Level 1 exclusion feared but ECBC says it’s not game over

Fears are mounting that covered bonds could fail to secure a position as Level 1 LCR assets after it emerged that the EBA’s Board of Supervisors is against such a recommendation. However, the ECBC and others have said that Level 1 inclusion remains a real possibility.

The Danish parliament last Thursday (28 November) released a Ministry of Economic & Business Affairs document saying that the European Banking Authority (EBA) Board of Supervisors has indicated it will not recommend that covered bonds are considered Level 1 LCR assets when, after a meeting on 11 December, it makes its report to the European Commission — which will take the ultimate decision on which assets are eligible as Level 1 assets (or extremely high quality liquid assets) under CRD IV.

According to industry sources, at a recent EBA meeting countries including Denmark, Finland, Germany and Luxembourg are said to have supported the case for covered bonds being recommended as Level 1 assets, with others — i.e. a majority — supporting alignment with Basel III, which would leave covered bonds as Level 2 assets (or high quality liquid assets). At the same time, the majority could back a position whereby eligibility criteria for sovereign bonds as Level 1 assets are softened relative to Basel proposals.

While some central and eastern European countries who were in favour of Basel III alignment are understood to have been less concerned about the covered bond issue and more focussed on government bond eligibility, representatives of France, Italy and Spain are said to have actively opposed covered bonds’ Level 1 claim. While the UK is understood to have suggested a compromise where both cases are presented to the Commission in the EBA report, the country has previously been against covered bonds being considered as Level 1 assets.

Florian Eichert, senior covered bond analyst at Crédit Agricole CIB and chairman of the ECBC statistical working group, noted that harmonisation between Basel III and CRD IV is the biggest problem.

“Historically covered bonds have been a European product and consequently Europe is the region with the biggest willingness to support the product,” he said. “Basel III rules, for example, still allocate covered bonds at best into category 2A and disregard those below AA- completely.

“This approach would eliminate all the Irish, Italian, Portuguese and Spanish markets from the list of eligible assets. It would also kind of create a big problem for countries like Denmark where sovereign debt isn’t sufficient to cover LCR asset needs.”

The Danish authorities have since last week come out strongly in defence of covered bonds’ claim to Level 1 status. Bloomberg reported Danish prime minister Helle Thorning-Schmidt (pictured) as having told a press conference that the government would stand by the Danish mortgage system.

“We perceive these bonds as first class and that’s the view we’re trying to purvey to the Commission,” she said.

Many industry officials who have been lobbying for covered bonds since the initial Basel III proposals came out and who believed that they were winning the argument have been taken aback by the EBA Board of Supervisors’ position.

An official from one of the supportive countries said that he is “extremely disappointed”, while another said that the EBA’s position was unexpected.

“That the board did not really follow the technical conclusions is a surprise,” he added.

He was referring to a presentation at an EBA public hearing on 30 October where an analysis of various asset classes’ liquidity carried a “very preliminary” draft ranking that put covered bonds alongside government bonds. The release of this analysis had been taken as a strong argument in favour of covered bonds’ case.

Industry representatives were critical of the regulator’s stance.

“The EBA is supposed to be a technical arbiter, but here they have based their decision on political judgements,” said one.

He noted that the EU authorities have not previously committed themselves to full Basel alignment.

“Parliament had fairly strong views on that,” he added.

Jesper Berg, head of regulatory affairs and senior vice president at Nykredit Realkredit, said that it is hard to foresee the outcome of the European Commission’s deliberations, but he fears that, if the rumours are true, an apparent compromise between strict Basel compliance and an “escape clause” for European government debt could create difficulties both for Denmark and the Commission.

“It would be as if we haven’t learned anything from history if it’s alright for Danish banks to hold Greek government bonds as liquidity reserves and not hold Danish covered bonds, which are by now trading at interest rates well below most European countries,” he told Nordic FIs & Covered. “That would be pretty silly and I think most people would be capable of seeing that that would not enhance financial stability.”

Luca Bertalot, head of the European Covered Bond Council (ECBC), said that even if the EBA board of supervisors is not behind recommending covered bonds’ inclusion as Level 1 assets, the situation could change before the final decision on LCRs is taken in June 2014.

He said that there is general sympathy for covered bonds’ case but that an important stumbling block may have been theAA- threshold for covered bond eligibility that has been proposed and its exclusion of the covered bonds of several countries.

“We have been delighted to see that the EBA technical analysis supports the inclusion of covered bonds in Level 1, confirming the indication made in the CRR text,” he told The Covered Bond Report. “We think that the current political debate at the EBA Board of Supervisors level highlights the need of a further reflection on the appropriateness of a rating trigger that can create serious competition issues, jeopardising the general support for covered bonds’ case.

“We are fully in line with the G20 recommendation of removing rating triggers from legislation and it is important to identify alternative solutions to allow a smooth political support to the inclusion of covered bonds in Level 1. The European Commission will consider all these points before June 2014.”

An industry representative from one of the pro-Level 1 countries said that the Commission will be “fully free” to assess the results of the EBA’s analysis and to make its own decision, even if the likely EBA position was unwelcome.

“There’s a good opportunity to convince the Commission that covered bonds as Level 1 liquid assets would be appropriate,” he said.