

“We welcome the EBA recommendation that fully matched funded amortised mortgage lending should receive the same treatment as interdependent assets and liabilities as envisaged in the Basel Standard (para. 45),” it added, “but believe this treatment should be extended to all situations where the matching principle exists in law.”

The EMF-ECBC then defines this in such a way that captures all covered bonds.

• Issuers are required by law to segregate cover assets and covered bonds from other assets and liabilities, i.e. the assets and liabilities are clearly identifiable.

• Covered bonds are secured by a first claim on the cover assets. In a bankruptcy scenario payments on cover assets must primarily be used for the payment of interest and principal on covered bonds, i.e. the principal payment flows from the asset cannot be used for anything else before the repayment of the liability.

• In some jurisdictions, payment imbalances on cover assets and covered bonds are capped by law (matching principle), for instance by way of a maximum duration gap. The proceeds on the cover assets therefore balance the interest and principal payments.

The industry body also addresses how NSFR proposals should be changed should such a broad carve-out not materialise, highlighting previously-identified aspects of the proposed framework that it considers – in its current form – would unduly restrict the covered bond market and, as a result, long term financing.

These include:

• the potential for derogation from the NSFR on an individual institution basis where the institution is part of a group/sub group;

• the adjustment upwards of ASF factors for covered bonds with a residual maturity of less than one year;

• the need for identical treatment of mortgages in terms of RSF weighting, regardless of whether they are funded through covered bonds or not; and

• the recognition of the secured nature of the asset in the assignment of RSF factors to swap agreements on covered bonds.

“The tailored and proportionate EU implementation of the Basel III framework is vital for the viability of the mortgage and covered bond industries, all the more so in light of the advent of yet more regulatory change in the form of ‘Basel IV’,” said Luca Bertalot, EMF-ECBC secretary general. “Appropriate liquidity and capital requirements will be determinant for the role the industry can play in supporting not only growth, but also in meeting the EU’s energy targets.”

The changes were set out in a response by the association to a consultation by the Basel Committee on Banking Supervision (BCBS) on a revised framework for long term funding requirements, which closed on 11 April.

Thomas Östros, managing director of the Swedish Bankers' Association

The Net Stable Funding Ratio (NSFR) complements the Liquidity Coverage Ratio, which focusses on short term liquidity, and is designed to ensure that banks have stable funding over a longer term horizon, with the NSFR built around a one year timeframe and the LCR around 30 days.

In its submission to the Basel Committee, the Swedish Bankers’ Association welcomed changes made to the original, 2010, NSFR proposal, but said that it would still create problems for the real economy without necessarily boosting financial stability.

“The proposed NSFR is constructed in a way that provides incentives for banks to abandon this stable funding source [covered bonds] for more unstable funding sources, such as senior unsecured bonds,” it said.

It argued that under the prevailing Basel NSFR proposal, funding mortgage loans with covered bonds as opposed to unsecured borrowing is effectively penalised because of a higher (100% versus 65%) Required Stable Funding (RSF) factor assigned to encumbered as opposed to unencumbered mortgage loans, which in its view does not correctly reflect the difference in liquidity risk between covered bond and unsecured funding.

It also said that the NSFR treats funding through deposits more favourably than funding through covered bonds.

“In summary, our view is that the NSFR proposal provides incentives for banks, which currently fund retail mortgage loans with triple-A funding instruments — with well documented and proven availability and stability even under stressed conditions — to change the funding mix towards more unstable funding sources.”

To address this, it suggested lowering the RSF factor on encumbered mortgage loans from 100% to 85% and increasing the Available Stable Funding (ASF) factor for covered bonds with remaining maturities of less than six months from 0% to 50%.

The treatment of corporate deposits — “unfairly harsh” — in the prevailing proposal should also be modified to avoid a negative effect on liquidity in the real economy, according to the association, by increasing their weight as ASF from 50% to 75%, and changes should also be made to the way in which total return swaps and repos would be treated under the NSFR framework.

The repo market is very important for a liquid secondary market, it said, noting that repos make up the majority monthly turnover in the Swedish covered bond market.

“If the repos are treated unfavourably it will hurt market liquidity,” it said. “Liquid markets are essential for banks’ ability to fund themselves in a robust way.

“It is especially important that repos with HQLA [high quality liquid assets] should not be treated in the way currently proposed by the BCBS.”