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Use of Proceeds

16 November 2016
Richard Kemmish


I was recently reading the supervisory guidelines for the granting of a covered bond license in one particular country (I do so you don’t have to). One of the less obvious items on the list was a description of the planned use of proceeds. Unless you are in the business of project finance or high yield bonds – where there is usually a story behind the bond issue, that is, a change in the credit profile of the issuer as a result of the issue – I’d always assumed that the “Use of Proceeds?” question can be answered with a suitably anodyne “general corporate purposes”. Cash is fungible.
 
Why would a regulator want to know this? Well on one level, any regulator wants to receive all information that they can – there is no cost to them of asking for information. If the cost to the issuer of supplying the information was somehow internalised for the regulator, the information requirements would be very different. But I digress.
 
I think in the case of covered bonds the partial link between the assets and the proceeds of the bond issue hints at one possible reason. Obviously the issuer doesn’t need the cash to originate the assets – they’ve already done that – but the cash will allow them to continue to originate assets of this type. Could the desire to know the use of proceeds in some way be linked to concerns that covered bonds are facilitating too much origination of the sort of assets that back covered bonds? The Spanish regulator in the period from roughly 2002 to 2007 would have a very valid concern that covered bonds might be fuelling a house price bubble.
 
The exact opposite is also a possible explanation. Is the cheap funding generated by high credit quality assets in covered bond pools being used to increase lending to higher risk assets? Well it might be, but then so might any funding and to the extent that covered bonds improve the economics of eligible assets relative to ineligible assets they are more likely to skew balance sheets towards lower risk.
 
And anyway, the riskiness of assets on a bank’s balance sheet is something that capital risk weights should be there to address. Funding tools are absolutely the wrong instrument to address this risk, unless that is the correlation between risk and risk weighting is undermined. By a leverage ratio for example.  
 
Perhaps the most legitimate use of the information though is not its impact on assets but its impact on liabilities. Assets are what they are (when does the bank’s head of funding decide how big the balance sheet is?), what is the right funding mix? To the extent that the answer to the use of proceeds question is “to replace bad forms of debt”, good. Bad here meaning expensive, or volatile. But if it replaces high quality sources of debt it could be a destabilising influence. But I struggle to think of higher quality forms of debt that will be replaced by covered bonds.

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