Im always a little bit nervous about making these pieces too technical but hey! you are reading a covered bond article on line so you must be just a little bit interested in the nerdy details. And an important development in the covered bond market currently is horribly technical but it is also horribly important, so forgive me.
As we know covered bonds, by better matching asset and liability maturities are a far more stable source of funding than, say, retail deposits. But the rules designed to increase funding stability, in particular the net stable funding ratio designed in Basle and currently being finalised for European use have the contrarian effect of actually discouraging the use of the product and encouraging the use of volatile deposits to fund long term mortgages.
The reasons are straightforward, encumbered mortgages have a higher need for net stable funding than unencumbered ones (which, in isolation is rational), short term funding counts for less stable funding than long term (again, rational) and net receivables under swaps need to be funded with stable funding (ditto).
Each part of this makes sense on its own. But each part of this is not on its own it is part of an integrated funding tool. Net stable funding ratio the clue is in the name is supposed to be the funding need for the net of the existing assets and their associated funding, not a gross measure.
There are rules for so called interdependent assets and liabilities but covered bonds dont qualify for them yet. This really has to change.
There is no point in me repeating here the arguments already excellently elucidated by the ECBC in their letter to the EBA on the topic. But I would like to add two small points.
Firstly, so called soft bullet covered bonds should not have to suffer the diminution in their value towards the available stable funding calculation in the last year of their expected life, but in the last year of their legal life. That is a five year bond with a one year extension period should count as stable funding until it is repaid on its expected date. It should only suffer the 50% haircut (for the first six months, 100% for the last six months) if it actually extends (something that has never happened).
Secondly, substitute assets should surely be taken into account better in the calculation. To the extent that they are clearly available and legally ring fenced to reduce the need to refinance a maturing bond, surely they at least should qualify for the interdependence rules and thus reduce the need for stable funding part of the calculation.
The EBA should report back to Commission in the near future. Commission should finalise the rules by the end of the year.
Hopefully this is another topic that we can discuss in the forthcoming Euromoney ECBC covered bond conference in Dusseldorf.
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