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Another reason to buy covered bonds

04 December 2015

People who are sceptical about the euro frequently point to the problems of setting a single interest rate across economies with very different needs. We’ve all heard the argument, it’s a strong one.

Now would be a fairly good case in point. Standard economic theory would suggest that the persistence of long and low in an economy as vibrant and as near full capacity as, say, Germany will lead inevitably to asset price inflation there. The hike in interest rates which Germany will so badly needs soon can-not come when the southern European Euro using economies remain in their depressed, deflationary state.

Fortunately interest rates are not the only tool available to the ECB. Bank capital ratios aren’t just increasing to unprecedented levels – as is frequently commented on - they are also become more discretionary – as is less frequently mentioned. When bank capital is discretionary regulators have another macro-economic tool, they activate the counter-cyclical capital buffer and reduce bank lending without having to raise interest rates.

Which is good. Except of course for a few problems. Firstly, the more banking union provides a ‘level playing field’ for banks in Europe the less the ECB (in its role of big bank supervisor) can set different counter-cyclical buffers: high for German banks, low for Spanish banks, for example.

Then there is the confusion about what bank capital is for. If it is a back-door alternative to conventional monetary policy it becomes almost the opposite of a risk mitigation tool – less capital is held by banks operating in more depressed economies.  As regulatory capital diverges from economic capital so credit ratings – and therefore the cost of funding the bank - across the European banking system will diverge. 

Monetary policy committees at central banks are frequently transparent, closely watched and relatively objective. There seem to be journalists and bank research analysts who spent almost all of them careers trying to predict MPC actions. The committee that sets bank counter-cyclical buffers, on the other hand is hardly ever even acknowledged in the press.

But what has this got to do with covered bonds? As one size fits all interest rates become increasingly untenable in the euro zone I see two big developments, house price appreciation in Germany and correlated countries (largely funded by covered bonds, securitisations or a combination of the two) and capital ratios going up, particularly for those banks issuing all of those securitisations or covered bonds.

Can you see where I’m going with this yet?

As the underlying assets – houses - become riskier, the banking system becomes better capitalised, mitigating that asset risk. The two sources of protection that covered bond holders enjoy increasingly balance one another. In contrast, in ‘single recourse secured debt instruments’ the growing asset risk has no counter balance. What is worse, as capital ratios increase so banks in those countries are incentivised to fund the boom in a way that arbitrages regulatory capital. 

I know which I’d rather own.

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