The supervisory authority set out its new stance in a letter to the British Bankers' Association almost a year after a similar communication had raised fears that the FSA was adopting a restrictive attitude towards the product.
Last August the FSA said that the proportion of covered bonds to total assets that would trigger discussions with an issuing bank about the materiality of issuance was 4%. The subsequent dialogue could have led to the FSA increasing a bank's individual capital requirement (ICR) — the capital ratio it sets for every bank — were such issuance found to be material.
The FSA's concern stemmed from its responsibility to protect depositors who are placed in a subordinated position with respect to the collateral backing covered bonds and who could therefore face greater risks.
Under the new approach the 4% level will remain a monitoring threshold, but a new 20% upper benchmark has been introduced which the FSA says is "the level above which we would be likely to consider issuance as being sufficiently material to require an increase in most banks' ICR."
Furthermore Paul Sharma, head of department, prudential standards at the FSA in London, said that neither the 4% nor 20% thresholds are hard limits, and that the level at which a bank's ICR would be increased would be set on a case by case basis.
He said that it would be atypical for a breach of the 4% level to lead to greater capital requirements and that the FSA would even be open to arguments that issuance above 20% was not material.
The 20% ratio is much closer to the level considered by mortgage lenders to be a reasonable trigger for the FSA to take covered bonds into consideration when setting banks' ICRs.
Rob Thomas, senior policy adviser at the Council of Mortgage Lenders in London, for example, said that, based on rating agency discussions, its members considered a material level to be closer to 30%.
Thomas said that the FSA's new approach, although conservative, was sensible. "We very much welcome this letter," he said. "Having the 20% number is helpful because it shows the sort of ballpark level the FSA is thinking of."
Tim Skeet, head of European bank origination at ABN Amro in London, also viewed the FSA's announcement as good news.
"This clarification, as well as the extensive consultation with the industry and their clear communication, demonstrates to the rest of the market that the FSA sees the advantages of covered bonds to UK banks," he said. "They have accepted the key arguments that the industry put to them and we now look forward to the UK playing its proper part in the European covered bond market."
The approach outlined yesterday applies to banks. The FSA, will in the coming months issue its guidance for building societies.
Liquidity arguments key
Sharma said that the two tiered approach should not be seen as the FSA's last word on the subject. He said that as the covered bond is still a newly emerging phenomenon in the UK, issuing final guidelines on the market would risk stymieing its development.
The FSA appears to have learned its lessons from last August, both in the transparency and consultative approach of its new guidance. The low level at which the trigger was set, and its apparently arbitrary nature, were seen as major obstacles to the development of the UK market. Two of the three issuers at that time — Bradford & Bingley and Northern Rock — were both already nudging at the 4% level.
Sharma said the 4% level was never intended as a hard limit on covered bond issuance but acknowledged that there had been confusion about the FSA's approach.
He said the 4% level had in some cases begun to be observed as a limit on the practical possibility of covered bond issuance and that while this had not caused any problems because the market is so new, it could soon have caused serious problems because of the market's rapid development.
In formulating its new approach, the FSA placed emphasis on the liquidity risk reduction that covered bonds can provide.
Sharma also co-chairs the working group on liquidity risk of the Joint Forum that operates under the aegis of the Basel Committee, the International Organisation of Securities Commissions and the International Association of Insurance Supervisors. He said that he has heard similar evidence as to the benefits of covered bonds in both his roles.
"We have received a very clear and consistent message that an ability to access the securitisation markets and the covered bond markets is a significant help to the liquidity profile of a financial institution," he said.
Successful Pfandbrief issues for credits such as Allgemeine HypothekenBank Rheinboden and HVB in Germany have, for example, shown this year how covered bonds can give banks access to liquidity while other funding routes are either closed or very expensive.
However, Sharma said that after a point covered bond issuance yielded diminishing returns in terms of reducing liquidity risk. Furthermore greater issuance increases the loss given default faced by depositors.
The challenge, he said, was finding the point at which the greater risk faced by depositors exceeded the gains made by the issuer.
Encouragingly, Sharma said that "nobody has come close as far as I'm concerned".
Risk weightings awaited
Participants in the UK covered bond market are now hoping that the FSA will adopt a similarly constructive stance in its attitude towards the risk weightings that will be assigned under the new Capital Requirements Directive.
Under the current Ucits regime the UK product has suffered from having a 20% risk weighting for continental European financial institutions, compared to the 10% level that other covered bonds have enjoyed.
Sharma said that the national discretion available under the Ucits regime that was used by regulators in other countries to assign favourable risk weightings to their covered bonds has since lapsed and the FSA could not, therefore, change matters today.
However, he said that the lower risk weightings of covered bonds makes sense and that the FSA would tackle the issue as part of its general consultation on the implementation of the CRD, which is due to come into force at the beginning of 2007.
Sharma also dismissed arguments that UK covered bonds compared unfavourably with their continental counterparts because they are not issued under special enabling legislation.
He said that while a supervisor could take comfort from theoretical arguments about financial instruments when formulating policy, seeing their actual performance was more reassuring, and that the techniques used in covered bonds have proved themselves to be robust in practice.