Friday, April 23, 2010

The covered bond industry is miffed about Basel

The European Mortgage Federation has taken a closer look at what the Basel Committee’s new proposed rules — dubbed Basel III — could mean for the covered bond industry.

Turns out they’re not best pleased about two proposals in particular: the ‘liquidity coverage ratio’ (LCR) and the ‘net stable funding requirement’ (NSFR). Both of these aim to improve the liquidity position of banks, and draw on lessons learnt from the 2008 global financial crisis.

On the LCR, Mauricio Noe, managing director of debt capital markets at Deutsche Bank, complains — on behalf of the industry — that while the rule appears to be good news for covered bonds since it requires banks to create a 30 day liquidity buffer comprising high quality securities, it actually isn’t because of the haircuts that are set to be applied.

His view (our emphasis):

The trouble is that covered bonds are being whacked with a 20-40% haircut and an overall holding limit of 50% on covered and corporate bonds.

As haircuts go, this is a grade 1 military “buzz cut” and banks are unlikely to actually use covered bonds given how close they trade to the haircut-less government sector – and don’t even get me started on the additional capital charge of holding our beloved instrument which is typically 5-10% under Basel II. Central Bank haircuts tend to be more of a light trim, typically in the single digits which are palatable for banks even when capital charges, over collateralisation and LTV haircuts are loaded in.

These haircuts have barely changed through the crisis therefore have proved to be a reliable reflection of the risk of holding such assets.

Which, in his opinion, means banks might actually be discouraged from using covered bonds for liquidity buffers.

But that’s not all. The rules, he says, also discriminate against covered bonds versus other securities on other levels too, and mainly by forcing additional criteria on the type of covered bonds that can make the LCR grade. These, he says, are set to be based on historic bid-offer spreads and recorded price declines.

But Noe feels this is unfair. When disaster strikes, all bid-offer spreads temporarily widen, including those of AAA government debt, he says. Why should covered bonds be treated differently when history shows their prices always recover and even the European Central Bank doesn’t look to such details.

What’s more, he adds, there has never been a credit loss associated with the products. Ever.

This is not something that can be said for government debt, which he notes is “constantly subject to the risk of restructuring, cancellation, moratorium and other similar fates”.

Furthermore, such provisions might even incentivize traders to push bond prices through boundaries just because there is a risk they might fall foul of criteria and be liquidated from LCR portfolios.

Long-term over short-term funding

When it comes to the NSFR rule, meanwhile, — which aims to mitigate a Northern Rock style funding crisis by forcing banks to fund themselves with longer-dated securities — there are again caveats in the proposals that discriminate against the use of covered bonds.

As Noe explains :

Effectively precluding banks from holding other banks’ debt under the LCR will make this process nigh on impossible, placing the burden squarely on the deposit market and real money investors – neither of whom has the capacity to absorb this supply.

Even if there are enough deposits and insurance/ pension funds out there, the cost of such funding will soar, adding whole percentage points onto end consumer borrowing.

Some banks won’t be able to afford their business models anymore as margins are compressed into oblivion. Giving banks an incentive, or rather removing the disincentive, to hold each others’ flagship and bulletproof debt seems to make sense and seems an elegant way of stabilising the system on both sides of the balance sheet.

All of which are fair points if covered bonds really are as safe as the industry makes out.

What we want to know, though, is what does the Basel committee see in the securities that makes them feel they might be riskier than pure government debt?

Unfortunately, we will probably have to wait until the G20 summit in Toronto on June 26 — when the rules are set to be discussed — to find out.

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