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One rule for all?

15 October 2015
Richard Kemmish

One of the panellists at the Euromoney covered bond conference in Barcelona raised a topic which worried me slightly: the standardisation of liquidity rules across European covered bond regimes. Now if it was just an opinion I wouldn’t have minded so much but it has made its way into the European Commission’s covered bond consultation paper.

What is the problem and why am I concerned?

Liquidity rules are a way to standardise responses to the fundamental problem that mortgages typically amortise unpredictably but fixed rate bonds really need to repay when they say they are going to.
A lot of time and effort has already gone into this problem and has produced very different answers. Most of the older systems of covered bonds rely on a combination of matching assets and liabilities, using substitute assets and having smooth liability profiles (easier for larger than for smaller issuers, or for issuers in countries where investors tolerate illiquid smaller issues). Most of the newer systems adopt either rating triggers to put in place such measures, or contractual features in the covered bonds themselves to allow maturity date flexibility in the disaster scenario.  
This is not a surprise for many reasons, in particular that mortgages can be either floating or fixed rate, covered bonds are used in fundamentally different ways by issuers in different jurisdictions and investor preferences are both mixed and mutable.

Whereas to me it should seem obvious that different markets require different solutions to this problem it isn’t always explicitly stated like that. I had a conversation with a regulator once about whether their latest upgrade to their covered bond law should introduce a requirement for ‘liquidity ladders’ – a matching of potential outflows and inflows over various time periods in the future. This suggestion was of course motivated by looking at another, very large and very popular covered bond jurisdiction which had just introduced precisely such a rule.

My response of course was that they shouldn’t. Just as you can’t turn a car into a Bugatti Veyron by putting a rear spoiler on it, so you can’t turn a different covered bond market into the pfandbrief market by adding German liquidity rules to it.

In fact, they are totally irrelevant in a covered bond market with floating rate assets with shorter average lives that most of the liabilities – as this one was. But these liquidity ladder rules are really important in a market with a lot of fixed rate, long dated assets and an economic incentive for issuers to run balance sheet mismatches as long as the yield curve remains upward sloping – as Germany is.

I lost the argument, the country now has a totally irrelevant set of new rules for liquidity because that’s the way the Germans do it.

What worries me is that the new Commission consultation will also try to apply an inappropriate set of rules. They could follow either approach. I suspect that the first German bank who is forced by Commission to issue a conditional pass through pfandbrief might have something to say about it.

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