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I'd prefer to be appropriate

27 April 2018
Richard Kemmish

The investor treatment of covered bonds is often described as preferential. It is nothing of the sort and we should stop saying that it is.

It’s probably a damning indictment of the people that I call my friends but more and more often recently the evening’s conversation turns to the politicisation of bank asset risk weights. We already have risk weights that are aligned to political considerations more than they are to the actual risk of the asset in the government bond market and for loans to small and medium sized enterprises (which have a capital scaling factor of 76%, presumably to encourage banks to make more of them). Precedent established, the debate is now turning to lower risk weights for green loans and higher risk weights for mortgages (got to stop those house prices rising somehow).

Whether this is appropriate or not I will leave for another day or, more likely, for people smarter and better paid than I.

But the debate does annex a phrase that we in the covered bond market have been using loosely for many years: preferential prudential treatment. Covered bonds get, for example, a lower risk weight for bank capital purposes than other bonds of the same rating, we call that preferential treatment as if the European Commission somehow has an irrational love for our product and wants to promote it.

Some people have argued that a AAA covered bond’s lower risk weight than a AAA uncovered bank bond (are there any left?) is only because there is no such thing as a AAAA. Nice idea; wrong. A single A covered bond is lower weighted than a single A uncovered bond. It could easily be AA rated if the rating agency and regulatory treatment were properly aligned.
Ultimately the discrepancy between the risk weight of a covered AAA and an uncovered AAA must reflect one of two things: either the capital directive doesn’t trust the rating agency – suspecting that they under-state the credit quality of covered bonds - or the directive wants to prefer covered bonds, that is give a lower risk weight for any given level of risk for policy reasons, as they might soon do with green bonds.

Help me out here with your opinions please. I genuinely don’t know which it is although my inclination is that the former explanation is the more likely.

If I am right then I have a request. Let us stop calling it a ‘preferential prudential treatment’. I would rather call it an ‘appropriate prudential treatment’ It reflects the actual risk characteristics, not what some politician wants to happen.

Why does this matter (other than the linguistic pedantry associated with my age)? One of the conditions precedent for the equal treatment of non-EEA covered bonds is likely to be reciprocal treatment for EEA covered bonds issued in local currency. When Canadians sit down to discuss a lower risk weight for European covered bonds it will be far easier for them to reach the right conclusion if we describe the domestic preferential treatment as appropriate rather than preferential.

We aren’t asking for a favourable risk weighting. Lets change our terminology to reflect that.


Event, Articles and Videos that might interest you

North America Covered Bonds 2018: Global opportunities for covered bond investors

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Panellists discuss the global growth of the covered bond market

North America Covered Bonds 2018: Special debate: Rule144A vs Reg S

20 July 2018 |

Wojtek Niebrzydowski, Vice President, Global Term Funding at CIBC and Rafael Scholz, Head of Treasury at Münchener Hypothekenbank eG, debate the advantages and disadvantages of issuing in each format