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Wow, Splendid Days!

19 May 2014
Richard Kemmish

It is difficult to overestimate the importance of the news, reported last week in The Cover, that covered bonds will be eligible for bank liquidity buffers in the same bucket as government bonds. Great news for all stakeholders except government debt management offices (who have lost their near monopoly power over these investors but I’m not shedding any tears for them) and non-bank investors in covered bonds, about whom, more later.

First though, how significant is this for bank treasurers themselves?  The cost to the banking sector of holding multi-trillion euro liquidity buffers is obviously potentially enormous if the eligible assets yield a lot less than the cost of funding them.  By allowing more covered bonds which have a significant uplift over govvies in most countries, the new criteria significantly reduce the cost of compliance with the liquidity regulations. This will be more of a benefit in lower beta countries such as Germany where the spread to governments implies that pfandbrief are relatively cheap (there’s a phrase you don’t hear often). In Spain and Italy where covereds are typically similar or more expensive than government bonds, the cost benefits are negligible.

Much, much more important than this though is the benefit to society as a whole. I don’t want to get all ‘saviour of the universe’ about this, but I firmly believe that the previous definition of eligible assets created a vast systemic risk to the banking system. By effectively forcing banks to hold vast quantities of their own government’s bonds the nexus between the solvency of the sovereign and of the banking sector was made even stronger, a totally contrarian outcome of the new regulations.

You could argue that the old rules didn’t force banks to hold their own government bonds, but in countries with their own currency (like Denmark) that was more or less the only option, and in Eurozone countries both the inter-government correlation and the spread environment (a Spanish bank would be hopelessly disadvantaged if they had to buy low yielding German government bonds) effectively amounted to the same thing.

But, other than people trying to sell govvie bonds, who are the losers? The biggest group that I can see is non bank covered bond buyers. According to the EBA, European banks currently need an additional €264bn of liquidity assets by the implementation deadline of 2019. Assuming that the bank treasurer fills this 60% with tier 1 assets and that covered bonds yield more than govvies (admittedly not true everywhere) this would translate into roughly €150bn of frustrated demand. You can assume at least a similar amount of new demand from treasurers rebasing their existing ‘government heavy’ portfolios to take advantage of the new rules and you are looking at €60bn of new demand per year for the next 5 years.

 In a market already desperately short of inventory the spread implications are obvious enough.

In short, buy more covered bonds.

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