A Quantative Solace

12 Sep 2016 | Richard Kemmish

The EBA’s second annual report on asset encumbrance was not hugely dissimilar to the EBA’s first annual report on asset encumbrance. Roughly one quarter of Europe’s banking assets remain pledged to someone else. Again the use of averages is particularly meaningless in the report. The best-worst difference was roughly 80%. Even on a national level it ranged from effectively zero (in Estonia) to over half (Denmark and Greece, for vastly different reasons).

Encumbrance is a stick frequently used to beat the covered bond market with – all we do is grab the good assets and impoverish the unsecured creditors. But the quantative analysis undertaken by the EBA contains several pieces of solace for us.

Firstly, covered bonds are a small part of the problem. 80% of encumbered assets are nothing to do with us, the biggest culprits being the repo market, derivatives and central banks. To the extent that total encumbrance has increased since the last EBA report it is to these markets, not ours.

Which hints at the second source of solace. Those other forms of encumbrance did increase between the reports, a time of relative calm in the markets. A time of more volatility will see a far higher increase in assets pledged elsewhere. Encumbrance in covered bonds is relatively constant, at least relative to covered bonds outstanding. This is not surprising, house prices and rating agency models may be affected by economic cycles, but their volatility is a fraction of the volatility in market values that determines the assets that issuers must pledge to central banks, repo transactions and derivative collateral agreements.

Request to the EBA: for the next encumbrance report could you please break down collateral pledged according to whether it has a mark-to-market clause in the pledge agreement? This will help us to judge how much the encumbrance levels will jump next time we have a Lehman like shock.

On a related point, how much of the non-covered bond collateral is posted according to agreements that are inherently pro-cyclical? If you get downgraded, you need to post more collateral, exacerbating the problem that you are already in. I don’t have to say that this is not the case in covered bonds.

The final graph in the report breaks down encumbrance according to its maturity. A shockingly large amount of it is very short dated – most is less than three months. Net stable funding is supposed to be about matching of assets and liabilities. We know that the current formula is flawed when it comes to the funding of encumbered mortgages but shouldn’t we also be a little concerned that the central bank and repo funding is so dependent on such short term asset rolls? 

Encumbrance will always be used as a ‘yes but’ whenever we explain how our product adds to financial stability. But looking at the numbers from the EBA it’s clear that it is not the covered bond holder’s claims on the assets that creditors should be worried about.

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