Research on covered bonds rarely screams ‘READ ME!’ — but here’s something to catch your eye from Bernd Volk, at Deutsche Bank’s fixed income team:
We shortly describe the few publicly available covered bond issuance limits set by regulators. In our view, as soon as financial stress allows it, regulators are likely to take a closer look at total asset encumbrance. However, for the time being, we expect issuers closely checking out all possibilities to issue covered bonds, probably also outside specific legal frameworks and with other asset classes.
Covered bonds might be the belles of the 2011 bank issuance ball – but there’s very little info floating around on just how much of these things banks are actually allowed to issue. Oh, and there’s that very subtle suggestion by Deutsche that regulators are ever so slightly uncomfortable with what limits they do have in place.
The UK’s Financial Services Authority announced in 2005 that it expects banks to let it know if their total covered bond issuance exceeds 4 per cent of total assets. If the proportion were to hit 20 per cent then the FSA could require the bank to raise more capital. Now though, the rules are a bit fuzzier. In 2008 the FSA said it would deal with the so-called ‘asset encumberance’ issue on a case-by-case basis.
In Canada, regulators set a limit for covered bond issuance of 4 per cent of total assets for deposit-taking banks. In Italy, issuance limits depend on the capital strength of the issuing banks — though there’s no ceiling if total capital ratios are over 11 per cent and Tier 1 is above 7 per cent. In Holland, the Dutch Central Bank apparently ‘works’ on issuance limits. In Australia there’s talk of a limit of 5 per cent of total assets. In New Zealand the suggestion is 10 per cent. The US doesn’t have a covered bond framework set up just yet, but the FDIC suggests a limit of 4 per cent of total liabilities. As a point of interest — in Greece cover pool assets aren’t meant to exceed 20 per cent of total bank assets. Though, erm, Greece has only one publicly outstanding covered bond but over €12bn of ‘retained’ covered bonds. That’s debt basically kept by banks to use as collateral at various central bank liquidity ops.
We bring up this useful Deutsche run-down, because covered bond issuance has been surging in certain (troubled) corners of the eurozone — at relatively high rates, and as suggested by the first Deutsche Bank quote, despite those regulatory limits.
That might have a crowding-out or cannibalising effect on the issuance of unsecured senior bank debt — but it also means more subordination for the investors too. Bank of America Merrill Lynch said last week that senior unsecured investors might not get any money back from a failed bank, if the bank’s covered bond issuance was more than 40 per cent of total assets. 49 covered bond issuers are already at that level.
Oh, and there’s that ever-present ratings risk too.
Back to Volk at Deutsche Bank:
Increasing issuance of covered bonds leads to increasing subordination of unsecured bank creditors and lower recovery values for senior unsecured creditors from a pure economic perspective. In our understanding, there is no clear view from rating agencies on this topic yet. Rating agencies are not finished with adjusting their rating methodologies. At this stage, Moody’s, takes only a closer look at subordination due to high issuance of covered bonds if the bank stand alone rating (Baseline Credit Assessment) is sub-investment grade (interestingly, this is already true for Euorhypo which is rated Ba3 on a stand-alone basis). Moreover, Moody’s highlights that covered bonds are not the only instrument leading to subordination of unsecured creditors. Particularly in case of banks in trouble, repos and (retained) securitization may play also an important role. The 2008 paper called “The Impact of Covered bond issuance on Bank Ratings” is a good read, but probably might no longer be relevant regarding the mentioned limits.
Indeed.
Related links:
Warning on fast rise of covered bonds - FT
Cap for covered bonds set to be lifted in compromise – Sydney Morning Herald
Next up for Europe, covered bond catastrophe? - FT Alphaville