The EBAs report on asset encumbrance provided a lot of quantative support for the notion that assets pledged to covered bond programmes are not the problem that they are sometimes held out to be see last post.
But it also raised some other interesting more qualitative, even philosophical, points. Most of all, the report starts with the EBAs statement about why encumbrance levels are important: they say that it is important to measure a banks ability to withstand stress and it is important to monitor the consequences of changes in funding sources. Nothing then about the impact of encumbrance levels on unsecured creditors the traditional bête noire in the debate. This is perhaps particularly surprising in the context of the growing discussion on pan-European deposit guarantee schemes. It is these schemes which make depositors whole who will suffer a greater loss from a failed bank with more encumbered assets, it is no longer simply about a greater loss given default for unsecured bond holders.
Perhaps regulator concerns are moving on because of the growth in MREL, perhaps because of the growing importance of resolution rather than bankruptcy in the analysis of risk return for unsecured creditors, perhaps regulators are starting to put more weight on access to funding as a determinant of default probability. Perhaps all three.
If you have enough assets that can be bailed in under a resolution scenario you will not fail as a bank, with all of the systemic damage that implies, but your bail-inable creditors whether they be all senior bond holders, opco bondholders or some subset of these will be hurt more by a higher level of encumbrance. But as the status of these bail-inable creditors is now explicit you are capital in all but name and as the quantum is clear, it is far easier for the regulator to be indifferent to the bondholders loss given default on the principle of caveat emptor.
But it is the third of the possible reasons that is the most interesting. The fact that the EBA wants to look at a banks ability to withstand stress makes encumbrance important. As I have said many times before it is market value based and rating contingent forms of encumbrance that actually bring down a bank, usually when they run out of spare assets to pledge for emergency liquidity at their central bank. It is not the transparent, non-market value and stable encumbrance in the form of their covered bond programme.
Different banking models, for example from 0% encumbrance to 80% encumbrance, undermine the ideal of banking union. MREL is one way to shore it up, the resolution regime another. But if the EBA really is shifting its focus away from vastly different encumbrance ratios, perhaps an alternative they might work towards is ensuring that there are enough spare assets that could be encumbered by a bank in a liquidity emergency. Requirement for a minimum quantity of un-encumbered assets: RMQUE? Maybe, but well have to think of a better acronym first.
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