Liquidity Risk – The Intriguing Treatment of Covered Bonds as HQLA

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Context: In our earlier article, we explored the significance of High-Quality Liquid Assets (HQLA) in bolstering the financial system’s resilience during economic downturns. We also emphasized the need for banks to maintain sufficient levels of HQLA to meet regulatory standards.

Link to the earlier article,

https://www.dhirubhai.net/pulse/liquidity-risk-hqla-effective-fulfilling-its-role-sathyanarayanan-chthc/

Exclusivity of 'Covered Bonds':

Banks hold various financial instruments as liquid assets, which are categorized into three levels based on their quality.

However, not all types of instruments can be maintained across all levels—specifically, Level 1, Level 2A, and Level 2B. An exception to this rule is “Covered Bonds,” which can be classified across these levels, albeit with a complex classification process.

Let’s first explore their characteristics before delving into the process breakdown.

• Covered bonds are backed by a pool of high-quality assets and this collateralized structure provides an additional layer of security for investors. These bonds are secured by cover assets, and covered bond investors have direct recourse to these assets as preferred creditors.
• Overcollateralization: The pool of assets backing covered bonds is often greater than the value of the bonds issued. This buffer protects investors in case of default by the issuing bank.
• A “Cover pool” refers to a well-defined collection of assets that specifically secure the payment obligations associated with covered bonds. These assets are kept separate from other holdings held by the credit institution issuing the covered bonds. The cover pool meets at all times an asset coverage requirement of at least 2 % above the amount required to meet the claims attached to the covered bonds.
• "Asset coverage requirement" means the ratio of assets to liabilities as determined for credit enhancement purposes concerning covered bonds.
• The term “Cover assets” refers to the assets that are part of a cover pool.

Dual recourse:

1. Dual Recourse Mechanism:

• A fundamental feature of covered bonds is the dual recourse mechanism.
• This mechanism allows claims against both the covered bond issuer and the cover assets.
• In case of insolvency of the issuer, investors have recourse to both these sources.

2. Priority Claim:

• Investors also have a priority claim against the credit institution (issuer).
• If the issuer faces insolvency, the cover pool serves as collateral, ensuring preferential treatment for covered bondholders.

3. Claim Against the Insolvency Estate:

• Additionally, covered bondholders have a claim against the insolvency estate. This provides an additional layer of protection for investors in covered bonds.

Transparency:

1. Issuers must publish an ISIN list for the covered bonds issued under the program.
2. Furthermore, detailed information related to market risk—including interest rate, currency, credit, and liquidity risk—is essential.

Background:

The Covered Bond Directive (CBD) and an associated regulation have substantial implications for the risk weighting and eligibility of covered bonds within the Liquidity Coverage Ratio (LCR) framework.

While the CBD necessitated adoption into national legislation by member states’ legislators, the regulation - incorporating modifications to the Capital Requirements Regulation (CRR) in the context of covered bond harmonization - became effective immediately on July 08, 2022.

Treatment in LCR:

The Delegated Regulation outlines requirements that are relevant to the EEA (European Economic Area). Additionally, it distinguishes between covered bonds issued within the EEA and those issued by entities from third countries. Here are the key points:

1. EEA Bonds:

EEA bonds can generally be classified as both Level 1 assets and as the two subdivisions of Level 2. They enjoy flexibility in their classification.

2. Covered Bonds from Third Countries:

Covered bonds issued by entities from third countries can only be assigned to Level 2A if they meet the eligibility criteria as LCR (Liquidity Coverage Ratio) assets.

The following mapping offers a clear understanding of how they are reported in the Liquidity Coverage Ratio (LCR),

Abbreviations:

RWA – Risk-Weighted Assets

CRR – Capital Requirements and Regulation

OC – Over Collateralization

UCITS - Undertakings for the Collective Investment in Transferable Securities

EEA – European Economic Area

The 2021 list of third countries and territories referred to in Article 2 is as follows:

(1) Australia (2) Brazil (3) Canada (4) China (5) Hong Kong (6) Indonesia (7) Japan (8) Mexico (9) South Korea (10) Saudi Arabia (11) Singapore (12) South Africa (13) USA        

CL2015R0061EN0020010.0001.3bi_cp 1..1 (europa.eu)

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