Basel urged to exempt covered bonds from large exposure limit

Covered bonds should be exempt from a proposed large exposure limit under Basel III, especially in local currency areas such as Denmark and Sweden, industry bodies argued in response to a Basel consultation ending last Friday (28 June).

Bank for International Settlements, Basel

The comments were made by organisations such as the Danish Financial Supervisory Authority, several Danish banking associations, the Swedish Bankers’ Association, and the European Covered Bond Council/European Mortgage Federation in response to a consultation on a proposed supervisory framework for measuring and controlling large exposures that the Basel Committee on Banking Supervision (BCBS) launched in March.

The views of the Norwegian covered bond industry are understood to have been communicated via the European Savings Banks Group, which also called for an exemption for covered bonds to be safeguarded.

The Basel Committee’s proposed standard comes on top of risk-based capital requirements and, according to the committee, is designed to ensure banks could withstand “traumatic losses” caused by the sudden default of a single counterparty or group of related counterparties.

The Danish Financial Supervisory Authority (Finanstilsynet) welcomed certain aspects of the proposal, such as the suggestion that the large exposure limit be based on Common Equity Tier 1 (CET1) and the proposal to limit Systemically Important Financial Institutions’ (SIFIs) exposure to each other in order to reduce the risk of contagion.

However, it and the other aforementioned industry bodies are concerned about the proposed inclusion of covered bonds in the large exposures framework, which they believe would have a harmful effect on the functioning of covered bond markets, in particular in small currency areas.

According to the ECBC/EMF, including covered bonds in the large exposures limit would be damaging by way of the link between this and liquidity buffer requirements being introduced under Basel III/CRDIV.

In small local currency areas the limit on exposures to single counterparties — 25% is being proposed — would be easily exceeded if covered bonds held in liquidity buffers count towards the limit due to the relatively small number of issuers in these countries, said the industry bodies.

“For these markets, the proposed framework could introduce new constraints for investors and banks on how they constitute their liquid reserves, and meet the new liquidity requirements,” said the ECBC/EMF. “Ultimately this could lead to a lowering of the supply of liquid assets in the domestic currency and the proper functioning of their covered bond market.”

Higher capital costs for holding sufficient liquidity buffers, especially considering the limited size of government debt markets in these countries, would also create competitive disadvantages for banks in these countries when competing against banks operating internationally, they noted.

In Sweden, the outstanding volume of domestic covered bonds accounts for one-third of GDP and represents around 125% of Swedish krona denominated government debt, said the Swedish Bankers’ Association, with covered bonds becoming an increasingly important part of the domestic fixed income market as the volume of Swedish krona denominated government debt rapidly shrinks.

“A significant part of the Swedish bank’s liquidity reserves consists of SEK denominated covered bonds,” it said. “If the current exemption for covered bonds in the large exposure framework is removed these bonds must be sold and the only SEK denominated alternative will be government bonds as long as they are available.”

The other option, continued the association, is for banks to hold a larger part of their liquidity buffers in foreign currency denominated securities, but this would introduce additional risks and complexity.

“[It] is crucial for the functioning of the Swedish financial system that exposures to covered bonds continue to have special treatment in accordance to current EU and Swedish legislation,” said the association, which also called for an exemption for interbank exposures, in particular for intraday, overnight and tomorrow next exposures.

Including covered bonds in the large exposure limit would also pose a threat to the Danish financial sector, said the Danish Mortgage Banks’ Federation, Association of Danish Mortgage Banks and Danish Bankers Association in a joint submission.

“The BCBS’s proposal for not allowing any exemption from the 25% limit for exposures to institutions in general or to covered bonds in particular, would have severe consequences for the liquidity and the well-functioning of the Danish financial market,” they said.

Karsten Beltoft, director at the Danish Mortgage Banks’ Federation, told Nordic FIs & Covered that although the existing large exposures framework in the EU is favourable towards covered bonds, European policy is influenced by the Basel Committee’s output and the Danish industry bodies therefore felt it important to take part in the consultation.

“We felt that we should stress as early as possible that we see a problem with what has been proposed,” he said. “We are concerned that the European Commission would end up with the same view as the Basel Committee, although it has so far shown to have a better understanding of covered bonds and the Danish system.”

An exemption for covered bonds from a Basel III large exposure limit is justified on the basis of the funding instrument’s special features, argued the various industry bodies in their submissions to the Basel Committee.

“Covered bonds have long proven to be exceptionally low risk financial instruments which are governed by strict supervisory and regulatory frameworks, which also help to ensure their exceptional safety characteristics,” said the ECBC/EMF. “Coupled with the related investor confidence, covered bonds have proved to be a safe harbour during financial crises and share many characteristics with government bonds in terms of rating stability and default history.”

Echoing these comments, the Danish FSA said that an exemption for covered bonds is justified “due to the fact that covered bonds in many Member States are subject to a very detailed regulation, e.g. in the form of a balance principle, loan-to-value limitations, asset quality, disclosure rules etc. which ensures a very high quality of the covered bond system which has been proven during the recent financial crisis where the assets underlying the covered bonds have had a very low default record”.

It pointed out that in the European Union, existing and incoming capital requirement legislation allows Member States to exempt covered bonds from large exposure limits under approval of the competent authorities. The Danish FSA urged the Basel Committee to adopt a similar, more flexible approach.

“We therefore believe that high quality covered bonds, under very strict prudential requirements, should be included in the scope of exemptions to large exposures limits as a Member State option as foreseen in the CRD IV/CRR,” it said.