Favourable covered treatment confirmed in EC LCR rules

Covered bonds’ anticipated favourable treatment in the Liquidity Coverage Requirement was confirmed by the European Commission on Friday, with the highest rated covered bonds eligible for up to 70% of liquidity buffers as Level 1 assets and others in Level 2A or 2B.

The Commission published its Delegated Act after years of discussion and negotiation during which the role of covered bonds in LCRs has been debated. Under the original Basel Committee on Banking Supervision proposals, covered bonds’ inclusion was restricted to 40% with a 15% haircut, with strict rating requirements, which covered bond proponents argued did not recognise their high quality and would harm some countries’ interests.

However, after an extensive lobbying effort by the industry as a whole and individual countries, covered bonds have won significant concessions and ultimately favourable treatment — in line with what was expected after the leak of various Commission drafts over the course of this year.

EU covered bonds rated AA- or higher and subject to other criteria can constitute up to 70% of liquidity buffers as restricted Level 1 assets with 7% haircuts, and those rated AA- or higher — as well as certain non-EEA covered bonds — and subject to other criteria qualify as Level 2A (up to 40% with 15% haircuts).

And in a surprise move, the Commission further included as eligible for Level 2B a category of “unrated high quality covered bonds”. These face a haircut of 30% and, like securitisations eligible for Level 2B, can constitute up to 15% of LCRs.

See Crédit Agricole CIB analysis on page 3 for further details.

Ane Arnth Jensen, managing director of the Association of Danish Mortgage Banks (Realkreditrådet), said that the outcome was as had been expected recently and was satisfactory.

“There has been a lot of struggle to get this result,” she said. “There was the report from the European Banking Authority in October that stated on an evidence-based analysis that covered bonds were actually under certain circumstances fully liquid, but after this the board of supervisors took the opposite decision in December. So it has been a hard job and many people have been involved in fighting to get this result.

“You have always to judge the result in light of what was at risk,” she added, “and any other result would have been a huge challenge for the Danish financial sector and would have cost a lot in terms of expenses and higher interest rates.”

The European Covered Bond Council (ECBC) welcomed how the Commission had recognised covered bonds’ qualities in the terms of the Delegated Act.

“The ECBC welcomes and supports the clear acknowledgement of the strategic importance of the covered bond asset class in the European long-term financing toolkit,” it said. “The ECBC strongly believes that enabling covered bonds to be eligible for Levels 1 and 2A of the LCR will empower banks to diversify their investments away from purely sovereign exposure and, therefore, help to remove systemic risks from the banking system.”

Explaining the Commission’s thinking on Friday, Mario Nava, director of the financial institutions directorate, DG Internal Market and Services, said that the Delegated Act “takes fully the spirit of Basel”, but is adapted to reflect European specificities.

“Covered bonds is a particular European specificity,” he said. “This is something of which the Europeans should be proud. They have an excellent track record. They are in several cases of very comparable quality to the top quality liquid assets (sovereigns), and therefore we have included them in the Level 1.”

He noted that they are nevertheless subject to both a cap and a haircut, “so we have taken everything in consideration, and it is truly ceinture et bretelles (belt and braces)”.

However, Moody’s today (Thursday) said that the divergence from Basel III standards are a credit negative and that failure to achieve comparability of liquidity ratios globally is detrimental to EU banks.

“The Delegated Act not only waters down the Basel Committee’s international standard,” it said, “but also deviates from some of the recommendations of the EBA, which was keen to minimise the differences between the EU framework and the international standard.”

Moody’s acknowledged that transposition of Basel III was very challenging in the EU given national differences, noting, for example, the harm that could have been done to Danish banks if Basel III limitations on their eligibility had been imposed. However, it highlighted the softening of the treatment of covered bonds in the Commission’s Delegated Act even beyond the lesser relaxation of standards versus Basel III that had been recommended by the EBA, as well as the broadening of eligibility for securitisation assets, loose criteria for government bonds, and other measures.

Following the publication of the Delegated Act, the European Parliament can reject but not amend it in the coming six months, although this is understood to be very unlikely, with part of the delay in its release said to have been the result of efforts to ensure that none of the EU bodies had objections to its contents. Implementation is due from 1 October 2015.