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Why covered bonds are so fundamental

With more than €2.5trillion outstanding at the end of 2010, covered bonds continue to play a key role in bank funding strategies by providing essential access to capital markets, even during volatile market conditions.

The €600bn issuance during 2010 at a global level is proof of their consistently strong performance, quality features and stable investor base, all of which has stimulated the interest of regulators and market participants in the asset class around the world.

Although the origins of the covered bond are deeply linked to the Old Continent, we are seeing a growing global appetite for this asset class.

It is essential the industry takes a critical look at its current funding models and strengthens its resilience

Stakeholders are pushing for covered bond legislation in countries as diverse as Australia, Brazil, Canada, Japan, Mexico, South Korea, Singapore and the US. A key driver is that the asset class constitutes a private sector and long-term funding tool, ensuring lending to the real economy.

Benefits

From an issuer perspective, covered bonds are an important contribution to the enhancement of its funding profile and to the management of its liquidity, providing the following benefits:

  • Adding duration to liabilities – allowing banks to properly match their long-term asset portfolios.
  • Providing stability to the funding mix – allowing asset liability management teams to increase predictability in maturity profiles.
    Increasing diversification of the investor base both in terms of geography and investor type.
  • Serving the industry as one of the most reliable funding tools, even in times of turmoil.
  • For investors, covered bonds provide significant advantages, including from a regulatory perspective:
  • Double recourse to issuer and cover pool.
  • Higher rating than unsecured debt.
  • Lower risk weighting for covered bonds bought by European Economic Area banks.
  • Favourable treatment under Solvency II.
  • Generally better liquidity through larger issuance size.
  • Favourable repossession treatment at the European Central Bank and other central banks.
  • Eligible as liquid assets under upcoming CRD IV rules.
  • No risk of bailing-in.

Key to success

The key to covered bonds’ success lies in their simplicity – a classic, plain vanilla instrument mostly backed by mortgages or public sector assets. Strong supervision and the underlying regulatory and legislative framework are designed to properly assign collateral in case of resolution.

It is also necessary to respond to the needs of new classes of investors by achieving higher levels of transparency to help them make investment decisions. In this respect, the European Covered Bond Council has been making progress in information at a macro level. Its website is the primary source for aggregate covered bond market data and comparative framework analysis while its annual factbook is the most widely read source of covered bond market intelligence.

Stabilising the future

Following several years of turmoil in financial markets, it is essential that the industry takes a critical look at its current funding models and further strengthens its resilience in the event of future funding crises.

The covered bond community is committed to developing a quality label intended to produce multiple benefits and ultimately in an enhancement of the overall recognition of, and trust in, the asset class.

The ECBC Label Initiative will facilitate access to relevant and comprehensive information for investors, regulators and other market participants. This demonstrates the determination of the covered bond community to tackle the challenges arising from the crisis and its active engagement in maintaining the high quality of collateral assets, improvement of transparency, and eventually, the promotion of liquidity, and the strengthening of secondary market activity.

In this context, we need to be aware that overextending the dependence of the system on covered bond funding or relaxing the eligibility of the asset class may result in weakening the system we are trying to preserve.

It is, therefore, understandable that in countries with soon to be adopted covered bond legislation, regulators and supervisors recognise the need to draw from existing best practices. Regulations in different European jurisdictions place clear limits on covered bond issuance, such as requiring licences and imposing strict collateral asset eligibility criteria. These regulatory and/or legal limitations have proven effective in helping to safeguard depositors’ and senior debt holders’ interests.

But the anticipated increase in demand for long-term funding – resulting not only from balance sheet growth but also from regulatory liquidity regimes – will place additional pressure on financial institutions’ funding plans. Such pressures may tempt market participants to innovate by using covered bonds as the new tool for collateralised funding in general.

Restoration of investor confidence in the asset-backed securities market is vital for the future of banking as it will be expected to provide funding for a range of asset classes now and in the future. But transforming the valuable covered bond asset class into a new, all-purpose form of collateralised funding is not in any way an adequate response.

The ECBC, which represents some 95% of the covered bond industry, holds a strong view on the subject – the quality of the asset class should continue to be the basis of the industry’s strength in the future. This, of course, does not preclude further enhancements to improved market liquidity and higher levels of post-trade transparency which will only increase the attractiveness of the asset class for investors.

Market stakeholders are keen to see additional work to further secure the value of covered bonds. The growing importance of the covered bond markets across many financial sectors makes their continued performance vital for financial stability and justifies their increased recognition by European Union policymakers and regulators.

Annik Lambert is secretary-general of the European Mortgage Federation

 

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