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Why I support the Italian proposal

17 July 2018
Richard Kemmish

The Italian government has proposed that the rule stopping banks with less than €250mn of capital from issuing covered bonds should be lifted. This is why I think this is a good idea.


If you are reading this you probably already share my opinion that covered bonds are a good thing both for the issuing bank and for society as a whole (unless you are a visitor from the securitisation market trying to pick holes in my arguments). So why wouldn’t you want to spread the benefits as wide as possible through the banking system?

You might also add that limiting the covered bond market to the big banks is inherently anti-competitive and discriminatory against the smaller, localised banks that attract politicians sympathy (not so many customers but plenty of political sympathy). Some have argued that the very nature of the covered bond market - with higher upfront costs and price advantages for larger deals – is inherently discriminatory, rules limiting access to the big banks just make it worse. In Australia it was once argued that covered bonds would just be another way for the big national banks to get an advantage and should be banned outright.

These points are, of course, true. But there are also some Italian nuances to the discussion worth highlighting.

We know that there is a lot of concern about asset encumbrance in Italy. This isn’t borne out by actual levels of encumbrance – no more than most countries in Europe and considerably less than in some countries where over-encumbrance isn’t even a debate. But a concern none the less. Ironically access to the covered bond market could reduce over-encumbrance in the smaller banks. Huh? Personally, I believe that if you are going to focus on encumbrance concerns you need to look at the over-collateralisation, not the notional encumbered. A bond backed by par value of assets is just turning one asset (a mortgage), into another (cash). Other creditors don’t lose out in the case of a subsequent insolvency until the cash is worth less than the assets (ie, in the case when you use that over-collateralisation). So if covered bonds can reduce the total over-collateralisation on a small Italian bank’s balance sheet they help other creditors. And to the extent that they will be used to replace less collateral efficient secured facilities, such as securitisations or the Bank of Italy’s ABACO facility, they will achieve this.

Another Italian nuance is the market volatility there. Larger Italian banks are better able to shrug that off but smaller Italian banks can be closed out of the market for months. That can be an existential threat. Covered bonds can prevent that either to the extent that the market is open when others are closed or to the extent that they turn illiquid assets into sources of emergency liquidity facilities from the central bank.

A final point is the importance of the retail investor. I know I keep going on about it, but over reliance on retail investors for funding is increasingly risky. Whether it is turning deposits into term funding via retail targeted covered bonds or turning bail-in-able retail bonds into safe retail bonds, the small issuers can feel a lot safer with a covered bond programme to hand.

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