· The final draft of CRD IV
has widened the proposed definition of tier 1 assets to include
some covered bonds;
· Covered bonds traded on transparent markets
with ongoing turnover would be considered top class
· Although the proposed
definition seems to make a carve-out for the Danish market, it
does not preclude covered bonds markets in other countries also
falling within the definition in future;
· The Association of German Pfandbrief banks
is optimistic that pfandbrief will be adequately dealt
with in the final liquidity coverage ratio
The final draft of the Capital Requirements Regulation (CRR)
has widened the proposed definition of assets considered as top
class regulatory capital. Certain covered bonds could now be
treated as tier 1 capital, alongside sovereign bonds.
According to the draft, released on March 28, covered bonds
that are traded on transparent markets with ongoing turnover
will rank on a par with sovereign paper.
Covered bonds are debt backed by pools of assets, usually
mortgages, which stays on the issuers balance sheet.
In setting out this new criteria, the regulation
seems to make a specific carve-out for Danish covered
bonds. However, the language used in the text also seems to
open the door for other jurisdictions to adapt their national
markets to meet the requirements.
The proposed definition doesnt refer exclusively
to Danish covered bonds, said Peter Green, London-based
partner with Morrison & Foerster. It doesnt
preclude other markets developing that could fall within the
definition, even if at the moment it is only Danish covered
bonds that would qualify.
So what led to the conclusion that Danish covered bonds are
liquid, and how can other jurisdictions adapt their covered
bonds markets to qualify?
Understanding the Danish market
The reference to covered bonds traded on transparent markets
with ongoing turnover has particular relevance to the Danish
market. Danish covered bonds are traded on Nasdaq OMX and use a
continuous tap issuance format.
In November last year the Bank for International Settlements
published a paper on market liquidity in government and covered
bonds in Denmark. It found that Danish benchmark
covered bonds by and large are as liquid as Danish government
bonds - including in periods of market stress.
One reason for this high
liquidity could be the Danish system of funding property
purchases. Commercial banks in Denmark can fund their lending
against mortgages on real property by issuing covered
The draft proposal also references transparency as a key
Jerry Marlatt of Morrison & Foersters New York
practice cited after trade recording of bond prices and bond
sizes as an example that would help with transparency in
national markets. If thats what the Basel committee
is focussing on it wouldnt be a surprise to see that
develop in other jurisdictions, he said.
Why the classification matters
The Danish government has lobbied hard to increase the pool
of liquid assets in the liquidity coverage ratio (LCR)
under the Capital Requirements Directive (CRD IV), the European
implementation of Basel III. Danish banks would have difficulty
filling the liquidity buffer with sovereign bonds alone. Its
covered bond market is, by contrast, significantly bigger.
Banks can hold as much tier 1 capital in the LCR (a buffer
to be tapped during periods of market stress) as they wish.
This capital can be included at its full market value, with no
haircut applied to asset values.
Previously covered bonds were considered
illiquid and risky on a par with corporate bonds.
Jens Tolckmitt, chief executive of the Association of German
Pfandbrief Banks, is positive that the pfandbrief
market will eventually and at least partly qualify as tier 1
The German pfandbrief market is the biggest and
most established covered bond market in Europe, which
enjoys a unique prestige in Germany. Its seemingly implicit
state sanction was emphasised when at the peak of the financial
crisis the federal government said that pfandbriefe
are safe already. The government noted that in the bonds
more than 200-year history there has never been a default on
The important part of liquidity is that an investor
can sell the bonds at a reasonable price, even in a stress
situation, said Tolckmitt. We question whether it
is necessarily the historic bid-offer spread that indicates
With regard to the general criteria, it is not within
the capacity of the European institutions to favour one country
over another, he added.
The EBA is
still working on the definition of what will be considered to
be extremely high liquid assets.
The European Parliament and European Commission will vote
again to confirm the text this month.
The EBA did not respond to a request for comment.
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