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The death of senior?

20 November 2015
Richard Kemmish

Most covered bond issuers are not significant. Significant that is in the Financial Stability Board’s definition of globally systemically important banks (G-SIBs). So they don’t have to have 18% of their risk weighted assets in the form of ‘loss absorbing’ bonds – or capital as we old fashioned people like to call it.

But plenty of them are in competition with GSIBs – so will voluntarily move towards, if not full compliance with the FSB rules then at least shed loads of more capital – and almost all are subject to the European Union’s MREL rules – not identical or as stringent as the TLAC rules but a) the differences are only of interest to capital aficionados  and b), I think you can guess the direction of travel: more capital.  
For a conservative bank with decent amounts of deposit funding there is a very real possibility that there will be no need for any senior bonds at all – ‘senior, bail-in-able debt’ is an oxymoron. I’d rather call them ‘the bonds formerly known as senior’.

 But what are the implications for the covered bond market?

From a very technical standpoint the ‘anchor’ for the covered bond rating may have to be defined by the rating agencies without the existence of any bonds actually rated at that anchor level. They can probably accommodate this in their models tolerably easily. But I do think that the simplistic ‘one or two’ notch differential between the rating of senior bonds and the anchor point for the covered bond ratings – because covered bonds are exempt from bail-in – needs to be thought through in more detail for the new capital structures.  5% - 10% = 1 notch is probably too simplistic now.

Then there are the structural implications for the market. The traditional capital/funding dichotomy at issuers and investment banks is increasingly breaking down. Sell side can accommodate the idea of a continuum from capital to funding relatively easily – give or take a few power struggles within treasury teams, DCM and trading desks. 

Buy side, on the other hand may struggle. The Euro-hydra’s dual heads – the unintended consequences of regulation and the intended consequences of monetary policy have made investors less able and willing to treat the bank capital-funding stack as a continuum.

As regulations increasingly differentiate asset classes, such that risk/return considerations are less important than conforming to the definition in your favourite directive, so the ability of investors to cross the covered bond boundary is diminished: “I’m only in it for the risk weighting, LCR category, repo treatment...” and so on.

Monetary policy, specifically quantative easing in some bank funding tools but not others artificially creates micro-climates of relative value. Fundamentals – such as credit – no longer determine inter-asset class value. Needless to say, the investors that we have lost as a result of the purchase programme have been precisely those who are able to choose between asset classes in a rational way.
Bank funding is becoming a continuum; are we moving in the opposite direction?

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