ECBC in covered Level 1 call else ‘simply impossible’ for Danes

Covered bonds should count as Level 1 assets under CRD IV, the ECBC argued in a position paper released on Monday, with this treatment particularly important for domestic covered bonds in Denmark as it would otherwise be “simply impossible” for the country’s financial institutions to fulfil LCR requirements.

As opposed to Level 2 assets, Level 1 assets would not be subject to haircuts or a cap on their total contribution to liquidity buffers. Under Basel III proposals, only public sector debt would count as a Level 1 asset, with covered bonds allocated a Level 2 slot.

Florian Eichert, senior covered bond analyst at Crédit Agricole CIB and a contributor to the position paper, said that regulators are still working on the technical standards for CRD IV, and that it is not yet clear whether the European Banking Authority (EBA) will accept all covered bond sectors as eligible investments or whether it will differentiate across sectors.

In Denmark, the eligibility of domestic covered bonds for Level 1 is crucial to allow the country’s financial institutions to fulfil liquidity buffer requirements, according to the ECBC position paper, given the country’s small economy and a shortage of public debt (Level 1 assets).

“Denmark presents a combination of a below average public debt to GDP ratio and an above average size of financial sector to GDP ratio,” it said.

“This combination implies that for Danish financial institutions to comply with the Basel III liquidity framework the institutions would need to import foreign currency assets to an extent more than likely to be a source of financial instability — or not within the objectives of the framework.”

The ECBC said that based on information from the Danish central bank and financial supervisory authority the shortage of Level 1 assets for the whole Danish financial industry can be estimated at Eu48bn equivalent, which rises to Eu60bn if a 110% LCR compliance is assumed.

This compares with a gross volume of Eu47.7bn of Danish krone denominated public debt accessible to Danish financial institutions, with debt held by life and pension funds only likely to be accessible at high costs as this investor group faces implementation of the Solvency II framework.

Compliance with the LCR based on Danish krone-denominated public debt is therefore “simply impossible”, said the ECBC case study.

The best solution therefore, it argued, would be for Danish covered bonds to be eligible as Level 1 liquidity buffer instruments. Danish covered bonds are in large supply and highly liquid, it said, and have proven resilient to past crises.

“The inclusion of these assets into the liquidity buffer at no constraints would not run counter to the overall objectives of the Basel III liquidity framework and financial stability would be maintained,” said the industry body.

Crédit Agricole CIB’s Eichert said that the EBA has already hinted at finding a solution for countries such as Denmark, but that it is not yet clear whether this means that Danish covered bonds will be allocated to the rank of Level 1 assets or some other solution is found.