EBA says LCR Level 2 only for covered: Does it actually matter for euro markets?

Jan 9th, 2014

The EBA on 20 December published its final recommendations on the Liquidity Coverage Ratio (LCR), which exclude covered bonds from Level 1 status. Crédit Agricole CIB’s Florian Eichert takes a closer look at the potential implications, and sees investor behaviour only really changing in response to a lower minimum rating criterion. 

Just to recap: The European Banking Authority (EBA) had to produce this report for the European Commission (EC) by the end of 2013. The EC now has another six months to turn the recommendation into a final delegated act, which will be applicable from 2015 onwards. We are therefore not looking at the final version as the EC can still deviate from the EBA recommendations on both the categorisation of covered bonds as well as the minimum rating.

Somewhat surprisingly, the final EBA recommendations stick very closely to the Basel LCR text. Only EEA sovereign debt and debt directly guaranteed by EEA sovereigns as well as supras such as BIS, EIB or EFSF and ESM are considered to be extremely high quality liquid assets (EHQLA), or Level 1 assets.

Covered bonds, on the other hand, can only be high quality liquid assets (HQLA), or Level 2 assets. We are also still looking at a AA- minimum rating in EBA’s proposals.

EBA has built on the recently published preliminary ranking of asset classes by looking at how various asset classes have performed throughout the crisis. In a second step, they have, however, added a second decision layer which EBA calls a qualitative/expert judgement. This is supposed to place great emphasis on aligning the European framework with global Basel rules.

Based on the empirical analysis, EBA states that some covered bonds do exhibit the characteristics of extremely high quality liquid assets (EHQLA) and should thus be moved to Level 1:

“EEA covered bonds rated ECAI 1 with a minimum issue size of Eu500m (or the local currency equivalent) and subject to additional conditions relating to the regulations governing the covered bond structure.”

However, unfortunately for covered bonds, EBA goes against its own empirical evidence in its final recommendations by introducing a qualitative or expert judgement, which factors in the importance of global harmonisation:

  • “The EBA is of view that the empirical conclusions on definitions of transferable assets of high and extremely high liquidity and credit quality included in the report item 3.1 should be supplemented by a qualitative/expert judgment substantiated basically on the supervisory advice to stress the great importance attached by the EBA to the alignment of the EU legislative framework with the international standards defined by the Basel Committee on Banking Supervision.”
  • “There are doubts as to whether the findings of the current analysis are sufficient to justify a deviation from the international standards and the inclusion of some covered bonds in the category of EHLQA…”

We have seen a degree of globalisation in the covered bond market in recent years. Yet, the market is still very European. The importance of covered bonds is still much higher for European countries such as Germany, Denmark or Spain than it is for countries from Africa, Asia or North and South America. Consequently the political interest in the product is far less prominent at the global level than it is in Europe, making it hard to achieve very favourable regulatory treatment.


EBA overviewSource: EBA, CA-CIB


Level 1 or 2 – Will it ultimately matter?

We don’t think the EBA proposals are going to change investor flows in euro covered bond markets for now:

Virtually all of those bank treasuries who are adding euro covered bonds to build up LCR buffers have done so assuming covered bonds are going to make it to Level 2 and will have a minimum rating of AA-.

  • Consequently, no-one has moved to lower ratings. In reality, non-domestic bank treasuries have stayed away from lower rated bonds almost entirely. So for peripheral covered bonds this is neutral in terms of demand compared with today.
  • At the same time, low issuance volumes in the euro space have meant that many treasuries building up covered bond holdings have struggled to find sizable volumes and most are still well below 40% as far as we are aware. Even assuming we end up in Level 2 after the EC has made its decision by mid-2014, we don’t see bank treasuries being less active. Don’t forget that we’re still looking at net negative supply in euro markets in 2014, the same as in 2013. And to merely maintain current levels of covered bond investments, treasuries have to buy core covered bonds to offset their redemptions.
  • Making it to Level 1 would ultimately make a difference for some German treasurers as they have been the ones buying covered bonds in the euro market for the longest and are thus the ones with the highest levels. But most other banks will need time to get even close to 40%.


So are we looking at disaster or not?

After EBA published its ranking of asset classes that put covered bonds at the same level as sovereign debt, it is a bit of a surprise to see EBA go against its own empirical results and recommend that covered bonds be only Level 2 assets.

The final decision lies, however, with the EC and not EBA. The way we look at it, the qualitative or expert judgement on global harmonisation is very much a political decision and the EC could in theory rethink this if it wanted to. EBA stating that statistics speak in favour of covered bonds at least leaves all options on the table for the Commission, in any case. Not having been considered worthy of Level 1 based on empirical evidence by EBA would have been the end of the Level 1 discussion even had the EC wanted to change EBA’s proposals.

Anyway, whether we end up in Level 1 or 2 isn’t going to trigger any major changes in investor behaviour in our view:

  •  In both situations bank treasuries will ignore the periphery and concentrate on highly rated core sectors as they have in the past.
  • Even if covered bonds remain in Level 2, there will be demand and treasuries will struggle to find sufficient volumes, keeping core sector squeezed.
  • Making it to Level 1 wouldn’t add much demand for euro covered bonds for quite some time as many bank treasuries are already struggling to get close to 40%. In addition to this, even if they had the choice we don’t think many would go well above 40%.
  • Spreads in many core markets are already squeezed. Getting to Level 1 would in our view not be a spread driver for further performance. LCR compliance is a strong motivation, but at the same time banks have to run a profitable business and investing in Pfandbriefe at ASW levels of -20bp is not exactly profitable.

Euro mart stats                                                                                                                                                        Source: Bloomberg, The CBR, The Cover, CA CIB

The only thing that could trigger behaviour changes would be a lower minimum rating. This would solidify the domestic demand and slowly add some international bank treasury interest to the mix.

In this context it is important to picture what two conflicting goals we are looking at here:

  •  Europe has a vital interest in protecting its covered bond market, which calls for lower minimum ratings.
  • At the same time, global harmonisation is important too, calling for AA-.

Ultimately the question could be at what rating step the biggest additional benefit from deviating from global rules can be generated for Europe.

In our view, the biggest political weight would sit behind lowering it from AA- to A-. This would enable Italy and Spain to have at least its biggest issuers in the scope of the LCR and based on Moody’s ratings (Moody’s is by far the most active agency in the periphery) add around 20% more benchmark bonds to the LCR-eligible universe. Moving further down to BBB- would merely add Portugal and Ireland to the picture, two countries with fairly low volumes of outstanding covered bonds and a combined share in the iBoxx EUR Covered of a mere 2.5%. It would also add some of the weaker names from Italy and Spain, but altogether we would be talking about not even 10% of the covered bond market.


Florian Eichert

Senior Covered Bond Analyst

Crédit Agricole CIB

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