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Why I oppose 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 bad idea.


Whilst I’m sure that the original reason for the rule was to provide a safeguard for the other Italian covered bond issuers and the market in general, you shouldn’t overlook the impact of covered bond issuance on the smaller banks themselves.

Shutting smaller banks out of the covered bond market may be detrimental to their cost of funding, but the upfront costs of issuance imply that the actual benefits to the smaller banks is marginal. Any bank with less than €250mn of capital is going to struggle to save more than a handful of basis points by issuing covered bonds. Their temptation, with big upfront costs to amortise, will be to overissue.

Also, covered bond issues for smaller issuers are less collateral efficient. By virtue of having ‘lumpier’ bonds relative to the number of mortgages in the pool they have greater refinancing risk, therefore more need for collateral. Most importantly, as this is not a ‘hard cost’ – no cash changes hands because you have too much over-collateralisation – it is likely that banks will not factor it into their appraisal of the costs and benefits of covered bonds properly.

But what of the potential damage to the reputation of the wider Italian covered bond market? With the non-statute barriers to entry – like upfront costs - it is clear that the Italian covered bond market will always be dominated by larger banks. Why should the small banks, which will only be a relatively small portion of the total market, have the potential to damage the much larger market?

This argument assumes of course that smaller issuers are more likely to default than larger ones. This may be true but remember that the Italians also introduced a rule restricting the access to the market of less credit worthy banks. The rule was based on capital levels. As all banks are now much better capitalised than they were when the rule was introduced, the calibration of the rule is now meaningless. Effectively all banks are in the category where they can issue as much as they like.

Banks failing can be detrimental to the covered bond market in two ways. Ex post, a default of one Italian covered bonds will make all Italian covered bonds less well regarded. But here the default is the thing and the correlation between size and credit quality is not valid – big banks can fail as easily as small banks.

But the possibility of default can also damage a market, ex ante. As no covered bond has ever failed this is the only ‘contagion’ that has ever actually happened. Then the perception of credit quality is the thing that matters. Rightly or wrongly, the rule restricting market access to larger banks is perceived by outsiders as an indicator that the supervisor is conservative and diligent in their approach to the market. That is important. Particularly in a country with historically wider credit spreads.

Whether the rule is justified or not, the perception that the proposed change is a loosening of standards is enough to do damage to the good reputation of Italian covered bonds.

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Tags: Covered Bond