Chickens, eggs and prudential regulations

14 May 2017 | Richard Kemmish

Prudential regulation of covered bond investments in western Europe are legion. They are also an accepted part of the structure of the market. Fortunately they are also quite broad. It isn’t as if one class of investors is particularly favoured in their holdings over another. If they were this would have the potential to undermine the stability of the market.

I believe that prudential regulations should be evidence based. They are about correctly aligning the actual risk (credit or liquidity) and the regulatory treatment of an investment. They should not be policy based – lower a risk weighting to encourage people to invest more in something that politicians would like funded. Debates about the risk weights of sovereigns and many of the discussions in the Capital Markets Union initiative seem to have lost sight of this principle.

But what if you have a product that has proven itself in other countries but not here yet? In member states of the European Union and for investor regulations this should be a non-issue. Never mind that no Romanian Lei covered bond has ever been issued, as long as it conforms to the EU definition of a covered bond them Romanian covered bonds can use the treatment allowed by EU regulations. But what of countries that are not member states or, for those that are, rules that are not directly imposed by Brussels?

There is an obvious chicken-egg risk. The covered bond market will not grow domestically until preferential prudential treatment is granted. In the absence of a domestic covered bond market the prudential rules are not justified by either investor acceptance of the asset class or, over time, by it developing a strong track-record.

This is particularly a risk when the domestic investor base is small and homogenous. If you only have four large pension funds and they are all stopped from owning more than 10% of an issue, it is going to be difficult to find natural buyers of the other 60% of a long dated bond.

What can be done? Looking at more detail at prudential regulations, they tend to be of one of three types: you can own the bond in this portfolio (for example the LCR delegated rules), you could own it before, now you can own more of it (the UCITS regulations), or holding it is going to be more cost efficient (ECB repo haircuts or capital rules for banks).

Without contradicting the ‘prudential regulation should be evidence based’ principle it seems that a more relaxed attitude towards allowing investors to buy more bonds (like UCITS) should come before rules that encourage them to buy (like bank capital). This is both practical – it will allow the market to develop that performance track record – and rational, prudential rules are about aligning risk and cost of holding an investment, not aligning risk and ability to hold an investment.

Another topic that I hope to get your thoughts on at the forthcoming CEE Covered bond conference, taking place in London next week.

Fore more information about the Forum, please visit the event webpage.

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