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Rising encumbrance is the ECB’s problem

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An undercapitalised bank in the crosshairs of a market rout can expect counterparties to demand higher margin calls, particularly when a lot of its assets are already encumbered, as is the case at many European banks. This is a problem of the European Central Bank’s making and one that only it can fix. Making covered bond repo haircuts more severe would be a good place to start.

As a firm encumbers a higher proportion of its assets — by pledging them to secure liabilities in the repo or derivatives markets, for example — it will have less room to offer similar security when markets are stressed, said the Bank of England in a September 2019 consultation paper on asset encumbrance.

This makes the firm vulnerable to market stress and creditors are likely to charge it higher spreads or respond more quickly to signs of stress. That will impact the bank’s ability to fund itself.

Since the Bank of England issued that warning, asset encumbrance levels have risen steeply enough that the European Banking Authority issued a thinly veiled warning to the ECB last week, saying that supervisory authorities needed to “pay attention” to the situation.

The EBA highlighted “extensive use” of central bank liquidity facilities, noting that encumbrance of central bank-eligible assets in the EU had “increased substantially” to almost half of eligible assets, as of June 2020.

“In the first half of 2020, the volume of total assets and collateral received rose by almost 10% while encumbered assets and collateral increased by more than 20%,” said the EBA. “As a result, in June 2020, the asset encumbrance ratio rose to 27.5% [from 25% the previous year].”

As asset encumbrance rises, the market’s confidence in a bank where capital was constrained would be expected to diminish and counterparties would then seek larger haircuts on collateral and make margin calls, forming what the BoE called an “adverse feedback loop”.

Faced with this dilemma, the ECB has a duty to reverse the course of asset encumbrance and encourage banks to seek more market funding, rather than maintain or deepen its already generous funding arrangements.

But with the lockdowns that have spurred those measures proving longer and stricter than expected, the ECB is more likely to shower the market with more liquidity, leading to a further rise in asset encumbrance in the near term.

The ECB knows that eventually it will be obliged to encourage prudent behaviour. But it has made a rod for its own back by normalising the idea that banks should accept central bank liquidity, rather than pay what the market decides, to the point where there now is a stigma for not taking it.

In the long run this behaviour is neither prudent nor sustainable, and will have to be reined in. Paying less to repo banks’ retained covered bonds — that is to say, raising the repo haircuts — seems like a good place to start.

This is because covered bonds are the largest asset class pledged for repo at the ECB and offer the next cheapest source of funding. The EBA pointed out that asset encumbrance was highest where covered bond issuance was a “predominant funding tool”, like in the Nordics or Germany, or where repo was an important funding tool, such as in France, or in countries where banks have relied upon central bank funding in recent years, such as Spain and Italy.

Covered bonds also benefit from a central bank purchase programme that can smooth bothersome price fluctuations for when issuers head back into the market. Not that they should need it: covered bond investors have been starved of normal levels of supply for years.

The problem of rising asset encumbrance will likely get worse before it gets better. But by starting with covered bonds, it is certainly one that the ECB can begin to fix.

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