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What Should Asian Covered Bonds Look Like? Part II

10 February 2017

In my previous post I discussed the extent to which Asian covered bonds should attempt to mimic their European brothers. It is of course ridiculous to generalise a market as diverse as Asia, covered bonds from Singapore can, should and do replicate European (and in future Basle) structures, covered bond from other countries in the region cannot and should not.

But what are the main areas of difference in the structural details to consider?

Firstly, not every national banking system is rammed full of the residential mortgages that are the mainstay of the asset class in Europe. Although there has been plenty of talk of alternative asset classes in a European context the impetus for this has weakened recently. This is, I think, a function of the liquidity in the European banking system – banks are no longer running out of traditional assets to put into their covered bond programmes to fuel their central bank repos.

But the European debate provides some pointers about which asset classes may be acceptable. Generally it is agreed that the alternative assets need to be granular, credit worthy and homogenous. Occasionally people also require that the assets themselves should have a low risk weighting, should have security over a physical asset and should be of importance to public policy.
Secondly, how many assets do we need for any given bond? In Europe there is often a cap of 15% on ‘other assets’ in the pool, in Belgium they have the more sensible approach of reversing that and requiring that there are at least 85% of the primary assets in the pool. This is straightforward and prudent when you fund the assets in the currency that they are originated in or in a currency that is tolerably well correlated to it. This does not work very well when you have a volatile foreign exchange rate against the euro. If the exchange rate halves, my bond backed by 100 residential mortgages will suddenly be backed by 50 of residential mortgages and 50 of derivative exposure. Not allowed in Europe; should be elsewhere.

Then there is the matter of local insolvency rules. European covered bonds are increasingly structured and rated with reference to the bank recovery and resolution directive. Take this away and you need a better covered bond framework – to take into account the lack of uplift due to bail-in exemption for covered bonds – and more emphasis on, for example, the transfer of servicing if you assume that a bank operational failure is concomitant with senior bond default.

Perhaps the question needs to be reversed. It is not what are the main areas of difference, but the main areas of similarity that we should focus on. My preferred answer to that is simply to refer to the European Banking Authority’s ‘Best Practice Recommendations’ for covered bonds. I would argue that conformity with those guidelines is both necessary and, given the above comments, sufficient for Asian covered bonds to gain true acceptance for European investors.
I looking forward to discussing this further with you at the upcoming Euromoney/ECBC Asian Covered Bond Forum in Singapore.

The Forum will take place on Tuesday 7th March 2017. For more details, please click here to visit the event webpage.

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