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A three tier market?

27 July 2017
Richard Kemmish

I am a firm believer that the covered bond market is sophisticated enough to cope with two tiers – tier 1 being what we have now, tier 2 being ‘European Secured Notes’ or some other designation for bonds that are covered bonds in all but underlying assets. The contrarian view is that there is a risk of reputational contagion for our perfectly functioning existing market if a tier 2 covered bond were to default. It’s a legitimate risk but one which, after quite a bit of work investigating it for a client, one that I discount.

If  two tiers, why not three?
This certainly seems to be the opinion of the European Parliament’s latest text for its ‘own initiative’ paper on the topic. They propose ‘premium’ and ‘ordinary’ covered bonds and European Secured Notes, three separate concepts. Before considering whether this is a good idea it is worth asking why it has been proposed and I’m sorry to say, I struggle to understand that.

In the majority of cases in the parliamentary text, all three concepts are treated equally. OCBs and PCBs are differentiated according to whether they meet the asset criteria in article 129 of the capital regulations and as a consequence PCBs get better preferential treatment than OCBs.

The difference between OCBs and ESNs however is less clear. OCBs should be “backed by assets of a long-lasting nature which can be valued and repossessed” whilst ESNs should be backed by riskier assets subject to definition at a national level, but without physical assets underlying – “if you can’t kick it, it isn’t an asset”. The text does not however explain the implications of this for prudential treatment (definitions of the covered bond product are meaningless without prudential treatment depending on those definitions. Non-European bank regulators, please note).

The wording of the text suggests to me that OCBs might be intended as a ‘half way house’. Perhaps in expectation that ships will lose and planes will not win recognition for article 129 but that they are still better than assets which lack the long-term, repossessable nature.

What are the costs of three rather than two covered bond-like products?

50% more confusion in the minds of investors. Sophisticated covered bond investors with large portfolios who go to covered bond conferences can probably get their heads around this. But what of the new investors outside the mainstream of the market – investors in Asia or North America, sovereign wealth funds or non-European bank treasurers with euro liquidity buckets to fill? It is bad enough that existing covered bonds can already fall into one of four ECB repo categories or three LCR categories. The nuances of the regulatory treatment of three subcategories of the product will be impossible to track for all but the most dedicated covered bond investor.

Don’t get me wrong, I have no problem with the inclusion of all of these asset classes in the concept of the covered bond family (shall we call it that?). I just think that two, rather than three categories are the appropriate response.

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