Swedish authorities in encumbrance transparency call

A joint council of Sweden’s Riksbank and Finansinspektionen has called for issuers to take the lead in releasing information relating to asset encumbrance after noting the potential risks of high levels of encumbrance, although they also highlighted the relative stability of covered bond funding.

The comments were included in minutes, published on Tuesday, of a meeting of the Council for Co-operation on Macroprudential Supervision, a joint body featuring senior central bank and financial supervisory authority officials that was set up in January and meets twice yearly to discuss issues of financial stability.

According to the minutes, the participants noted that Swedish banks have a relatively high degree of encumbered assets.

“This is a natural consequence of the fact that the banks fund a large part of their mortgage lending using covered bonds, which grant the bondholder a pledge in a specific pool of mortgages, as well as of their business model, under which encumbered mortgages remain on their balance sheets,” it said. “This model has advantages from a stability viewpoint.

“When banks retain mortgages on their balance sheets, incentives for sound lending practices are created. The market for covered bonds has also proven relatively robust even when the financial system is highly disrupted.”

However, the minutes cited the possibility of extensive asset encumbrance giving rise to liquidity risks in the financial system, with banks having fewer free assets to pledge as collateral in a stressed situation when the demand for collateral for existing debt rises.

“Moreover, a high degree of encumbrance may transfer risk to the taxpayers, because the deposit guarantee system cannot recover as much from a bankruptcy estate, something which is not currently taken into account in the fee which the banks pay into the system,” it said. “Due to the government safety net, both the banks themselves and the investors have weak incentives to take into account how the encumbrance of assets affects liquidity risks and credit risks, respectively.

“This creates a possible breeding ground for an exaggeratedly high level of encumbrance.”

The Council participants said that greater transparency regarding which and how much of banks’ assets are encumbered could reduce negative effects.

“The participants also found it desirable that the banks themselves should take the initiative of beginning to publish information that makes it possible for external parties to assess their level of encumbrance,” it said.