Politicians and regulators would like to see Swedish banks’ dependency on wholesale funding reduced. Some, such as Swedish finance minister, Anders Borg, believe the best way to do this is to grow deposits and cut covered bond issuance. But deposits are not a panacea. They can quickly be withdrawn, which is in stark contrast to the cheap, long term funding covered bonds provide.
Deposits may come with guarantees, and depositors may well have no reason to fear they will lose money if the institution they bank with happens to be failing, but humans are a fickle lot and generally distrust one another — especially politicians and bankers. Anybody who remembers the lines that formed outside UK lender, Northern Rock during the financial crisis will recall just how readily they will withdraw their money at the first sign of trouble.
Deposit guarantee schemes may have received much attention since, but nobody knows if they will work in practice. The risk is that deposits held in a bank may in fact become depleted just at point they’re most needed.
And if banks are continually competing for deposits, as they have been in many regions for the last few years, depositors will surely become less loyal and more inclined to shift their money around to get the best deal.
In contrast, covered bonds provide guaranteed funding for up to 10 years without too much difficulty. This term funding is also particularly useful for institutions striving to meet Basel III’s net stable funding ratio and its liquidity coverage ratio.
Meeting the LCR requirement is particularly tricky in places like Sweden because there are few alternatives on offer. Local banks would normally buy their government's bonds for liquidity purposes but since Sweden doesn’t issue much debt liquidity portfolio managers must buy covered bonds instead.
If local covered bond issuance becomes as scarce as Swedish govvies, investors will herd into buying foreign bonds, which may then introduce an extra degree of currency risk to the Swedish system. And, with no capital charge on foreign sovereign bonds there are further incentives to buy these supposedly risk-free instruments which are in fact, anything but.
Covered bonds provide the cheapest form of bank funding. That means they can help to improve a bank's profitability which, in contrast to core tier one capital, is the first buffer against losses.
While it is clearly helpful to have a solid deposit base, regulators and politicians should be mindful that a balanced approach to funding will include a broad mix of instruments. that mix must embrace covered bonds.