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The gentle art of compromise

09 May 2014
Richard Kemmish


If you’ve ever wondered why the assumed loss given default for covered bonds under EU law is 11.25%, received wisdom has it that it was an exasperated EU Presidency (at that time it was Britain’s turn) who couldn’t reconcile industry demanding 10% and commission demanding 12.5%. So they simply split the difference.

In that same tradition, rumours coming from Brussels seem to suggest that covered bonds will be categorised in the bank liquidity rules in a new category in between level 1 and level 2a (prize for whoever comes up with the best name). Again a compromise between industry  - maybe I’m biased, but industry does have some pretty compelling arguments for level 1 treatment - and, who exactly?

The loudest cries in the debate have been the now traditional, “it’s just not fair” from the securitisation lobby (Hi lads, good to see you still haven’t given up). Their argument being that covered bonds shouldn’t receive preferential treatment relative to RMBS. I’m not going there on that argument this time, partly because it’s an argument that’s been done to death but mainly because I don’t believe they are behind the reticence in Brussels to grant covered bonds tier 1 treatment.

At Brussels, government funding programmes don’t make as much noise as the securitisation market but they certainly carry more weight (‘talk softly, carry a big stick’). With government bonds the vast majority of the current definition of tier 1 (and with covered bonds regularly trading through govvies in more and more jurisdictions despite their worse liquidity categorisation) sovereign debt management offices will do everything they can to keep the membership rules of the tier 1 club as strict as possible.

Setting aside the debate as to whether the different tiering can be empirically justified (summary: no) it does create some fairly significant practical problems. Denmark is the obvious example- the government there just doesn’t borrow enough and there aren’t a whole load of other governments issuing in Danish Krona, so a tier 1 consisting of government bonds is going to cause a few problems for Danish Krona denominated banks,

But the more systemically dangerous implications of the ‘govvies only’ rule are two fold.

Concentration of liquidity risk is every bit as dangerous as a concentration of credit risk. Particularly in those countries where spreads are generally wide banks will hold mainly their own government bonds in their liquidity buffer. Which bond’s liquidity is most heavily correlated with that of a Spanish government bond? Another Spanish government bond. If liquidity pools are there to provide cash in a crisis then it probably doesn’t help if a systemically important Spanish bank holds it entirely in Spanish government bonds.

Then there is credit risk. I’ve said it before but if the new liquidity rules were in place before the Greek crisis every single Greek bank would be bankrupt now. Reminder: the government bonds failed, the Greek covered bonds didn’t.

Tier 2A Upper (got to think of a better name) might be preferable to Tier 2A but sometimes compromises aren’t good enough.  

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