ABN AMRO’s Niels Slikker illustrates the covered bond versus securitisation debate with a case study.
The case for optimising funding and capital has received much attention over the last year. The catalyst has come from the move towards Basel II and with it the convergence of banks’ regulatory capital models with their internal economic capital models.
This article looks at a theoretical bank, ABC Bank, which has the choice of financing a E100m portfolio of residential mortgages, either by issuing covered bonds or through securitisation. For this example a 10-year funding requirement is assumed. The same time horizon is applied to any capital requirements. The major capital and funding aspects are examined and the importance of the right regulatory capital mix within capital and funding optimisation is demonstrated. This economic cost analysis will compare outcomes under both Basel I and Basel II.
For the purposes of this article, some simplifications have been made in order to make the comparison easier to present. It is recognised that there are many other factors at play in funding and capital management decisions. However, for this example, any requirement for capital relief, access to a specific investor base or a maturity requirement have not been taken into account.
Option 1: Covered Bond
Covered bond financing is sometimes referred to as “on-balance sheet securitisation”. This description covers two essential aspects. Firstly, as the assets remain on-balance sheet there will be a regulatory capital charge associated with their retention. Secondly, “securitisation” refers to the additional security the mortgage assets are providing to investors, thereby reducing the pure funding cost.
With regard to the capital charge relating to the first lien mortgage assets, these are risk weighted at 50% under Basel I rules. Given a residential mortgage pool of E100m and the current BIS ratio of 8%, this leads to a regulatory capital requirement of E4m (E100m x 8% x 50%).
It is assumed that the bank will want to issue the cheapest capital possible to meet the E4m regulatory capital requirement. As equity is the most expensive form of regulatory capital, the bank should aim to minimise this component. This can be done by issuing a maximum of 50% in Tier II capital, of which half should be Lower Tier II capital instruments. Of the remaining 50% of Tier I capital, the maximum of 15% of Tier I capital should be raised in the form of Hybrid Tier I capital instruments. This creates the least expensive mix of regulatory capital. The ultimate total capital cost is then dependent on the rating of the issuing bank, the market level of interest rates, spread levels and the tax shield on the coupon payments.
Under Basel II, the risk weighting of mortgages will fall and thus the capital requirement will decrease. It is assumed the issuing bank will adopt the foundation internal ratings based (IRB) or advanced IRB approach, and the risk weighting will be 25%. In this instance the amount of regulatory capital will halve to E2m (E100m x 8% x 25%). Assuming the weighted average cost of that capital remains constant, then the total capital cost will also halve.
On the funding side, three separate channels to access liquidity can be utilised. First, covered bonds require a certain amount of over-collateralisation (OC). In this example 5% has been selected and hence only 95.24% of the E100m in mortgages are funded by the covered bond proceeds. A further 4% is already funded through the issuance of regulatory capital (see above) leaving the remaining E0.76m to be provided by senior unsecured debt. Obviously, the lower the amount of OC, the lower the portion of senior unsecured funding required. In general, the funding cost of senior unsecured debt will be more expensive than the funding cost of covered bonds; thus a lower OC requirement will reduce the ultimate total funding cost for the pool of mortgages.
The total economic cost of the covered bond alternative is found by adding the cost of regulatory capital to the cost of funding.
Option2: Securitisation
With securitisation, assets are removed from the balance sheet of the originator and so no regulatory capital needs to be held. However, generally the originating bank will retain the first loss piece of a securitisation and this has regulatory capital consequences. If we assume that a first loss piece of 1% is retained by ABC Bank, then this will be deducted from the bank’s regulatory capital base under Basel I (see table: supervisory deduction level). Therefore, it is assumed that ABC Bank will employ Lower Tier II capital towards countering the deduction.
Typically, a residential mortgage backed securitisation (RMBS) capital structure will have an AAA-rated tranche of more than 90%. The AAA-rated tranche is the cheapest to fund, with further tranches rated AA, A and below carrying higher spreads. The total funding cost will decrease as the relative size of the AAA-rated tranche increases within the securitisation capital structure.
Analysing the changes under the proposals for Basel II for the securitisation option is less straightforward. Starting with the capital requirement, the size of the first loss piece will not increase under Basel II, however, the weighted average cost will increase. Under the latest proposals, 50% of the E1m first loss piece will be deducted from Tier I capital and 50% from Tier II capital (see table). Obviously, any reduction in expensive Tier 1 capital means that the effective cost of the deduction will increase compared to Basel I.
As for funding, the price effects are less clear-cut. Under the current proposals, the risk weighting of the AAA-rated tranche to an investing bank is set to decrease from the current 50% (or 100%) to around 7% (or 20%) under Basel II. This will have a positive impact on the funding costs for the senior tranches. On the other hand, risk weightings for non-investment grade tranches may increase compared to their current level. Yet, the latter’s effect should be limited as it applies to a much smaller part of the securitisation. Overall, the total cost of funding is expected to fall.
By combining the cost of the capital of the first loss piece with the cost of the funding, it is possible to derive the total economic cost of the securitisation.
Value drivers
When comparing the total cost of each option under Basel I rules, the effective costs of each structural alternative are quite similar. This would suggest that both markets are more efficient in relation to each other than is often assumed. Another point to note is that the covered bond route is generally the most beneficial from an economic cost viewpoint. This difference may well be the risk premium in respect of the mortgage assets, which are only transferred in the case of securitisation.
The actual numbers are very sensitive to a variety of inputs. One of the most important being the regulatory capital mix. In an example where the issuing bank only uses equity, the capital cost will increase to such an extent that the benefit of capital relief from securitisation leads to a reversal of roles. Covered bond financing then becomes significantly more expensive, while the securitisation cost will go up slightly, leading to a clear advantage for the securitisation route. In this scenario, the securitisation route is clearly the cheaper option on a relative basis. However, this is sub-optimal from the bank’s point of view, as the absolute cost of both options is higher due to the inefficient capital mix. This shows that having the right regulatory capital mix is an important requirement for banks to access different financing options. Clearly, the more financing options a bank has (on comparable and competitive terms), the better for its financial flexibility.
What’s the verdict?
Under the current regulatory rules, covered bond financing tends to have lower economic costs than securitisation. The combined total funding and capital cost for the covered bond alternative will decrease under Basel II, principally because residential mortgages will require less regulatory capital.
For securitisation, capital costs will increase slightly while funding costs are likely to decrease, leading to a lower total financing cost. Under scenarios with aggressive funding assumptions for the investment grade tranches, the cost advantage of covered bonds can be eliminated.
The fact that outcomes of the calculations were very close suggests that securitisation and covered bond financing are more similar in cost than perhaps some issuers may believe.
The current trend in the market is towards a combination of covered bonds that are enhanced with securitisation techniques which are described in greater detail in the accompanying article on page 11. These structured covered bonds may well turn out to be the powerful offspring from this marriage.
Niels Slikker is director, financial markets advisory at ABN AMRO
