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Deposit tiering change less harmful for covered bonds

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By Bill Thornhill
28 Jul 2020

A prospective improvement in the European Central Bank’s deposit tiering facility mitigating the punitive impact of negative rates should be bad for covered bonds, 95% of which are negative-yielding. However, the unprecedented scale of reserves held on deposit with the central bank implies that many key investors will still be looking for anything that pays more than its deposit rate of minus 0.5%.

The ECB is expected to improve terms of its deposit tiering, possibly in September, by increasing the amount of cash that can be held on deposit at 0%, rather than the usual minus 0.5%. At the moment banks can pledge up to six times their minimum reserve requirement (MRR) at 0%. This multiple could be doubled.

As a result it’s fair to assume that more bank investors are likely to lose interest in buying covered bonds, as an investment with the ECB at 0% would be more attractive. While an improvement in deposit tiering is likely to hit a portion of bank investor demand for covered bonds, it may not be as large as originally feared.

This is because the amount of reserves placed with the ECB is far above the higher tiering limit of 12 times the MRR. Back in October 2019, aggregate excess reserves held by bank in the eurozone stood at €1.9tr. However, following a series of policy measures this year, that amount ballooned to €2.8tr.

Under the present tiering scheme, an aggregate €846bn of eurozone bank deposits benefit from the 0% tiered deposit rate. But if the tiering rate was doubled to 12 times MRR then almost €1.7tr of excess deposits would be protected with a 0% interest rate. But that still means there’s another €1.1tr of excess reserves that are not protected — and these will be charged at the usual deposit rate of minus 0.50%.

Crucially, the dispersal of this €1.1tr of unprotected excess reserves is unevenly distributed across Europe. The bulk is held by banks in core European countries — which, in contrast to the rest, also happen to be among largest covered bond buyers. The fact that top-rated covered bonds are eligible for the liquidity coverage ratio (LCR) has created structural demand that has so far proved to be somewhat insensitive to spread.

As a result, the share of bank investor demand from Germany, Finland, France and the Netherlands has increased over the past five years in line with falling rates and tighter spreads. Demand from asset managers has been steady but, since many of these institutions also buy on behalf of bank LCR investors, they are driven by the same regulatory dynamic. 

In contrast to core European banks, those in the south generally have less excess liquidity which means they should benefit most from an improvement in deposit tiering. However, because they were never big buyers of covered bonds in the first place, they will not be missed in the event the ECB offers them a juicier alternative.

By Bill Thornhill
28 Jul 2020