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Winding down

03 August 2017
Richard Kemmish

The ECB have announced that covered bonds issued by wind-down entities will not be eligible for their purchase programme - at least, for purchase under the purchase programme. Those that they have already bought will presumably, hopefully, still be ok - and from 2021 will not be eligible repo collateral.

As ever with the actions of the ECB, you have to ask whether this is about risk mitigation for their balance sheet, or public policy. Here those two objectives seem to be at odds with one another. It’s all about the former.

The argument goes that the bonds issued by these entities are less safe than bonds issued by going-concern banks. Our friends at Commerzbank pointed out in a recent research piece that the bonds from banks in wind down may have a lower asset quality, lower over-collateralisation and worse transparency than those from going concern banks. Furthermore, they are more likely to drop one or more ratings – the agencies are just an unnecessary cost when you are winding down a bank.

All of these arguments are to some extent true. Although the decline in asset quality is presumably due to cherry picking of the best assets for sale from the cover pool. This is only really a problem for heterogeneous asset pools (commercial mortgage and public sector assets) and even then the assets are rarely hair-cut by more than the over-collateralisation in the pool (therefore the residual o/c percentage should increase as a result of the sale). In the case of residential mortgages, the asset quality of a closed pool should increase thanks to the improved seasoning of the extant mortgages and the absence of risky new origination.

The possible decline in over-collateralisation in wind down may have been the case in the past. But increasingly now levels of collateral are determined by law, regulation or contract (the new European directive will hopefully soon to be added to that list). They are rarely a function of issuer discretion.
All of the above risks may well be real but surely the existing risk mitigation in the central bank repo rules capture them already? Wind-down banks still need to be regulated banks, their bonds still need to meet rating and other criteria that the ECB puts in place.

And what about the conflict between a central bank’s risk mitigation and it’s policy objectives? Realistically we are going to see a lot more wind-down entities in the coming years. With investors understandably nervous about the (can we say) arbitrary decisions of resolution authorities and with wind down banks an easy target for politically motivated punitive measures, which private sector investor would buy their bonds? Without a willing repo counterparty, the task of winding down the bank is going to get a lot more difficult.

Ultimately the ECB’s decision could become a self-fulfilling prophecy – banks in wind down are about to become a lot riskier. But that is a result of the ECB’s decision as much as it is a cause.

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