Early EBA liquidity ranking boosts covered bonds’ LCR case

Oct 24th, 2013

Covered bonds are virtually as liquid as government bonds, according to a “very preliminary” draft ranking released by the European Banking Authority yesterday (Wednesday), which market participants have said puts the asset class in a strong position to be considered as Level 1 assets in Liquidity Coverage Ratios.

EBA offices in London

EBA offices in London

The regulator released its findings at a public hearing on liquidity in London, where it also summarised responses to a discussion paper on defining liquid assets released in February and its views on the feedback. The EBA is charged with advising the European Commission, by 31 December, on the determination of “extremely high” and “high” quality liquid assets (HQLA) for LCRs under the Capital Requirements Regulation (CRR), corresponding to Level 1 and Level 2 assets under Basel III, respectively.

The covered bond industry has been lobbying strongly for covered bonds to be included as Level 1 assets alongside sovereign debt, which was initially the only bond class considered as to be of a sufficiently high liquidity and credit quality by the Basel Committee on Banking Supervision. Level 2 assets are subject to haircuts and limits under the Basel III proposals, whereas Level 1 assets are not.

In the EBA’s preliminary ranking of liquidity levels across five asset classes it ranked government bonds, covered bonds, non-financial corporate bonds, ABS (including RMBS) and equities according to eight criteria.

Covered bonds achieved exactly the same average ranking as government bonds, 2.00, which put the two asset classes at the top of those measured. Covered bonds came highest in the categories of price impact, roll measure, return volatility and 30-day price change, while having their lowest ranking (fourth) in zero-trading days.

Covered bonds were slightly behind government bonds, with an average ranking of 1.63 versus 1.50, when the EBA considered only debt instruments with credit quality ECAI 1. The asset class came out top in four categories and its worst position, again zero-trading days, was third.

The ranking is based on, for bonds, MiFID data, for the period 1 January 2008 to 30 June 2012.

Market participants drew strong encouragement from the regulator’s findings.

“It is important to stress once more that we’re talking preliminary findings of their empirical analysis,” said Florian Eichert, senior covered bond analyst at Crédit Agricole CIB. “We’re not talking final results and we’re not talking explicit allocation of asset classes into level 1 or 2.

“What I can say, though, is that we’re starting to look good. EBA ranks covered bonds at the same level of sovereign debt, which hints at Level 1 being a realistic possibility for the asset class, at least for those sectors rated predominantly above AA-.”

Eichert added that one remaining area of concern is the fact that the EBA could differentiate within asset classes when it comes to Level 1 and 2, and its strong focus on the rating threshold AA- to A+.

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