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What does systemic importance mean?

15 April 2016
Richard Kemmish

All of the rating agencies to some extent look at the systemic importance of covered bonds to a country. Although a fairly nebulous concept I think we can all agree that it is important to the probability of a government stepping in to a crisis in a benign way if the covered bond system is at risk.

But how is it measured? Usually by covered bonds outstanding relative to GDP.

When I think about systemically important covered bond regimes the first two names to come to mind are Germany and Denmark. On the covered bonds:GDP metric I’d be half right but the simple fact is that there are many countries that have more covered bonds relative to income than Germany.

We could modify the measure. For example, by adjusting for the size of the residential mortgage market. It could easily be argued that the proportion of homes funded via covered bonds is an important political, and therefore systemic, consideration. But then Germany would come off even worse, the German residential mortgage market is smaller than average relative to national income, but that is far less significant than the fact that so many pfandbrief are backed by commercial mortgages, public sector or other assets. 

None of this was true even ten years ago, when there were twice as many pfandbrief outstanding (and far less covered bonds in every other country, except Denmark). Is the idea that covered bonds are so systemically important in Germany a relic of a previous age?

The best counter-argument is that covered bonds are far more relevant for German investors than they are for German issuers. In a total reversal of the conditions that formed the modern pfandbrief market, Germans are huge net importers of covered bonds from abroad.

Nobody ever uses national investor exposure as a way of measuring systemic importance. It is more difficult to measure (although not that hard to estimate with a reasonable degree of confidence) and less useful – systemic importance is used as an indicator of the likelihood of support for failing issuers in the country, not bailing out investors suffering defaults from abroad.

You could argue, given the thought leadership that Germany enjoys in this product, that their implicit support for pfandbrief influences the probability of implicit support in other states which have sold their covered bonds to German investors. I don’t think I’m being cynical if I suggest that it is in Germany’s interests most if every national government supports covered bonds the way that they do.   This is even more the case now that the ECB’s covered bond exposure is so high relative to its capitalisation. A government rescue of a failed issuer is a transfer of value from that government to the ECB. Germans approve.

As I said at the beginning, systemic importance is an input to credit thinking. Quantative measures of  bonds outstanding are flawed, qualitative measures such as politicians statements are unreliable. Is there a better way to measure systemic importance? I’ll discuss that next time.

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