May 15, 2014 / 5:01 PM / 4 years ago

EC LCR proposals to drive banks to buy each other's debt

* EU liquidity proposals at odds with Basel

* Spanish and Italian banks to be greatest beneficiary

* Real money investors fear crowding out by banks

By Anna Brunetti and Aimee Donnellan

FRANKFURT/LONDON, May 15 (IFR) - Europe’s top banking regulator is poised to provide covered bonds with the highest liquidity status in the coming days, potentially giving a huge boost to the asset class by creating a captive investor base.

Covered bonds are expected to be included alongside sovereign assets in the top tier of the Liquidity Coverage Ratio (LCR), which requires banks to hold enough highly liquid assets to cover a 30-day credit crunch. If they achieve this status, banks will be pushed to buy covered bonds to meet their regulatory requirements.

“The banking industry has put forward a very strong argument that banks need to diversify away from buying their own government debt,” said Luca Bertalot, Head of the European Covered Bond Council (ECBC) on the sidelines of the ICMA covered bond conference in Frankfurt. “This will be achieved by putting covered bonds in the Level 1 category.”

Covered bonds are debt instruments backed by prime residential mortgages and public sector assets that, due to their dual recourse and top ratings, became the backbone of European bank funding in the height of the financial crisis.

If the European Commission’s draft circulated among national finance ministries in the past week goes through, it would mark a victory for both covered bonds and asset backed securities, that could be included in the Level 2 bracket.

According to parts of the drafts seen by IFR, it would allow certain covered bonds to be included in the Level 1 class, which they could cover by up to 70%, with a 7 % haircut on their value.

As a concession to both Northern European players and peripheral ones, covered bonds of at least EUR500m and AA- rating - which include Swedish, Germans and Danish bonds - would now make it to the Level 1 class, while bonds of minimum EUR250m and single A rating - such as Italian and Spanish notes - would count as Level 2 buffers.

It would also recognise ABS other than RMBS as highly liquid assets, under Level 2 class and with a 25 % haircut.

This compares favourably with significantly stricter rules outlined by the Basel Committee on Banking Supervision, which allows covered bonds to form only 40% of the liquidity buffer with a 15% discount, and would have included only some type of RMBS, while leaving all other ABS class out of the scope of the LCR.

“The battle is in Brussels but the war is with Basel,” said the ECBC’s Bertalot. “I have to salute the efforts of the Commission to not stick to what Basel said and instead decide to defend Europe.”


The inclusion of covered bonds in the top liquidity bucket is expected to have a measurable pricing impact on banks’ funding. Bank treasuries will be incentivised to diversify away from buying their own government bonds in favour of secured bank debt.

“This will of course drive spreads tighter but it’s all about how the regulation is phrased and how they select what banks are eligible,” said Armin Peter, head of debt capital markets EMEA syndicate at UBS.

“It may work out that it only helps the Danish banks because they don’t have enough access to eligible assets and therefore need help with liquidity,” he said.

However, speaking on the sidelines of the ICMA covered bond conference in Frankfurt, bankers pointed to the 61% bank treasury allocation of Swedbank’s 1bn seven-year covered bond that was sold this week as evidence of the impact the LCR could have on demand.

“We’ll see the real impact of all of this when a AA- rated issuer comes to the market with a bit of yield and then we’ll see enormous order books from bank investors that will pile into the market,” said a covered bond banker.

Italian and Spanish banks are expected to be the greatest beneficiary of the LCR decision despite the fact that their covered bonds already often price significantly through their sovereign.

However, not everyone is excited about the upgrade of covered bonds to Level 1 assets. Georg Grodzki, head of pan-European credit research at L&G believes that covered bonds have enough preferential treatment and any further support may prevent real money investors from buying the product.

“To the extent that covered bonds become very attractive to banks they may become less attractive to real money accounts because they will become too expensive. Regulators need to make sure that certain investors are not adversely effected by the cost of covered bonds going up.” he said. (Reporting By Aimee Donnellan and Anna Brunetti, editing by Helene Durand and Anil Mayre)

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