Can Europe covered bonds count as tier 1 capital?

Author: Gemma Varriale | Published: 10 Apr 2013
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· 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 regulatory capital;

· 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 definition.

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 issuer’s 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 doesn’t refer exclusively to Danish covered bonds,” said Peter Green, London-based partner with Morrison & Foerster. “It doesn’t 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 bonds.

The draft proposal also references transparency as a key requirement.

Jerry Marlatt of Morrison & Foerster’s 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 that’s what the Basel committee is focussing on it wouldn’t 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 capital.

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 instrument.

“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 that.”

“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. 

See also:

Revealed: the structure behind Commerzbank’s covered bond

Ratings breakthrough for Russia covered bonds

How Bilkreditt PCS first could bring back European securitisation

Global Bank’s covered bond first