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Danger: cliffs

30 November 2016
Richard Kemmish

There seems to be a lot of confusion about the newly proposed treatment for covered bonds in the issuer’s net stable funding ratio. The text released by the European Commission is just a proposal, we are probably a year from the final text, it is rather complicated and, most important of all, smarter commentators than I have already written plenty about it. So I won’t.
What I will comment on though is the more neglected and yet more straightforward part of the proposed changes that discusses the buyer’s treatment of the bonds, (assuming that the buyer is a bank subject to the directive, which would be about 40% of the current buyer base). These changes address two very important risks that have long been bothering me.
First though, what is the change?
A bank buying a covered bond, for whatever reasons but most likely for their liquidity buffer, will normally fund it short term via the money market. Except that when their regulator is calculating the funding needed for the position, they assign some long term funding cost to it. (I for one have always had a problem with this concept. The whole point of a liquidity buffer is that it can be sold when needed, if an asset can’t be quickly liquidated it can’t count towards the buffer. So it doesn’t seem to make much sense to assume that one day it will need term funding. When that day comes, it’s off the books. No matter.) The assumed long term funding need (aka the required stable funding factor) is a direct cost of holding the position and, therefore an input to relative value. The greater a bank’s cost of debt, the more relevant it becomes.
What particularly worries me about the current rules is that the RSF for covered bonds is very high relative to government bonds. This distorts the relative value of the asset classes and forces banks to hold more govvies and less covered bonds than they otherwise would. As the experience of Greece shows, this is not a good thing.
My second concern is the rating ‘cliffs’ in the RSF. Get downgraded over one of the magic lines (from A- to BBB+ for example) and the RSF and therefore the cost of holding the bond, jumps. Another pro-cyclical dependency on the rating agencies that we could really do without.
Needless to say the new proposed rules have ameliorated both of these risks. The cost of holding a covered bond against a govvie has reduced and the differential in the cost of holding an A- and a BBB+ rated covered bond has narrowed. 
A rating cliff has become that much lower, a bias towards concentration of risk in govvies has reduced and, best of all, the biggest impact is for banks with higher costs of debt in those countries that are trying to develop their covered bond law.
Now we just have to sort out the confusing text about sell side NSFR.

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