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What is the point of ESNs?

12 November 2018
Richard Kemmish

Now that the European Commission has published my study on ESNs I can share a few thoughts on the topic. Firstly, is there really a need for the product?


The idea that making an asset class eligible security for an efficient funding tool will increase the flow of funds to that asset class is predicated on the belief that banks fund themselves in a fragmented way. It underlies the political impetus for European Secured Notes and most of the assumptions published about the potential market size.

It is also wrong.

Most banks fund themselves holistically. They borrow money as best they can, then they charge the different businesses internally for the use of funds. Money is fungible. So if the mortgage business provides collateral for €1bn of funding, that €1bn gets added to the general pot, not the mortgage pot. The cost saving from the security doesn’t usually flow back to the mortgage business. There are exceptions. But that is generally the rule.

So, will banks use ESNs?

If they can issue traditional covered bonds, no.
Traditional covered bonds will always be better in two important ways. Investors will prefer them, even in the unlikely event that they are given the same prudential treatment as regular covered bonds, investors will still demand a premium. And the collateral efficiency will be less, loans to SMEs are riskier than loans secured on residential property. How much I will come on to in a later post but rating agencies will need more collateral to keep them happy.

If they can’t issue traditional covered bonds, yes.
Even with the exceptionally tight spreads in the senior preferred market currently, ESNs will price tighter. They will be better rated and will get a better prudential treatment than unsecured bonds by virtue of their better credit rating, even if the European Commission decides not to give them any special treatment under the new directive.

So, who can’t issue traditional covered bonds? Of the 133 biggest banks in Europe included in the EBAs annual transparency exercise almost all either issue covered bonds, have assets that could back traditional covered bonds or don’t have the assets for either traditional covered bonds or ESNs. There are though a very small number of banks who lend to SMEs or infrastructure projects but not mortgages or public sector assets. They are issuance candidates.

Then there are the banks in countries where either the covered bond law isn’t very good (usually due to high barriers to entry) or the mortgages aren’t very good or very plentiful compared to SME loans. This was the case in Turkey (the ‘not very plentiful’ bit at least) when they introduced SME backed ‘covered bonds’. I expect there will be many more cases (in the ‘aren’t very good’ category) when house prices crash, excessively debtor friendly (populist) policies get passed or both.

Whilst we are on the subject of future crashes, a further role for ESNs could be as collateral for emergency funding from central banks (who are generally very long mortgage exposure already). When meeting central banks as part of my ESN study I was shocked by their preference for traditional covered bonds over ESNs as collateral for repo operations despite their current exposure to overheated mortgage markets.

More optimistically - ever the optimist - I think ESNs will have a role to play in the growth of the CEE banking system. The relatively small mortgage markets in the region haven’t been a problem so far because the banking system in those countries is small relative to GDP. It has to grow. And it will fast run out of mortgages as collateral.

So yes, there is a role for ESNs, even with abundant liquidity in the market (which will go away) and even with the efficiency and quality of the traditional covered bond product (which won’t).

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