How will covered bonds be treated after Basel II implementation? This will depend on whether banks adjust their holdings to the new risk-weighting regulations, write Mauricio Noe and Christoph Anhamm.

Similar to Basel I, Basel II neither recognises covered bonds nor provides for special treatment. Instead, covered bonds will be treated like either unsecured debt or possibly secured loans. This will be notably different under the Capital Requirements Directive, which will be implemented under Basel II within the EU.

To benefit from special treatment, covered bonds need to comply with the definition set by the directive. The first part addresses the technical aspects of covered bonds and repeats the definition of covered bonds under the Ucits (Undertakings for the Collective Investment of Transferable Securities) Directive, Article 22(4). The second part defines eligible assets, comprising public sector assets, mortgages, mortgage-backed loans, ship loans and bank debt.

Risk weighting changes

Under the Revised Standardised Approach (RSA), risk weightings will be directly linked to external ratings. Outside the EU, the risk-weighted regime for covered bonds will be equal to that for unsecured debt of the same financial institution. Where there are two split ratings, the lower is considered the relevant one. Should there be three or more ratings of different levels, the two better ratings can be used. Should these better ratings be split, the lower of the two is applied.

The RSA leaves two options for assessing the risk weightings of financial institutions. It can be based on the risk weighting and thus the rating of the sovereign where the institution is incorporated (option 1), where the risk weighting for the institutions will always be one notch higher than that of the respective sovereign. Alternatively (option 2), the institution’s risk weighting can be based on its unsecured rating. Each national supervisory authority determines which option applies. In both options the lowest risk weighting achievable for covered bonds under the RSA outside the EU is 20%.

The various EU member states have not yet given any clear indication as to which option they will apply. Given the high sovereign ratings, the majority are favouring option 1, although some countries, including the UK, have expressed a preference for option 2.

In summary, covered bonds will not achieve a lower risk weighting under the RSA than is currently the case (10% if legally based, 20% if not). All issuers rated below double-A (the majority) will face an increase in risk weighting for their covered bonds if option 2 applies. Finally, the unfavourable treatment of issuers without a rating under option 2 is expected to result in all issuers obtaining an unsecured rating.

Foundation internal rating

Within the EU, based on the Capital Requirements Directive, the target was to implement a homogenous loss given default (LGD) level for covered bonds, reflecting the quality of the collateral and not that of the total balance sheet of the issuer. However, officials faced two problems when attempting to set the level: first, the absence of recent default data for a covered bonds issuer in the EU25; and second, the different composition of collateral pools. It appears, for the sake of a level playing field, that covered bonds using mortgage loans were used as a benchmark and therefore no distinction will be made with public sector loans.

Initially, EU officials proposed a 25% LGD level, with industry representatives arguing for lower levels. The industry collected sufficient data outlining the quality of the collateral assets leading to a base LGD of 12.5%. Furthermore, it was agreed to apply a level of 11.25% should the covered bonds either be triple-A rated or meet certain collateral criteria. This is the only aspect of the risk-weighting process where a covered bond’s rating is of any relevance and can result in a risk weighting as low as 3.6% under the foundation internal rating-based (FIRB) approach.

Outside the EU, covered bonds will be treated according to the same LGD as unsecured bank debt – that is, 45%. Based on this and Moody’s idealised cumulative probability of default levels, the risk-weighting structure for covered bonds would change notably: 90% of the number of jumbo covered bonds currently outstanding would benefit from lower risk weighting and 10% would suffer from a higher risk weighting. The lowest achievable risk weighting (14%) and the highest one (64%) could differ by 50 percentage points.

Advanced internal rating

Financial institutions electing to use the advanced internal ratings-based approach (AIRB) will estimate all risk components without reliance on external data, although industry representatives are lobbying at an EU level to allow the use of data provided by the issuer. Banks outside the EU will find it difficult to estimate the LGD of the collateral pool. Consequently, it seems unlikely that they would assign LGD levels below those of unsecured debt or secured loans. This is likely to keep covered bonds holdings by such banks quite limited.

To solve this dilemma in the EU, financial institutions will be allowed to use the same LGD ratios as for the FIRB if the bonds meet the eligibility criteria mentioned above. Consequently, financial institutions in the EU will probably use the same risk weighting for covered bonds when following the FIRB or the AIRB.

Spread implications

Banks make up a substantial part of the covered bonds investor base. Based on individual risk-weighting requirements, it is therefore possible that an investment in the same covered bonds could simultaneously offer an attractive return on equity for one bank but not another. This will have implications for both covered bonds swap spreads and the investor structure of covered bonds. The clear winners would be covered bonds issued by institutions with double-A unsecured ratings.

Should banks maintain their share as investors, the changes in risk weighting would require some price action if covered bonds investments returned a constant return on equity. Covered bonds that face an average increase in risk weighting could widen by up to 2 basis points (bp), while the winners could tighten by almost 3bp. Most covered bonds, however, will change by no more than 1bp. A higher spread differentiation is expected should banks increase their covered bonds share or if a higher proportion of banks adopt IRB or RSA option 2 instead of RSA option 1.

The key question will remain whether banks will actively adjust their holdings to the new risk-weighting regulations. Banks tend to hold covered bonds as collateral for their repo activities with the European Central Bank (ECB). Higher yielding asset-backed securities (ABS) will also benefit from a lower risk weighting and so banks might increasingly use higher rated tranches as ECB collateral. This could put pressure on covered bonds spreads and cause a narrower differential between highly rated ABS and covered bonds. At the same time, such widening could provide buying opportunities which, coupled with the scarcity of assets, should ensure covered bonds spreads remain well bid.

Mauricio Noe is global head of covered bonds, ABN AMRO and Christoph Anhamm is head of ABS and covered bond research, ABN AMRO.

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