Fitch Ratings says the introduction of liquidity buffers as recommended by the European Banking Authority (EBA) could in some cases increase the difference between the Issuer Default Rating (IDR) and covered bond rating determined by Fitch.
The potential for rating upgrades would apply to legislative covered bonds secured by standard assets such as mortgages and public sector exposures issued in jurisdictions with no mandatory liquidity protection such as Austria, Slovakia and Spain.
The proposed liquidity buffer forms part of step one of the EBA’s three-step recommendations on harmonisation of covered bonds frameworks in the European Union, published in December. Step one aims to provide a definition of covered bonds for regulatory recognition.
While many covered bonds include liquidity protection, requiring it as a basic feature would mark a departure from the historical concept of this type of secured bank debt. Without liquidity buffers, investor protection primarily rests on the prospect of higher recoveries from the segregated cover pool if an issuer defaults. Adding liquidity protection may also lower the probability of default on a covered bond relative to that of the issuing institution. This would depend on the length of the protection, and whether alternative refinancing can be found during this time at a cost which can be met through over-collateralisation.
The EBA proposes a buffer of liquid assets covering net outflows between cover assets and covered bonds at least over the next 180 days following an issuer default. It does not distinguish between interest and principal payments. The same timeframe would apply irrespective of the cover asset type. The proposed minimum protection of 180 days is less than the market standard for mortgage programmes, which is a 12-month extension. Fitch does not expect legislation or programmes with longer liquidity protection mechanisms to revert to the proposed minimum, and as a result we do not expect negative rating impact.
Unlike the EBA recommendation, Fitch differentiates between interest and principal payment interruption risk. For interest payments, Fitch expects at least three-month coverage on a rolling basis plus a buffer for senior expenses to assign rating uplifts for payment continuity of four or more notches. Fitch generally expects this protection to be provided on a gross basis, ie disregarding scheduled incoming cash flows. This is to mitigate disruption stemming from operational hurdles such as redirecting cash flows or setting up alternative management after an issuer default.
Regarding principal payments, the recommended six-month protection would be eligible for a maximum five notch payment continuity uplift if the cover pool consists of public sector exposure in developed banking markets, and a lower uplift of three or four notches if the cover pool consists of residential or commercial real estate mortgage loans in developed banking markets. A six-month protection is unlikely to lead to any payment continuity uplift for programmes secured by ship mortgages or aircraft financing, as Fitch views these asset classes as too illiquid, and a limited number of programmes offer an alternative refinancing option.
The EBA’s recommended definition of liquid assets is slightly wider than Fitch’s, in particular regarding LCR Level2A assets. In our programme analysis, we take the respective definition of liquid assets into account and may reduce payment continuity uplift if the discrepancy to our criteria is material. However, we expect this to be the case for a limited number of programmes, as we generally see liquid assets defined as cash in combination with an account bank replacement provision.
