18 February 2014

Bundesbank/Dombret: The euro area, the German economy and the Pfandbrief

Bundesbank's Andreas Dombret warns that the eurozone banks shying away from unsecured lending could create bottlenecks for banks looking to refinance as well as making such financing more expensive.

Looking to the future, the Pfandbrief might benefit from crisis-driven regulation. Basel III sees the introduction of global liquidity standards for banks for the first time ever. These new standards will increase the need for secure collateral in the financial system. And Pfandbriefe are eligible assets for the envisaged Liquidity Coverage Ratio and will in all likelihood count as "stable funding" for the Net Stable Funding Ratio. Likewise, stricter standards for margin requirements on OTC derivative transactions will probably increase collateral usage. Furthermore, the prevalent use of central bank lending against secure collateral underpins demand for collateral in the euro area - at least for the time being. As a consequence, Pfandbriefe, along with other secure collateral, might be increasingly sought after.

For participants in the Pfandbrief market, these are certainly positive developments. As a central banker in charge of financial stability, however, I have to take them with a pinch of salt. This is mainly because an increasing amount of assets in banks' balance sheets may get tied up as collateral - a development that has been coined "asset encumbrance".

Increasing asset encumbrance tends to increase expected losses for unsecured investors should a bank fail. Consequently, unsecured investors are inclined to demand compensation for their more junior position in the debt hierarchy - in effect driving a bigger wedge between secured and unsecured funding costs. As a result, some banks may find it more challenging to meet their overall refinancing needs.

Potential problems could also arise in conjunction with policies aimed at bail-ins. If the ratio of encumbered assets rises, bail-in policies could be less effective, as losses would have to be distributed between fewer and fewer unsecured investors. Some argue that to combat the potential effects of higher asset encumbrance we need to introduce widespread limits on covered bond issuance. The objective is to restrict the share of encumbered assets on banks' balance sheets.

Indeed, central banks and supervisory authorities need to monitor the matter closely. Nevertheless, I would argue that we should not rush to implement heavy-handed measures, lest we throw the baby out with the bathwater. My argument rests on three pillars.

1. Most observers agree that there is still an adequate general supply of collateral in the global financial system. Any potential scarcity of collateral may vary by jurisdiction. And different levels of asset encumbrance may well be justified taking into account specific business models of banks. In Germany, for example, there are currently no signs of an increase in asset encumbrance that would worry us. Against this background, it does not seem advisable to introduce international regulation directly aimed at limiting asset encumbrance at the current juncture.
2. Incoming regulation already addresses the potential problem of asset encumbrance, albeit somewhat implicitly. Liquidity regulation within Basel III, although accepting covered bonds to a certain extent, at the same time implements a "buffer" of unencumbered assets. And minimum requirements for "bail-inable" debt, as foreseen in the European Bank Recovery and Resolution Directive, will likely tackle the issue of asset encumbrance from another angle.
    
3. Collateral shortages could well be a temporary phenomenon. As regards Europe, once the banking system has recovered and bank funding markets have normalised, collateralised funding through the Eurosystem should decrease perceptibly. As a result, demand for collateral would shrink.

This last point also illustrates a more general thought: we should focus on the underlying root causes of any excessive encumbrance of assets. Soothing the symptoms alone will not take us forward. In this vein, the ECB's comprehensive assessment of banks' balance sheets is an important step as is continued support for an orderly deleveraging process of European banks. Both steps should take us a long way towards addressing any adverse effects from asset encumbrance in the financial system.

Full speech

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