ECBC pitches Label, A- covered LCR plan to EC

CRR-compliant covered bonds rated at least A- should count toward liquidity buffers with the Covered Bond Label playing a role as a quality criterion under a new approach the European Covered Bond Council (ECBC) has suggested to the EC ahead of its final decision on LCRs.

The European Commission (EC) is due by the end of June to decide which assets qualify as Level 1 or Level 2A assets for banks’ Liquidity Coverage Ratio (LCR) requirements under the EU’s capital requirements framework (CRD IV/CRR). The covered bond industry as a whole, and jurisdictions such as Denmark in particular, are eager for the Commission to deviate from a December recommendation of the European Banking Authority (EBA) and designate covered bonds as Level 1 liquid assets, without any limit or haircuts.

Carsten Tirsbæk Madsen, BRFkredit executive vice president and ECBC chairman, reiterated the argument at a plenary meeting of the industry body in Paris yesterday (Thursday).

“The ECBC stands ready to assist in its role of market catalyst and think-tank with regards to the identification of appropriate criteria for defining Level 1 assets under the LCR, and hopes that the European Institutions will take into consideration the unprecedented effort made by the covered bond industry to continuously improve market best practice and transparency through its establishment of a quality label,” he said. “The ECBC strongly believes that a European solution is the only way to ensure growth and financial stability in Europe.”

The Commission held a public hearing on the LCR requirement and leverage ratio on 10 March, and accepted submissions in writing as a follow-up to the hearing until Monday. It said that it will consider organising a further hearing “to revisit some of the more complex issues” but a covered bond market participant said this was the latest round of consultation and that a “decision period” is being entered.

In a response to an EC question on whether covered bonds should be included as Level 1 assets in the LCR or on an “enhanced Level 2 basis”, the ECBC on Friday argued for covered bonds to count as Level 1 assets, noting that this would be in line with eligibility criteria suggested in Recital 100 of the Capital Requirements Regulation (CRR) and the results of an empirical study carried out by the EBA.

The industry body has previously expressed concerns about a touted AA- cut-off point for covered bonds to be included as liquid assets, and in Friday’s submission to the Commission reiterated its critical stance on the inclusion of rating triggers in European legislation.

To avoid pro-cyclicality associated with what has been referred to as a “rating cliff” and address other problems linked to the EBA’s recommendation for the composition of LCRs, the ECBC has come up with “a two-pronged approach” for the Commission to take into consideration as part of its decision-making.

This is based on extending the LCR eligibility of covered bonds rated AA- (credit quality step 1) to those rated at least A- (credit quality step 2), using the covered bond industry Label as an another quality criterion in the context of Level 1 assets, and, for Level 2A covered bonds, to replace a blanket 15% haircut with haircuts informed by the approach used by the European Central Bank (ECB) under its repo collateral framework.

“A step 1 rating trigger, as proposed by the Basel framework, introduces pro-cyclicality, which would amplify the effect of a potential crisis scenario,” said the ECBC. “In our view, not including step 2 covered bonds in the LCR eligible assets would jeopardise the financial stability of the LCR structure and fail to prevent the risk which could arise from a systemic crisis.”

The two-pronged approach it has suggested involves designating CRR-compliant credit quality step 1 covered bonds as Level 1 assets, “using as a reference, for example, the Covered Bond Label — aligned to Article 129 of the CRR as of 1 January 2014 — as an alternative means for identifying a qualitative segment of the covered bond market, an alternative which is based on objective criteria in terms of transparency, credit quality and liquidity”.

These are the criteria mentioned in Recital 100 of the CRR in relation to the type of covered bonds that, alongside government bonds, “would be expected” to be considered top level liquid assets.

CRR-compliant credit quality step 2 covered bonds should, under the ECBC’s suggested approach, be included as Level 2A assets, “using as reference for the haircut the ECB repo haircut policy”.

The ECB’s haircut schedule differentiates haircuts according to the credit quality step as well as residual maturity, coupon type and asset class category.