An article in Risk by Lukas Becker, dated Oct. 1st “Banks avoiding covered bonds for LCR buffer over liquidity fears” caught our attention. For those not familiar with covered bonds – they are more typical in Europe than elsewhere and resemble a securitization.
The author reported on the comments made by speakers at Risk’s Liquidity & Finding Conference taking place in London Oct. 1st and 2nd. The focus was on covered bonds, which use mortgages or public sector loans for collateral. Unlike securitizations, covered bonds remain on the borrower’s balance sheet. Buyers have recourse to both the borrower and (if the borrower goes bust) the underlying collateral. In that way they resemble long dated repos, where cash lenders have the credit risk of the cash borrower and, should the obligor default, the underlying collateral. The difference is that in a repo the collateral actually moves to the cash lender (and can be hypothecated under most circumstances) or ends up segregated in tri-party with a lien on it.
Covered bonds qualify as a Level 2A asset under LCR. They are subject to a 15% haircut. Other 2A assets include securities guaranteed by the GSEs or sovereigns with a risk weighting under Basel III of no more than 20% (0% risk weighted assets are part of Level 1). There is a 40% cap on Level 2 assets as part of the overall pool of HQLA.
The author quoted Christopher Blake, senior manager of liquidity and risk at HSBC:
“…Somehow covered bonds have gotten classed as a liquid asset, but we don’t think they’re particularly liquid under stress…”
Jamie West, head of liquidity management (West) at Standard Chartered was quoted as saying:
“Just because covered bonds are a high-quality liquid asset (HQLA), [are they] in our appetite for what an HQLA should be?”
From the article:
“…John Matthews, senior manager of liquidity at Santander agreed, saying that just because an instrument is included in the liquid asset buffer (Lab) it doesn’t automatically become liquid…”
The banks have an incentive to broaden out what is included in the liquidity buffer. Yet these risk managers are questioning the wisdom of including covered bonds. It should not be a surprise that in an insolvency situation, the complexity of using the underlying collateral to pay off lenders is going to result in the paper becoming highly illiquid. What is surprising is that there is pushback on the LCR rules. We applaud these risk managers for not toeing the company line, calling it as they see it.
The article is behind the Risk pay wall, so we apologize if you can’t access it.