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Due diligence

09 October 2014
Richard Kemmish

“And after much thought he filled two great iron-bound chests with sand, and locked each one with three locks. Thereafter he sent a messenger to the two Jews, Rachel and Vidas, to say that the Campeador had two great chests of treasure which he would fain leave with them till his return, if they would lend money upon the chests.”    - The Song of El Cid
You can still see one of the chests in the Cathedral of Santa Maria in Burgos. Obviously my first thought on seeing it was of paragraph 129(7) of the Capital Requirements Directive. A failure on the part of the money lenders to look in the chests was a fundamental breach of due diligence that wouldn’t be allowed by Brussels today (assuming that they were bank investors holding the loan to El Cid in their banking book and assign it a preferential risk weight. Otherwise, fine).
Whereas it is relatively easy for a credit department to tell the difference between a chest of sand and one full of treasure, it isn’t so easy to judge collateral on the basis of the data described in 129(7). I’ve already commented in a previous post (19th August) about the challenges of understanding loan to value ratios in different jurisdictions, there is a similar tale to tell about the other data fields.

This could be a trite comment – make sure you look beyond the numbers – but that wouldn’t be very helpful to you, would it?

The covered bond market is granular on both sides. No jurisdiction represents more than 18% of bonds outstanding (contrast with the RMBS market where the British and Dutch issuers dominate). To be able to buy most available covered bonds you need to understand many different assets serving as collateral.

And of course most investors don’t have the resources to do that. The granularity of the issuers is echoed by the granularity of the investors. This is a very positive thing for liquidity and price stability, but how do these investors allocate sufficient resources to understand the subtleties of the 129(7) disclosure fields?  

The answer of course is that they don’t. Which is why I think the EBA’s ‘Best Practice Recommendations’ about both stress testing and the supervision of the asset pool monitor (or equivalent) are vital and under-appreciated. Buried on page 147 of their report, they haven’t got the publicity that they deserve.

129(7) might be a nice attempt to shift the burden of due diligence to the investor -  which is of course a good thing in theory  – but if I were a small, under resourced investor, the first thing I would look at was whether the supervisor conducts and/or supervises sufficiently challenging stress tests.  Better to do that properly than to take a superficial glance at an LTV stratification table.
Whilst on the subject of vital but under considered factors; will this responsibility be passed over to the ECB under the Single Supervisory Mechanism? And how will they interpret this responsibility in the light of the EBA’s suggestions? Hopefully better than El Cid’s money-lenders.

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