Covered bond programmes typically hold much more collateral than the legal minimum, or the amount needed to reach a given rating. This is the excess overcollateralisation (OC).
Yet, when it comes to national regulation, excess collateral is a grey area. Many legal frameworks are silent on how excess collateral should be treated when a bank gets into trouble.
Without a contractual commitment to maintain a given level of OC, there can be no certainty that covered bonds will retain their OC buffers during the course of their life.
And despite their best intentions, there is nothing to prevent issuers from removing all excess collateral to use in derivatives elsewhere in the balance sheet, or to issue covered bonds that are retained for repo purposes.
But for bondholders, excess OC is crucial under stressed market conditions, as the protection it offers can help soften a possible deterioration in the credit quality of mortgage assets.
It can also compensate for mismatches between assets and liabilities, which are likely to be exacerbated by interest rate and currency volatility, and cushions against issuer and swap counterparty rating downgrades.
Despite this, the ECB’s liquidity stress test requires banks to report the maximum volume of covered bonds they could potentially issue — even though this extreme hypothetical scenario implies excess overcollateralisation shrunk down to minimum levels.
A recent report published by Scope Ratings highlighted this concern, saying the ECB’s 2019 liquidity stress “sends the wrong signals and highlights the importance of independent covered bond supervision”.
If the ECB is running its supervision — and its minimum liquidity requirements — on the basis of no excess OC, that's not good news for covered bonds, and, far from the ultra-robust instrument they are today, they would become, in stressed circumstances, a “fair-weather funding product,” Scope warned.
But all is not lost. The forthcoming covered bond directive, which is expected to make legal passage during the second half of April, sets out the case for dedicated covered bond oversight, separate from the overall prudential supervision the ECB does.
That's a move in the right direction for covered bond buyers, yet because the directive is principles based it may not be prescriptive enough when it comes to the national specifics of how excess OC is treated. The conundrum may ultimately depend on how each national supervisor transposes the directive into local regulation.
As matters stand Article 22 of the Single Supervisory Mechanism (SSM) says the ECB has the right to instruct national supervisors “to take action if the ECB has a supervisory task, but no related power”.
The ECB could therefore order national supervisors to reduce OC or delay the effective separation of assets from a wind-down entity.
The European Banking Authority has warned that supervisory guidelines on the specifics of risk management, governance, management quality and other aspects related to the issuance of covered bonds “is not widespread”.
As a consequence, it recommended that the covered bond supervisor’s job specification should be comprehensively defined.
This precise theme has been addressed by the Association of German Pfandbrief Banks (VDP). Under a recent amendment to the German Pfandbrief law, Germany’s national regulator, Bafin, will now have the right to set specific OC levels for individual issuers.
This amendment should prevent the ECB from clawing back collateral in excess of the current 2% legal minimum set out under Pfandbrief law which, in a stressed scenario, would probably be insufficient to protect bondholders.
Though the German amendment is good for Pfandbrief bondholders, it remains to be seen whether other jurisdictions will follow, and how other national supervisors transpose the directive into their respective covered bond frameworks.
Until then, treat with caution — investors should not expect excess OC to remain in the cover pool at the only time it is really needed.