Last Thursday, the Basel Committee on Banking Supervision accredited covered bonds with low risk weights, closely following a precedent set by European regulation. A low risk weight is credit positive for issuing banks’ sales of covered bonds outside the European Union (EU) given the global application of the Basel rules.
In Australia, covered bonds funded about 10% of all outstanding mortgages in 2016, up from 6% five years earlier. More will be funded this way once the new rules are in place.
Existing EU covered bond issuers will benefit from the Basel IV regulation because their covered bonds become a more attractive investment for non-EU bank investors. Amid rising minimum requirements for regulatory capital, risk weights applied in the calculation of banks’ stock of risk-weighted assets have gained importance in their investment decisions. European covered bond issuers can diversify their investor base and potentially reduce their funding costs as demand for their bonds increases. However, some issuers may be incentivised to increase their share of covered bond issuance in foreign currencies, thereby increasing their exposure to foreign-currency fluctuations given that cover pool assets typically are denominated in euros or other local European currencies.
Outside the EU, lower risk weights for covered bonds will foster the development of covered bond markets and encourage the bonds’ use as a funding tool. The additional funding source will make non-EU banks less reliant on deposits and the sometimes volatile unsecured wholesale funding market. Additionally, the covered bonds will provide an opportunity to improve their asset-liability matching, particularly for mortgages, which typically have 20- to 30-year maturities, versus five to 10 years for covered bonds. In the EU, banks investing to fulfil liquidity coverage requirements, for example, typically absorb about one third of primary covered bond market issuance.
Covered bond markets outside the EU include Australia, Canada, New Zealand, and Singapore, where the bonds have had a less relevant, but growing, role in financing local mortgage markets. In Australia, covered bonds funded about 10% of all outstanding mortgages in 2016, up from 6% five years earlier, but significantly less than in Sweden, where covered bonds finance about 55% of all outstanding residential loans, according to the European Covered Bond Council’s HypoStat 2017. Once Basel IV rules are implemented, we expect that non-EU banks will become more active investors in their domestic covered bond markets, thereby facilitating domestic mortgage funding.
Lower risk weights reflect covered bonds’ status as the only bank debt that cannot be bailed-in and that has a proven track record of sound credit and liquidity. Basel IV regulation stipulates certain requirements that issuers must fulfil to achieve low risk weights for their covered bonds beginning January 2022. The Basel IV requirements include that the covered bond issuer be subject by law to special public supervision designed to protect bondholders, that the value of the cover pool backing the covered bonds is restricted to a maximum loan-to-property value ratio of 80%, and that the covered bonds are protected by at least 10% over-collateralisation.
