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No Room for Complacency in the Covered Bond Market

30 May 2017
Richard Kemmish

The covered bond market might be in good health now, but it will need regulation to keep it that way.

The Elephant in the Room

Apologies to regular readers. I haven’t been able to talk about the single most important subject in the covered bond market these past few months: the harmonisation of covered bond frameworks along the lines proposed by the EBA. Now that my report for the Commission on this topic is in the public domain I can now safely make up for this neglect, probably until you are sick of the subject.

Let’s start with the biggest question of all: do we need a covered bond directive? Ostensibly, no. Critics argue that the covered bond market’s current robust good health is a result of the support of the European Central Bank. This is obviously untrue. Whereas the first purchase programme may have been a support to our market, the third has turned the relationship on its head. This purchase programme is the covered bond market helping the ECB, not the other way round. Ok so we don’t have a choice about helping out the goal of QE, but that is hardly the point.

The covered bond market would be in very good health without the ECB’s current support. Arguably much better health than it currently is. Spreads would be wider but liquidity would be better and the investor base more diverse.

Not only does the covered bond market work well now, it worked well throughout the crisis. That this is oft repeated does not make it any less true. It does however save me from having to elaborate. The realisation by Commission that this was the case was the single most positive outcome from the public consultation that they launched in late 2015.

So, why do we need a covered bond directive? Many reasons.

Firstly, it isn’t about what covered bonds do but what they don’t do. An underappreciated argument against the covered bond market is that it provides funding (ok, great funding) for the assets that need it the least. Great for the covered bond market; not so great for the real economy. Clearly there are ‘non-traditional’ covered bond assets which badly need funding in Europe. People keep talking about SMEs in Italy and occasionally about infrastructure projects and green technology. But feel free to be creative about this.

Then - in contravention to most regulatory responses to the crisis – the next crisis will not look like the last one. It will push different stress points. At the same time, the regulatory responses developed to address the next crisis may or may not work for the covered bond market. It just depends. Some of the responses – such as stricter rules against state bail-in – will clearly be negatives for all bank creditors.

Finally, the market is changing. Everyone speaks about different asset classes and structures but the development of covered bonds in lower rated banking systems is just as much of a concern.

So yes we do need this. There is no room for complacency, we do need a regulatory response. Getting it right, that’s the challenge.

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