A better way to measure systemic importance

18 Apr 2016 | Richard Kemmish

In my previous post I argued that the obvious way to measure the systemic importance of covered bonds for an economy – bonds outstanding – is flawed, in particular it fails to capture the putative systemic importance of covered bonds in Germany.

However that gap – the gap between the perceived and actual importance of the product to the financial system – is even wider in Germany if you use a more rational metric than bonds outstanding.

I would argue that when you look at the importance of covered bonds to funding the financial system in a country you need to weight the number of bonds outstanding by the benefit that they provide relative to other funding sources. Apply this logic to Germany and you get the totally counter-intuitive result that covered bonds are more or less irrelevant to financial stability. With copious liquidity in the banking system, high savings rates amongst (oddly loyal) depositors and easy access to term unsecured debt, German banks would be some of the least affected in Europe if the covered bond market ceased to exist tomorrow.

In many ways this is the national equivalent of the case that the best funded and rated banks in Europe – such as Rabobank – don’t bother so much with covered bonds because they don’t have to. Whilst the less well rated banks take the product very seriously indeed.

So why are covered bonds always said to be so much more systemically important in Germany? Historical factors, as I argued in my last post, are part of the explanation. Cultural factors are another part. But I still see a large unfilled gap between perception and reality. Any thoughts on how to fill that gap would be gratefully received.

Where are covered bonds really systemically important then? Most obviously in those countries where they are the only available funding source for much of the banking sector, including those banking systems addicted to central bank funding of the financial system.
It isn’t just a matter of credit though. Systemic importance is also a relevant factor in countries where the covered bond market is being developed for other reasons. Covered bonds are vitally important in, for example, countries trying to develop their local currency capital markets. They are also increasingly important in countries which are trying to develop a mature pension fund market, or developing local currency denominated assets for bank liquidity buffers.

In new jurisdictions the importance of persuading the pensions regulator / markets regulator / banking regulator / central bank that the home-grown covered bonds are good enough for these purposes is a major force driving the quality of the new covered bond regimes.

There are other ways in which systemic importance can occur – central bank exposure to the asset class, providing access to foreign investment or supporting public sector finance to name just three. Suffice to say that a simple, ‘how many bonds are there?’ is not a particularly good way to think about this important topic.

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