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Scandinavian dis-integration

16 February 2016
Richard Kemmish

Danske bank have announced that they will be separating their previously integrated Norwegian and Swedish cover pools and moving towards a one country-one pool model. Is this a good thing?

It is difficult to argue that the combination of Swedish and Norwegian assets in one cover pool is a credit concern for many investors. Even with a low oil price and high levels of migration it would be a contrarian (not to mention creative) investor who could find any grounds for concern in either country’s economic or political outlook. Even the free option that the structure gave Dankse – to put in assets from whichever jurisdiction has the higher credit risk at that time – is effectively valueless given the correlation and current ratings.

It isn’t just about credit. If I had to find a reason to object I might point to the lower future liquidity caused by one programme becoming two, but that is really clutching at straws.

So lets generalise. What if Sweden and Norway had vastly different economies (as they did before the oil started flowing)?

As Danske have pointed out, the EBA’s best practice recommendations favour the greater clarity of risk from less mixed asset pools, which can be in terms of either mixed asset classes or mixed jurisdictions. Many investors have said the same thing – that it is their job to allocate their cash to different jurisdictions, not the issuers. The ‘free option’ point in particular rankles with many investors.

On the other hand, the European Commission recently asked what barriers there were to the cross-border asset pools, presumably because they see pan-European pools as a desirable outcome.  Their position is understandable: the free movement of capital is a founding principle of the Union and there should not be significant difference between asset qualities in member states within the Eurozone, in which case investor objections to pan-European pools are mere atavistic prejudice.

Rather than agree or disagree with this viewpoint it is perhaps more useful to ask, under what conditions could this be true? A more effective immunisation of asset pools from sovereign credit is the most obvious condition; this is a worthwhile objective but probably as much outside the scope of Commission’s  covered bond consultation as investor prejudices are. 
There is a third, perhaps counterintuitive, alternative: that there are national differences in asset pool quality but that does not mean that cross-border cover pools are a bad thing. Credit heterogeneity can be a stabilising force in cover pools.

Why assume that an issuer with a two-country cover pool will necessarily put more of the assets from the weaker country in? Arguably this would be the case for a one-off trade, or a trade where risk is to be transferred to end investors.

But this is clearly not the case in covered bonds.  Throughout the crisis issuers have positively – not adversely - selected assets to put in their cover pools in order to protect their ratings and therefore access to future funding. This applies within a country, why not between countries too?

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