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Playing Chicken

01 December 2014
Richard Kemmish

Chickens have developed highly sophisticated pecking orders – literally the order in which members of the flock are allowed access to a food source – in order to avoid conflict which can be both damaging and can attract the attention of predators. When introducing mature chickens to an existing flock there is always a period of stress until the new birds find their position in the order.


Chickens have developed highly sophisticated pecking orders – literally the order in which members of the flock are allowed access to a food source – in order to avoid conflict which can be both damaging and can attract the attention of predators. When introducing mature chickens to an existing flock there is always a period of stress until the new birds find their position in the order.

Bank creditors are broadly similar to chickens and exhibit similar stress levels when the biggest, meanest new chicken in town – the ECB – barges into the pecking order at precisely the time that access to food becomes critical for survival.  This has happened in practically every bank failure through the crisis.

So far bank bail-outs by tax payers have meant that only the weakest chickens at the back of the queue (equity holders, for example) have suffered. With the bank resolution directive in place that will not happen anymore and the pecking order (or priority of payments if you think my analogy is getting a little over-stretched here) is becoming more important than ever.

The problem with the asset encumbrance debate, which frequently resurfaces whenever covered bonds are seen to be in the ascendancy is that it looks at the impact of encumbrance on various classes of creditors, assuming the same chickens will always be in the queue. Which is simply not the case in anything but the most extreme jump to default.

Any normal bank failure – via the slow deterioration of balance sheet quality and rating downgrades - is associated with an increasing cost of funding and, increasing reliance on central bank funding. Central bank funding does not price credit per se – same cost to all - because the central bank takes collateral rather than credit risk. 

As the bank declines, so probably does the quality of the collateral that they can post, so margin calls accelerate. The new chicken in the pecking order becomes bigger and hungrier, less food is available for the lower ranking birds. As the ECB is both creditor and regulator their appetite is quite likely to be sated.  

It’s unfair to just blame the ECB of course. Other new chickens appear – swap contracts hit collateral posting triggers, CCPs require more collateral posting. Plenty of new chickens, few of which were acknowledged in the disclosure before things started to go wrong, all of whom have a vast potential appetite.

Covered bonds, in contrast, are fully disclosed and their appetite for assets more predictable. If house prices fall, over the course of a few months a few more mortgages are required. But this is slow, poorly correlated to the value of financial assets and negligible when compared to the rapidity with which securities pledged to the ECB need to be topped up.

Look at the growing encumbrance levels as banks failed under the old system, imagine how much worse that will be in the new collateral heavy system and you’ll appreciate that the assets pledged to covered bond creditors are mere chicken feed in comparison.

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