16 May 2019

Investment & Pensions Europe: Analysis: Experts warn of bank stress test impact on covered bonds

In a note regarding new stress test information requirements for the European banks, the ECB has told tells banks to report “the estimated nominal value of additional covered bonds [CBs] which could be generated out of assets already mobilised into CBs cover pools… the expected additional liquidity… potentially obtained assuming that such additional CBs were retained and encumbered in central bank funding operations”.

German rating agency Scope has voiced concern that this information could mean the ECB was “focusing solely on the survivability of banks” and thus “jeopardising the credit strength deriving from the dual recourse nature of covered bonds”.

“Investors will be deprived of the umbrella of strong cover support and high over-capitalisation just as it starts to rain,” wrote Karlo Fuchs, head of covered bonds at Scope Ratings, in a commentary.

Fuchs added: “Maximising liquidity for the bank with covered bonds can swiftly and significantly alter a covered bond’s risk profile.”

Eberhard Schwarz, Swiss consultancy Complementa’s representative in Germany, shared Fuchs’ concerns. He said: “The criticism voiced by Scope is interesting as it points to a weakness in a market downturn: banks could be tempted to use existing cover pools for covered bonds to up their liquidity in crisis situations.” 

Covered bonds are an important and long-standing investment for many institutional investors. In Germany in particular, the local variant – known as Pfandbriefe – makes up a significant part of institutional portfolios.

Scope confirmed that its criticism of the ECB stress test proposal still stood even if only applied to new issues of covered bonds.

“This sends the wrong signal,” Fuchs stated. “Allowing the reduction of over-capitalisation to the legal minimum could prompt investors to demand higher risk premia if they know that supervisors are comfortable with issuers diluting existing security packages.”

Schwarz said the ECB should leave this element out of the stress test altogether.

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