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Crisis Talk — VDP's Tolckmitt believes in strength of Pfandbrief bank liquidity

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By Bill Thornhill
05 May 2020

A strong and growing deposit base, an active private placement market and sizeable proportion of prefunding has put the Pfandbrief banks in a strong liquidity position, the chief executive officer of the Association of German Pfandbrief Banks (VDP), Jens Tolckmitt, told GlobalCapital in an interview on Tuesday covering a wide range of other topics such as real estate values, the mortgage lending value and Basel III’s output floor.

GlobalCapital: Why are you confident that the liquidity situation of Pfandbrief banks is strong?

Jens Tolckmitt, VDP: Member banks of the VDP have access to the Pfandbrief which is a stabilising factor and has shown its usefulness in a number of crises. Issuers have also been active in the private placement format during the current Covid-19 crisis. The covered bond market is working and issuers can tap it if they want to, as has already been demonstrated with a number of deals from foreign issuers.

Secondly, pre-funding was done at the end of last year and the start of this year. So far this year we’ve seen Pfandbrief issuance of €28.6bn against an estimate we did last November for the year 2020 as a whole of €48bn. And when you see the strong performance of spreads lately it makes sense to wait and see where they settle before committing to benchmark issuance, which has been absent since March 3.

Thirdly, we have a large number of issuers that also benefit from a strong deposit base, which, as far as we know, hasn’t changed much. 

On top of that there are a number of different opportunities to access liquidity from the European Central Bank. 

Finally, on the lending side, the business has not been as dynamic recently as in the last two years. So, when you put all this together, the Pfandbrief banks feel they are in a comfortable liquidity position.

How do you expect rent losses and mortgage deferrals to impact Pfandbrief banks and their cover pools?

It’s still a little too early to tell, but so far we’ve not seen a lot of deferrals across our industry. There have been some in the residential sector. The overall impact on banks’ loan books is proving to be manageable so far but there is an expectation that these numbers will increase.

There have not been many mortgage deferrals so far and they are not expected to be a problem for the cover pools, which are dynamically managed. 

So, if there’s a problem loan it could be replaced and our member banks have plenty of spare collateral to do that. And when you consider the capital requirements, there’s been a lot of helpful regulatory measures to make sure these mortgage payment deferrals, as low as they are for the time being, won’t automatically lead to higher capital charges. A lot will depend on how the crisis plays out and how long these measures will remain in place.

Do you think 2019 is likely to prove a high water mark for the real estate values and outstanding Pfandbrief volumes?

After a relatively steep rise in property prices in some areas in past years, it now seems likely that levels will stabilise or even fall slightly, but depending on the length and severity of the crisis, it remains to be seen how this eventually plays out. 

And in terms of outstanding Pfandbriefe, after a very long decline over the past 15 years, volumes have begun to stabilise around the €365bn mark and we think this stability will continue around this level. 

As with every year the big question around volumes is, what are the opportunities to use alternative funding tools — such as the new ECB facilities — so we’ll have to see how volumes develop.

In the context of a rise in public sector issuance that has come in response to the Covid-19 pandemic, do you think public sector Pfandbrief volumes could provide useful funding?

There is a possibility that public sector Pfandbriefe could be helpful to fund the fight against the pandemic and its consequences. In the past, public sector Pfandbrief had been a product used to refinance capital markets-based funding of European sovereigns and sub-sovereign entities but today it is an instrument that’s mainly used to refinance loans to smaller local public entities. So the question of whether we see an uptick in issuance very much depends on whether they have a need to increase funding. 

It could well be that, given decreasing tax income at the local level, there is a need for more funding but we cannot say that for sure.

Pfandbrief banks have a 45% market share of German regional public sector lending, so if they have an increased funding need it stands to reason that some of this lending will, to a certain extent, end up in the cover pools of public sector Pfandbrief.

Why do you think commercial retail real estate lending fell 25.4% in 2019, was this fortuitous given what has happened since?

The sharp drop in lending was a consequence of a development that we’ve seen in this area of commercial real estate lending for some time — which is that traditional shops have faced increased competition from internet-based companies and the crisis is reinforcing this trend. Banks have therefore been deliberately cautious about financing main street businesses like shopping centres for some time but, in a way, it was fortuitous that they had been particularly cautious last year.

How do you expect residential lending to shape up over the next year or two?

It remains to be seen as it’s too early to say how the crisis develops and how it affects households. In the residential market German banks concentrate on financing German property as opposed to the commercial real estate market where you see a much higher proportion of foreign real estate exposure. The dynamic price development in the German residential property market has been based on strong fundamentals in recent years. These are still in place. A lot of loans are granted with long term fixed rate interest rates which should provide a stabilising influence. In the short term we expect prices to move sideways or even decrease a little bit. Over the next three to five years we could see small price rises close to the inflation rate.

The Basel III output floor, which sets the minimum capital levels banks must hold, has been especially counterproductive for lending in the current circumstances. Why?

The overall strategy of the European Commission in this crisis is to prioritise lending to the real economy and this is the right way. At this point in time if we implement the Basel output floor there is an immediate and strong effect on regulatory capital, especially on low risk real estate loans and SME loans. 

As a bank, if you have a given amount of capital on your balance sheet and a strong increase in the requirement per loan then obviously this limits your potential to grant new loans. Based on the European Banking Authority’s July 2019 advice Pfandbrief banks need to increase capital by an average of 38%, of which more than half is due to output floor. So you can see how dramatic the effect of the output floor is and how harmful that’s likely to be for additional lending to the real economy.

When it comes to implementing the output floor, the VDP has advocated an approach referred to by the European Banking Authority as the parallel stacks approach. Can you tell me how this is calculated and what it effectively means, in terms of increased capital requirements?

The basic idea of the Basel agreement is that the Pillar One capital requirements are floored at 72.5% of the capital requirements of the Standard approach. In the EBA report of July 2019 on how to implement the Basel agreement in Europe there are three approaches to calculating this output floor.

In the first approach, favoured by EBA, it is suggested that the output floor is applied to Pillar One and Two, which would mean all capital requirements are floored for banks. The problem is that Basel only requires flooring Pillar One, so EBA’s suggestion is essentially EU gold plating and therefore we are critical of this because of the strong effect it has on the overall capital requirement.

Under the second approach the capital requirement is gauged from flooring Pillar One then adding Pillar Two based on internal ratings based models. On average this results in a capital requirement that is approximately 90% of the first approach.

The third approach is the parallel stacks approach developed amongst others by the VDP. Under this method, banks basically stick to the Basel recommendation and calculate their requirement based on the flooring of Pillar One. In this case they still face an average increase in their capital requirement of up to 14% compared to Basel III in its current form, which is quite a lot but not as substantial as 38%.

And, in order to make regulators more comfortable we suggest to calculate the capital requirement using a two stack approach. Under the first stack you simply follow what Basel III requires, the floored Pillar One requirement. That is then compared to a second stack where the capital requirements according to Pillars One and Two requirement are calculated under the internal ratings based approach. The higher capital requirement of those two stacks would then be taken.


Do you think covered bond harmonisation is likely to be put on the back burner? Is there anything that needs addressing in the Pfandbrief law?

From the German perspective there is no reason to anticipate a delay as we have been ready for quite some time. But from a pan-European perspective I could guess that the EU may well decide to extend the implementation period.

Are restrictive limits on mortgage lending values (MLV) constraining lenders from using Pfandbrief to finance real estate lending?

We have been in discussion with the regulator about this issue for several years. We think the parameters in the calculation of the MLV have to be adapted to the current interest rate environment. 

The problem is that MLV interest rates were enshrined in law many years ago. As interest rates have fallen following the global financial crisis and already before, the gap between market value and MLV has risen substantially.

 As a rule of thumb that difference used to be 10% but it’s now much higher. The regulator sees the challenge and we are optimistic that we will reach a solution that will address this issue.

By Bill Thornhill
05 May 2020