A single resolution regime, a single supervisory regime and a single fund, should, in theory, mean that southern Europe’s banks become delinked from their sovereigns.
While it may be difficult to achieve this aim completely, the covered bond market is generally in favour of the move.
Covered bond encumbrance and over-collateralisation remain key concerns for the market. Given the variety of bank business models, there is strong opposition to the idea of setting a hard issuance limit. The focus on encumbrance is at odds with the preferential treatment of covered bonds and sends out a mixed message for the asset class.
Meanwhile, the European Union’s Bank Recovery and Resolution Directive will affect covered bond spreads versus senior unsecured, given the extraordinary central bank liquidity support.
With statutory and contractual bail-in both designed to save taxpayers from bailing out banks, both may have the same objective but one may be preferable to the other.
These and other topics were part of a panel discussion that took place at DZ Bank’s Covered Bond Day in Frankfurt in mid-November, in front of an audience of around 100 issuers and investors from across Europe.
Below is an edited version of the discussion.
Participating in the roundtable were:
Luca Bertalot, head of the European Covered Bond Council
Ralf Burmeister, portfolio manager, Deutsche Asset & Wealth Management
Petya Koeva Brooks, chief in the advanced economies unit, IMF
Andrea Larruccia, head of term funding, UniCredit
Martin Rydin, head of treasury, LF Hypotek
Bill Thornhill, moderator, EuroWeek
EUROWEEK: Petya, what are your thoughts about contractual mechanisms for bail-ins, such as Cocos, versus statutory mechanisms?
Petya Koeva Brooks, IMF: I see them more as complementary, rather than substitutes. As you know, Cocos are relatively new instruments and they’re quite untested. Based on the experience with other hybrid instruments during the crisis, they didn’t do what was expected of them, so there are good reasons for being sceptical. However, they have a lot of appealing features, including the way they work cross-border, which is a very good thing, relative to the statutory bail-ins, where regional differences make the assessment more complicated.
That said, it’s hard to imagine, given the capital structure of the banks, that if we were faced with a large shock and tail risks, they would be sufficient to address and to fulfil this role of saving money for the taxpayers. So yes, they have a role to play, but together with the statutory bail-ins.
It’s important to keep in mind that for some banks, the structure of their liabilities is such that deposits play a very important role. So in this context, it is an interesting question to consider what mechanisms could be put in place to avoid contagion across countries.
EUROWEEK: As an issuer, do contractual bail-in bonds have a role to play in your funding?
Andrea Larruccia, UniCredit: I agree with Petya, the two approaches are complementary. As an issuer, we try to make sure that we have enough bail-inable instruments to protect the senior bondholders, as this will allow us to make our cost of funding more efficient. But we have to resolve a trade-off because the funding from instruments that can be bailed in is more expensive. But not to have them would make our senior funding more expensive, so it is a question of getting the right balance between the two approaches.
EUROWEEK: Do you have any visibility on where the debt to equity trigger might be set?
Martin Rydin, LF Hypotek: Hybrid debt such as Cocos can definitely play a role and help top up the capital structure. But from a Swedish perspective, we have tougher capital requirements than in many other parts of Europe, which makes it difficult to see at which level the debt to equity trigger will have to be set.
None of the Swedish banks have issued this kind of instrument yet. Added to which, LF Bank is ultimately owned by an alliance of mutual insurance companies, which makes it more complicated to issue an instrument embedded with an equity conversion.
EUROWEEK: What’s your view on the point of non-viability, Petya?
Brooks, IMF: It’s clearly important where the trigger is set but it is a hard question and would be difficult to tell without knowing the specifics of the bank and the particular situation.
EUROWEEK: It is true we’ve seen very few examples, only relating to small banks in Denmark. But we’ve got the asset quality review coming up, and the ECB is saying that for it to be relevant some banks must fail. In any case, the final decision may be down to the discretionary powers of national regulators, which may lead one to question at what point does a national regulator cede control to the single supervisor?
Brooks, IMF: Once the single supervisory mechanism is in place, the ECB is going be in charge of supervising the 130 systemic big banks in Europe, and of course national supervisors will also be very much involved for the rest.
In the context of the upcoming comprehensive balance sheet review, the stress tests will be important. This is where there are still a number of unknowns. We don’t know yet what the stress test parameters will be.
EUROWEEK: As an investor, Ralf what’s your view on setting the right ratio of loss absorbing capital and hybrid debt? Presumably there must be some confidence in the faith of the bank?
Ralf Burmeister, Deutsche Asset & Wealth Management: That’s easy, the more debt subordination underneath me the better my position is, because it is implicit over-collateralisation. Subordination doesn’t necessarily have to be in the cover pool but the more there is, the stronger my position. Much will depend on the business model of the bank.
I’m happy to see more issuance of senior and capital and less of covered bonds if that means I’m investing in a stronger bank as prices will be stable. I would prefer to see rare, high quality bonds where prices are stable than an overdose of lousy quality covered bonds. So from that perspective I’m totally relaxed.
The interesting thing with banking union is the side effect, namely how retail deposits will be treated. If a bank just has deposits and covered bonds, how will they be split up in the event of a bank’s resolution?
Brooks, IMF: What you want to avoid is having a deposit flight just because there is a lack of confidence that the sovereign does not have the resources to protect depositors. This could be the case where the banking system is very large, relative to the size of the economy. In that context having the common deposit insurance should help to reduce the probability of a deposit flight. But you’re right, having a harmonised deposit insurance scheme would be a step in the right direction.
Burmeister, DeAWM: From the perspective of the depositor, nothing changes, as up to €100,000 is insured by the state. Now there is a proposal for some kind of harmonised cross-guaranteed European mechanism.
But the main achievement of banking union is the harmonisation of definitions such as the non-performing loan ratio and of capital ratios.
We’ve had the special inspection where the banks were brought up to one standard ahead of the asset quality review — that is an achievement in itself. So it is the way towards this exercise that is important, not the exercise itself.
EUROWEEK: On the subject of harmonisation we’ve recently seen the European Banking Authority (EBA) publish transparency templates for encumbrance reporting. But as a covered bond investor, do you worry about encumbrance? Surely you should only be worried about encumbrance if you were a senior investor?
Burmeister, DeAWM: You can’t talk about asset encumbrance without defining what you are talking about. Encumbrance is essentially a function of the business model pursued by the bank. For example, Norwegian issuers are specialised lenders and have little else on their balance sheets other than covered bonds and equity. So in their case asset encumbrance should be around 80%-90%, which is fine. But I would be very concerned if a universal bank had 80% asset encumbrance. You cannot discuss the topic, or the ratio of asset encumbrance, without first considering the bank’s business model.
The other important thing is that asset encumbrance is so volatile. By doing bilateral repos you can change the ratio to a massive extent overnight. The more assets that are pledged, the lower your potential senior unsecured recovery. Even then you have to take into consideration the fact that the bank gets more availability of funding at cheaper spreads, which may help to stabilise it. Higher asset encumbrance may be correlated to a lower probability of default for different debtors across the entire capital structure of a bank. The situation is not black and white.
EUROWEEK: Martin, the Swedish regulator is getting tetchy about reliance on term covered bond funding and would rather see issuers build deposits, which from the UK experience, can quickly be withdrawn. What’s your bank’s approach?
Rydin, LF Hypotek: Swedish banks in general have more asset encumbrance from covered bond funding than banks in many other countries. But it is important to bear in mind that asset encumbrance from other sources is very limited for Swedish banks.
Should investors be worried by the relatively high reliance on covered bond funding? I don’t think so. It is big strength of Swedish banks to have access to the stable and well-functioning domestic covered bond market.
Covered bond funding is the cheapest and most reliable funding source and it leads to low probability of default and has a positive impact on earnings capacity. For our institution, a retail bank with a large share of mortgage lending on the balance sheet, a relatively high level of covered bond funding is a natural effect of the business profile.
EUROWEEK: What is the Bank of Italy’s approach to encumbrance?
Larruccia, UniCredit: The Italian covered bond legislative framework is relatively recent, so the banking system has not relied on covered bonds as much. This means that the percentage of encumbered assets is probably going to be lower than the average in Europe. Italian banks are less active in derivatives, which also contributes to lower encumbrance. On the other hand they have accessed the ECB, but they are actively managing that repo liquidity. The important point is that the Bank of Italy is a very strict as a regulator and is closely monitoring our banks to ensure they are well capitalised.
EUROWEEK: And presumably higher encumbrance can be tolerated by unsecured investors, provided there is sufficient capital below them?
Larrucia, UniCredit: Yes, the legislative framework is specific on the amount of mortgage collateral issuers can use in their cover pools and this is closely linked to the bank’s capital ratio.
EUROWEEK: A general question for the audience: does encumbrance matter for covered bond investors? Can I have a show of hands? [Show of hands from the audience.] Well, that’s two out of around 100 people, so it clearly isn’t a big worry.
Burmeister, DeAWM: There was a study from Fitch showing that for the top 60 banks asset encumbrance was stable at around 30% on average and didn’t change much over the crisis. Encumbrance is one part of the regulation that is trying to fix a perceived problem.
In Sweden the regulators have imposed additional capital for bank mortgage portfolios and set loan to value caps, which was supposed to reduce loan demand and lower lending volumes. But in fact it has driven down the funding costs of Swedish banks, making it cheaper for them to lend and this has led to greater loan origination. This is the opposite of what the regulator wanted.
EUROWEEK: Talking of unintended consequences, we have preferential treatment of covered bonds for risk weightings, ECB repo purposes and bank liquidity buffers. But on the other hand there is this asset encumbrance bogeyman. What is the ECBC’s view on this apparent dichotomy?
Luca Bertalot, ECBC: We should not confuse the cause of covered bond issuance with the consequence. Asset encumbrance is a consequence. The cause is that covered bonds trigger a virtuous cycle ensuring access to capital markets even in periods of crisis, which is the reason why this asset class benefits from favourable regulation. In the context of the asset encumbrance debate, we should bear in mind that there is an implicit limitation in the use of covered bonds, that risk mitigants are already contained in the legal covered bond frameworks and that covered bonds remain a very transparent asset class.
Over the last two years we have seen an impressive improvement in the level of transparency of covered bonds. In this regard, I would like to thank the Covered Bond Investor Council (CBIC), for its clear indication of what the investor community needed. This was central for the Covered Bond Label, allowing all the European issuers to align their disclosure to a level, agreed at national level, set between the minimum standards required to have the Label and those suggested by the CBIC.
We should ask what the strategic role of covered bonds is in the funding mix of banks. In Norway, Spain, France or Italy the models are completely different, so a one-size-fits-all approach does not work.
And when we speak about transparency we must consider standardising definitions which will provide investors with the key to undertake their due diligence across different markets. Issuers have accepted the challenge to improve transparency by first harmonising definitions. Harmonisation of definitions will also be the solution for dealing with asset encumbrance and the industry is moving in the right direction.
EUROWEEK: Once the bank recovery and resolution regime comes into effect, unsecured investors may sit up and take more notice of encumbrance. But for now we have a lot of money sloshing around and investors are happy to take unsecured, even if they’re not pricing for this risk. Do you expect covered bond to senior unsecured spreads will remain tight?
Larruccia, UniCredit: I expect senior unsecured spreads will continue to trade tight to covered bonds throughout next year. Supply of covered bonds will remain limited, not just due to concerns about encumbrance, but also because banks are lending less and don’t need the funding. Demand is likely to remain strong, thanks to favourable treatment such as Liquidity Coverage Ratio (LCR) eligibility. However, given that investors have plenty of liquidity, senior spreads will hold.
EUROWEEK: What’s the investor view on spreads?
Burmeister, DeAWM: We see this tremendous demand, which is a regulatory influence and this is not going away. The results of the European Banking Authority’s study into liquidity suggests well rated covered bonds could be eligible for inclusion into level one of the LCR, which means the strong demand for bonds will become structural and will not go away. The really interesting thing is that all these regulations refer to ratings. Everything will therefore ultimately depend on how the agencies behave, which leads to the question of how they revise rating methodologies in light of incoming bank resolution rules.
The implication is that bail-in and all other pillars of the banking union might spoil senior unsecured bank ratings. Covered bonds are very much a regulatory driven market, as the regulators almost exclusively always refer to ratings as being the only providers of an “independent opinion” about the credit quality. In any case, I do not foresee that this regulatory interest and the regulatory demand for covered bonds will dry up.
As far as the spread to senior is concerned it’s a question of how much is issued, how fast the deleveraging process is and how fast banks can grow their deposits. But then you have conflicting signals from various regulatory institutions, which on the one hand say banks must grow deposits, and on the other say banks must issue more term funding in the capital markets. Everything is in a state of flux.
EUROWEEK: Martin, do you think senior unsecured will trade tight to covered bonds, are there other factors we should consider?
Rydin, LF Hypotek: Yes, and it’s also a question of each individual bank and how large their capital buffer is, along with other available loss-absorbing debt that sits lower down in the capital structure. Covered bonds will benefit from demand, but bail-in will affect senior unsecured more.
EUROWEEK: Is it merely a question of time?
Rydin, LF Hypotek: Yes, and it’s also a question of each individual bank and how large their capital buffer is, along with other available loss-absorbing debt that sits lower down in the capital structure. Covered bonds will benefit from demand, but bail-in will affect senior unsecured a lot more.
EUROWEEK: How about your bank’s funding strategy and the mix of deposits, relative to capital, senior and so on. How will that change, from your perspective?
Rydin, LF Hypotek: We have, during the course of the last 18 months, increased our senior unsecured issuance and we are trying to continue to grow our deposit base, as Swedish banks in general have a weakness in loan to deposit ratios. This is due to the nature of the Swedish market for household savings where people tend to save by investing in mutual funds and pensions, rather than in bank deposits.
But also there is a risk when regulators set too big incentives for banks to try to build their deposit base, as you then might face the risk of a price war on deposits. This means depositors become less loyal as they will increasingly shop around for the best rates. Then the question is, is it better to lock in long-term capital market funding where we know the maturity and can plan for it?
EUROWEEK: So would you say that deposit funding is not necessarily the panacea that regulators would have us all believe is worth chasing?
Rydin, LF Hypotek: Yes, I think so.
EUROWEEK: One key thing running through this whole debate, that goes back to the rating question, is the inextricable link between bank issuers’ debt ratings and their sovereign’s ratings. The sovereign rating is the largest driving force behind the senior unsecured rating and therefore to a large extent, the covered bond rating. Coming back to the presentation on the banking union, isn’t the whole point of it to enable banks to become more delinked from their respective sovereigns?
The three pillars are slowly coming into place, namely the single resolution framework, the single supervisor and the single fund. In theory it sounds like it might work, but in practice is it questionable whether banking union will work as it has been conceived?
Brooks, IMF: Let me start by saying that I think completely delinking banks from sovereigns...
EUROWEEK: ...is never going to happen?
Brooks, IMF: It’s an unrealistic goal to have. The question is, to what extent can we weaken the link? There is still some bias in terms of banks buying the bonds of their sovereigns, and that will never completely go away, so the question then is, to what extent we can reduce the link?
We are on the right road. We are making progress towards this goal. The important thing is not to stop with the single supervisory mechanism. What could really help to weaken the sovereign-bank link is completion of the banking union, including a single resolution mechanism, common backstops and safety nets.
Hypothetically, imagine the situation where you look at the capital needs across countries, and you do very rigorous stress testing. Then you uncover capital needs in countries that also have very encumbered balance sheets and high levels of debt.
If there’s not a clear idea of where the money is going to come from, or if the sovereign were to take this debt, as it may already have a very high level of debt, what is going to happen?
The bank-sovereign links could re-intensify and the situation goes back to where things were a year ago. We could see renewed market pressure on sovereign spreads, which will go back to the banks.
This is why it’s so important to have the common backstops, in addition to the national backstops. That’s not to say that the other elements are not also important. On the contrary, they are, but in this debate on delinking banks and sovereigns in the euro area, it’s important to keep the backstop in the forefront of people’s minds.
EUROWEEK: The number you mentioned in an earlier presentation was €60bn, but is that going to be a sufficient backstop?
Brooks, IMF: First of all, this refers to the possibility of the European Stability Mechanism (ESM) fund directly recapitalising banks. Right now, under the current situation, this option is not available. But there is the possibility of an indirect ESM recapitalisation. This is essentially what we saw in Spain with the government’s bank recapitalisation programme.
We need to think much more about the process. Markets would also feel much more assured if they knew that there was both a national backstop and then on top of that, to make it even stronger, a common backstop. If we could get this, it would be a huge positive, for restoring confidence in the euro area financial system, and for moving forward, and having a really strong recovery. So, achieving that would be a big thing.
EUROWEEK: Andrea, speaking for the Italian banks, rather than UniCredit, which is a leading light, as we know, not all banks are alike in Italy, and a few are looking to raise capital right now. How confident are you that they will be sufficiently capitalised and that these three pillars, and especially the backstops, will breed confidence in the European banking system?
Larruccia, UniCredit: I will try to give you both our perspective at UniCredit and that of banks in the south of Europe. Let us consider a multinational bank, such as ours. We have a presence and can raise liquidity in different European hubs. However, we face a problem in moving capital and liquidity efficiently from one hub to the other because of the national regulations. In any case, in the long run it’s got to be beneficial for a global institution such as ours to have a presence in the various countries.
From the point of view of an Italian issuer, the harmonisation process, in terms of the definition of the metrics, such as risk-weighed assets and non-performing loan definitions, is going to turn out a pleasant surprise. Italian banks will look stronger than some people may now probably perceive.
This is because the Bank of Italy has been closely monitoring the Italian banking sector. It’s been a very strict regulator, but it has also played an important role in defining important metrics of risk assessment. I believe we in Italy are not operating on a level playing field relative to other jurisdictions and we are still not where we would like to be. But in the medium term this process of having a single regulator and banking union will certainly help improve the situation.
EUROWEEK: Ralf, what bottlenecks and challenges do you foresee with the implementation of a banking union?
Burmeister, DeAWM: There is some question about the effectiveness of ratings, as well as the unintended consequences of regulation.
Let’s look at the bank’s rating link to its sovereign. On the one hand, policymakers are doing everything to build up firewalls and build backstops to protect and shield banks from the rating of their government. But on the other hand regulators are inadvertently forcing investors to closely consider ratings. In this context I’m speaking about pension funds and insurance companies that give us asset managers mandates. The problem is that regulators kindly ask these funds every quarter or every half year what their quota is on single-A, triple-B and worst rated bonds.
If the regulator is consistently asking, ‘what is your non-investment grade quota?’ it is implicitly saying ‘don’t buy non-investment grade’. That’s a problem if, on the other hand, there are other measures, such as the LCR and cheap central bank funding, that implicitly incentivise bank investors to buy this stuff.
Rating agencies are supposed to give an opinion. It’s their right to have an opinion that countries under some kind of aid programme do not deserve an investment grade rating. Fair enough.
So you have regulations where the judgement of credit quality is driven solely by external credit rating agencies. Then on the other hand we’re doing everything to build up the firewalls and ratings matter less. We are still very much restricted by the rating issue, and on top of that we now have this proposed change of methodology at Moody’s and a prospective change with the way S&P tackles the sovereign rating cap. So you have to question how good the credit rating of a bank can get.
The other thing is Europe has totally different housing markets and totally different systems for financing them, using totally different types of mortgage product.
Look at Spain, with the 20 year and even 50 year mortgages, and then we have the German habit of 10 year fixed loans. This translates into the mortgage system and to the mortgage loan production, and finally into covered bonds. Do regulators really want to harmonise all this?
EUROWEEK: Probably not.
Burmeister, DeAWM: Look at, for example, a system like Denmark, it’s getting a lot of pressure from abroad to change the system. But the system has worked well — even when Lehman Brothers collapsed, the system worked. The covered bonds didn’t fail, even following the senior bail-in of Denmark’s Amagerbanken. My Danish colleagues told me that the recovery for the senior holders was initially capped at 55% but it has grown closer to 90%.
EUROWEEK: So you’re saying ratings are so intrinsic to the genetic make-up of regulations that this will cause a potential bottleneck to the implementation of banking union?
Burmeister, DeAWM: You can’t escape it.
EUROWEEK: So what’s to be done?
Burmeister, DeAWM: I wouldn’t dare to say that the US is doing everything right, but from what I can understand people there are trying to extinguish all hint of ratings from regulations.
EUROWEEK: So if you get rid of rating agencies, which are completely endemic in the regulatory culture and the foundation of any investment, what do you replace them with?
Burmeister, DeAWM: The one thing you can do is take an average rating in the same way that the ECB does. That’s probably one of the reasons why DBRS has gained some market share recently. Institutions could be given space to make their own interpretations in terms of rating credit quality. We could explicitly allow average ratings or we could even go for the best ratings.
Because in the covered bond space we have the situation where one rating institution says the rating is at a higher level than another rating institution, so someone is horribly wrong. The problem is investors are being forced into investment grade and this is usually the worst of all an issuer’s covered ratings.
EUROWEEK: Notwithstanding that, it does seem we are making progress with banking union and we’re going in the right direction.
So, a question for the audience: would those people that think the European banking union is moving in the right direction, please put up their hands? [Show of hands.] So, a clear majority think we’re making progress.
Is there anyone here who could speak on behalf of the Spanish banking industry? Because it would be useful to know what the Spanish think of the banking union process, and whether that’s going smoothly in their direction?
Alejandro Sánchez-Pedreño Kennaird, managing director, Ahorro Corporación Financiera: I’m not a bank as such, but our shareholders are all the same as banks, and we’ve gone through the crisis together. We’re in favour of the banking union, we believe consolidation will take place, and we think it will happen in other jurisdictions, whether that’s in Italy, France, or even in Germany.
EUROWEEK: Do you think banking union will help deliver credit to the most wanted areas of in the Spanish economy and help generate growth?
Sánchez-Pedreño Kennaird, Ahorro: A banking union is nothing without fiscal union, or politics to a certain degree. I don’t think Spain will get more credit, just because the banking union goes forward. We’ll get more credit because we are part of the European Union. But I don’t think we’ll get any favours from other Europeans.