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Haircut policies

30 November 2015
Richard Kemmish

The ECBs announcement that they are tightening up the rules for ‘own issued’ covered bonds seems reasonable enough. The own issue haircut (the reduction in the value of the collateral that you use if it is a covered bond that you yourself issued) will now apply to all covered bonds of that type not just the bonds that almost entirely exist just for that purpose.

Covered bonds still get a much better treatment than other bonds issued by the repo counterparty – which aren’t allowed at all as collateral, just less better treatment than they used to get.

Needless to say though, I’ve got a few concerns about it.

The objective of the ECB when they set these collateral haircuts is self protection. The collateral and the haircut imposed to its value is supposed to be a way of mitigating the risks that the ECB takes when they extend liquidity to banks. The own issued haircut is a mitigant of the extra amount of risk generated by the correlation between the covered bond’s value and the issuer’s creditworthiness.

But if risk mitigation is really the reason for these recent changes, why now? Surely if anything the bank recovery and resolution directive has just significantly reduced the correlation between issuer credit and covered bond credit – the rating agencies certainly think so. If anything own issued haircuts should be reduced to take this into account.

We have to assume that this is not about risk mitigation but policy. Most likely this is a way to change the economics for perfectly solvent banks forcing them into the public market rather than funding via the ECB. That this will increase the supply of bonds in the public market that are therefore eligible for the ECB’s purchase programme is a fact that is presumably not lost on the voracious ECB portfolio managers.

Then there is the traditional comment about central bank collateral rules, that they are rational, transparent and consistent, right up to the moment that they actually become relevant. What will happen in the only case that really matters – a potential bank failure? History suggests that that is when the rule book is set aside. Either the own collateral rules get weakened to allow the bank to survive (most often) or made far more stringent to allow the central bank to protect itself.
Will the new haircut rules simply encourage reciprocity? I sell my covered bond to you, you sell an identical covered bond to me, we both use them as repo collateral, we both avoid the greater haircut. On the face of it this looks like cheating, in the same way that banks holding each others capital is,  but it is of course perfectly legitimate to the extent that it takes the correlation risk out of the central bank’s balance sheet and gives it to the private sector.  In this case at least, the new ECB rules achieve what they intended to.

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