2A+ status and higher limit seen as likely LCR result from Commission

The EC is steering toward keeping covered bonds as Level 2 assets for LCR purposes but allowing them to make up a larger share, according to sources, and an EC spokesperson said “talks are progressing well” about a solution addressing Danish concerns.

The European Commission faces an end of June deadline to adopt secondary legislation on Liquidity Coverage Ratio (LCR) rules, which will be the final verdict on covered bonds’ status within the liquidity buffer requirements introduced under the Basel III framework. However, an industry official said that this deadline may not be met, and Chantal Hughes, spokesperson for the European Commission, Internal Market and Services, told The Covered Bond Report that the “exact date is TBC [to be confirmed]” for when the Commission will adopt the legislation this summer.

“We can’t pre-empt what will be in that text, which also requires College endorsement,” she added. “Once proposed, the delegated act will be subject to scrutiny by Member States and European Parliament.”

Covered bond market participants also emphasised that the end of June deadline is still nearly two months away, and that key political events in the EU will take place in the meantime, notably European Parliament elections in late May.

However, according to market participants familiar with the Commission’s deliberations, it is moving toward designating covered bonds Level 2 assets, in line with the Basel III framework and a recommendation from the European Banking Authority (EBA), but allowing them to comprise a larger share of liquidity buffers.

Under Basel III rules, covered bonds of Credit Quality Step 1 count as Level 2A assets, subject to a 15% haircut and a 40% cap on their contribution to total liquidity buffers.

The European Commission is said to be considering lifting this limit from 40% to 60% as part of a compromise solution aimed at addressing industry concerns, in particular from Danish mortgage banks, while not deviating too much from the Basel III standards.

An industry official said that there are two main options on the table, either an enhanced Level 2 categorisation — “Level 2A+” — where the cap would be increased from 40% and ideally also the haircut lowered, or a sort of “Level 1-” category, albeit with a limit on the volume of covered bonds banks could hold. (Under the Basel III rules Level 1 assets are allowed to comprise 100% of the overall liquidity buffer.)

“The Commission probably tends to go for the Level 2A+ option,” said the official.

Karsten Beltoft, director at the Danish Mortgage Bankers’ Federation, paints a similar picture about the direction the Commission is heading in.

“What we are hearing is that covered bonds probably won’t be Level 1, but there will be an increase in the cap from 40% to 60,” he told The CBR, adding that the approach would be applied to all covered bonds and not specifically to Denmark.

“We would prefer for covered bonds to be part of Level 1, as 1B category, for example, because that would send a better signal, but they will probably end up as a special subdivision of Level 2.”

An increase of the cap from 40%, ideally to 70% rather than 60%, is second on the Federation’s wishlist for improvements to covered bonds’ LCR treatment, according to Beltoft — Level 1 categorisation is top, and lower haircuts third.

“We haven’t received any information about what the Commission will do about haircuts, but we think it would be fair and reasonable for them to be lowered to below 15%,” he said.

Hughes at the EC said that Michel Barnier, Commissioner for Internal Market and Services, met with Margrethe Vestager, Danish minister for economic affairs and interior, on Tuesday.

“We are in regular touch with the Danes on the issue of how covered bonds will be treated in CRDIV/CRR delegated acts,” said Hughes. “Talks to develop such a solution are progressing well.

“As previously indicated, the Commission recognises that appropriate treatment for Danish covered bonds is warranted,” she added.

Florian Eichert, senior covered bond analyst at Crédit Agricole CIB, said that it appears the Commission is moving in favour of covered bonds, which is welcome.

“Whether more 2A or a new 1B category is better for covered bonds will in the end depend on haircuts,” he said. “Even though some might see more value in being able to say they made it to Level 1, overall covered bond haircuts could be lower with a higher 2A share.

“The bottom line is, irrespective of how we get there in the end, a 60% or 70% number is higher than the 40% in Basel rules.”

Spreads on domestic Danish covered bonds have widened since April due to the expectation that covered bonds will not end up as Level 1 LCR assets, according to Anders Aalund, chief analyst at Nordea Markets.

“They have underperformed, but the pricing is in line,” he said. “Our view is that covered bonds are a buy because if we get a 60% cap the situation will be OK. Minor adjustments will have to be made, but it should not be a big problem, and spreads reflect this.”

Spreads on adjustable rate mortgage (ARM) bonds have widened by around 5bp in recent months, although the underperformance is greater than this given tightening in other asset classes.