Danes safeguarded as EBA ends capital ploy

The European Banking Authority on Monday released technical standards that ensure banks can no longer imprudently generate capital by writing down liabilities due to changes in their own credit risk, but the regulator did so in a way that safeguards legitimate Danish practices.

The EBA move came in final draft Regulatory Technical Standards (RTS) on “close correspondence between the value of an institution’s covered bonds and the value of the institution’s assets relating to the institution’s own credit risk” under Article 33 of the EU Capital Requirements Regulation (CRR).

That article specifies the criteria that must be met in order for an institution to be allowed to include the amount of unrealised gains and losses on its liabilities in own funds. However, according to analysts, banks have been able to take advantage of this to generate capital by writing down their liabilities to generate capital — something the EBA frowns upon.

EBA offices in London

“In general, changes in gains and losses on its liabilities following changes in own credit risk should not lead to changes in the capital position,” it said. “The reason for the rule is that it is not considered prudent for the regulatory capital to strengthen when the fair value of a liability decreases due to an increase in own credit risk (own credit standing).”

Under CRR Article 33, an institution may include gains and losses on its liabilities in its own funds if the following four conditions are met:

• The liabilities are UCITS 52(4) compliant covered bonds,

• The changes in the value of an institution’s assets and liabilities are due to the same changes that institution’s own credit standing,

• There is a close correspondence between the value of the covered bonds and the value of an institution’s assets, and

• It is possible to redeem the mortgage loans by buying back the bonds financing the mortgage loans at market or nominal value.

The EBA’s final draft RTS clamps down on the way in which banks might take advantage of this by specifying three conditions that must be met for close correspondence to be deemed to exist:

• Changes in the fair value of the covered bonds issued will at all times result in equal changes in the fair value of the assets underlying the covered bonds,

• Mortgage loans underlying the covered bonds issued may at any time be redeemed by buying back the covered bonds at market/nominal value (exercise of the delivery option), and

• There is a transparent mechanism for determining the fair value of mortgage loans and covered bonds, which includes fair valuing the delivery option.

Florian Eichert, senior covered bond analyst at Crédit Agricole CIB, says that this only allows certain Danish covered bonds to qualify, namely those based on the balance principle, hence not Danske euro benchmarks, but Realkredit Danmark and Nykredit Realkredit issuance, for example.

The EBA itself refers to the Danish system in the rationale for its RTS.

“For example, due to the nature of the Danish mortgage system, at some banks, there is a direct link between a mortgage loan provided to a borrower and the corresponding covered bond financing that same loan – so-called match funding – and a connected special option for the borrower,” said the EBA. “This option allows the customers to buy back the specific covered bond financing the mortgage loan in the market and deliver the covered bond to the mortgage bank as an early prepayment of the loan.

“The value of the mortgage loan is thus directly connected to the value of the corresponding covered bond. An increase in the value of the bond means a corresponding increase in the value of the mortgage loan, and a decrease in the value of the corresponding covered bond means a similar decrease in the value of the mortgage loan.”

The Association of Danish Mortgage Banks (Realkreditrådet), the Danish Bankers Association and the Danish Mortgage Banks’ Federation (Realkreditforeningen) had jointly written to the EBA on 30 August supporting a draft of the RTS and suggesting only minor changes.

“We are happy about the specification that came on Monday because it says that if a change in fair value on the liability side — the covered bonds — results in an equal change in the fair value on the asset side — the loans that are underlying these covered bonds — then it is a close correspondence, and that is exactly the case in the Danish system,” Peter Jayaswal, deputy director at the Association of Danish Mortgage Banks, told Nordic FIs & Covered.