The ghost of Bradford and Bingley

17 Mar 2015 | Richard Kemmish


For me the crisis started on 5th March 2007 when the FT led with HSBC’s US subprime woes. I remember it clearly because I was roadshowing with them at the time. It made for a very interesting breakfast presentation.

Thinking about that it occurred to me that the crisis is now entering its 9th year. Given how young the investment banking community is, for most of your DCM coverage team names like Washington Mutual and Northern Rock are historical events rather than clients that you used to pitch to.

With so many banks having failed some of the smaller ones have dropped out of our collective memory. Who still now remembers EBS or Bradford and Bingley? But Bradford and Bingley should be remembered in the covered bond market for one small detail that reverberates around the world to this day.

A couple of years before their failure in 2008 Bradford and Bingley were enthusiastic issuers of covered bonds. As a percentage of their balance sheet total covered bonds outstanding were 3.9%. Not much by the standards of Scandinavian or most Eurozone banks but the highest percentage of any British bank at the time.

At this stage the British Bankers Association asked the Financial Services Authority – the then regulator of banks – whether too many covered bonds could be a bad thing. Speicifically whether the subordination of unsecured creditors and their subsequent losses in a default scenario was destabilising. The FSA replied saying that yes, this was a risk that they recognise risk in theory. However, they also noted that the most encumbered British bank currently had 4% exposure to covered bonds and that they did not consider this to be particularly material. 

Crucially, disastrously as it turned out, they went on to say that a higher level of encumbrance – which they didn’t specify at the time - could potentially be a problem. The slight ambiguity in their letter was immediately picked up by journalists as suggesting a 4% cap on issuance. By the time the FSA got around to clearing up the ambiguity with a second letter over a year later it was too late; a 4% cap had entered the collective consciousness of the covered bond market.
 
The 4% cap has since reverberated around the world’s new jurisdictions. Some of them, such as Canada and Australia have come to realise that the cap is too low and have doubled it. But still double an arbitrary number is still pretty arbitrary.

Arbitrary does not always mean wrong of course. Except that it is here. A ridiculous over-simplification will suffice: assume a bank has a 75% recovery rate. If it has no covered bonds the recovery for other creditors is 75%. If it has 4% covered bonds outstanding that falls to 73.9%. Irrelevant really. 4% is clearly far too low to be material.

If there aren’t enough covered bonds coming from the new jurisdictions (which there aren’t), blame Bradford and Bingley.


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