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Cooling down the housing market

25 February 2016
Richard Kemmish

I recently mentioned some comments from the Canadian bank regulator which seem to suggest that limits on covered bond issuance should be about ensuring access to funding in emergencies rather than about avoiding structural subordination of unsecured creditors.

Another regulator that I have discussed this with recently raised an interesting point: could covered bond limits also be used to control excessive growth in mortgage lending? The traditional way in which a regulator would cool an over-heating property market is via an increase in the regulatory capital that banks must assign to their residential mortgages. But this regulatory tool is becoming less effective as banks find ways to circumvent regulatory capital rules (in particular securitisations, whether public market or, more often, synthetic).

I think that the answer is no, covered bond limits are not an effective policy tool for this purpose. But it is worth exploring: why not?

Firstly, it is uni-directional. When a bank has issued covered bonds up to the limit allowed by the regulator it would be difficult or impossible for them then to reduce that limit to any material extent – compliance would take many years as bonds mature. The risk weight of mortgages in contrast can be adjusted up or down as macro-economic conditions dictate.

An upward adjustment in risk weights – as we saw recently in some jurisdictions – is also an appropriate form of response: to the extent that property price appreciation is a policy concern it is also a risk to stability in the banking system, so a requirement for more regulatory capital to address this risk is justified. In contrast a limit on covered bond issuance is using a negative outcome (less of a thing that actually helps stability) to control bank behaviour – no-one benefits from the punishment.

Covered bond limits are also a ‘blunt tool’, whereas a hard limit on term funding for mortgages may stop lending by banks at or near the limit, it doesn’t have any effect on those who are not. In contrast a control mechanism that changes the economics of new mortgage lending for all banks incrementally (ok, apart from those with excess regulatory capital) – making it a bit more expensive (in terms of capital usage) is less disruptive of a normal market appraisal of the price/risk relationship.

Using covered bond limits as a tool also overlooks the importance to the stability of the banks themselves to have matched asset and liability profiles and market access in extreme stress scenarios. Do you really want to restrict that at times of house price inflation?

Having said all of this, an increase in regulatory capital is not perfect. As mentioned, securitisations can be an effective way to circumvent regulatory capital rules. A way to avoid that and to keep this important policy tool effective would be to put some form of limit on the number of securitisations that a bank enter into. Odd that this has never been proposed.

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