Wow, Splendid Days!

19 May 2014 | Richard Kemmish


It is difficult to overestimate the importance of the news,  reported last week in The Cover, that covered bonds will be eligible for bank  liquidity buffers in the same bucket as government bonds. Great news  for all  stakeholders except government debt management offices (who have lost their near  monopoly power over these investors but I’m not shedding any tears for them)  and non-bank investors in  covered bonds, about whom, more later.

First though, how significant is this for bank treasurers  themselves?  The cost to the banking  sector of holding multi-trillion euro liquidity buffers is obviously potentially  enormous if the eligible assets yield  a lot less than the cost of funding them.   By allowing more covered bonds which  have a significant uplift over govvies in most countries, the new criteria  significantly reduce the cost of compliance with the  liquidity regulations.  This will be more of a benefit in lower beta countries such as Germany where  the spread to governments implies that pfandbrief are relatively cheap (there’s  a phrase you don’t hear  often). In Spain and Italy where covereds are typically  similar or more expensive than government bonds, the cost benefits are  negligible.

Much, much more important than this though is the benefit to  society as a whole. I don’t want to get all ‘saviour of the universe’ about  this, but I firmly believe that the previous definition of eligible  assets  created a vast systemic risk to the banking system. By effectively forcing  banks to hold vast quantities of their own government’s bonds the nexus between  the solvency of the sovereign and of the  banking sector was made even stronger,  a totally contrarian outcome of the new regulations.

You could argue that the old rules didn’t force banks to  hold their own government bonds, but in countries with their own currency (like  Denmark) that was more or less the only option, and in Eurozone  countries both the  inter-government correlation and the spread environment (a Spanish bank would  be hopelessly disadvantaged if they had to buy low yielding German government  bonds) effectively  amounted to the same thing.

But, other than people trying to sell govvie bonds, who are  the losers? The biggest group that I can see is non bank covered bond buyers.  According to the EBA, European banks currently need an  additional €264bn of  liquidity assets by the implementation deadline of 2019. Assuming that the bank  treasurer fills this 60% with tier 1 assets and that covered bonds yield more  than govvies (admittedly  not true everywhere) this would translate into roughly  €150bn of frustrated demand. You can assume at least a similar amount of new  demand from treasurers rebasing their existing ‘government heavy’  portfolios to  take advantage of the new rules and you are looking at €60bn of new demand per  year for the next 5 years.

 In a market already desperately  short of inventory the spread implications are obvious enough.

In short, buy more covered bonds.

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