“I’ve been imitated so well I’ve heard people copy my mistakes” – Jimi Hendrix
It’s a story that I’ve told before, but it doesn’t tire of being told and it is one that is particularly important to the development of the Canadian covered bond market. So, for one more time, why is there a 4% limit on the amount of a bank’s assets that can be pledged to covered bond programmes?
I’m not going to discuss why have a limit at all. We all know that there is some kind of balance to the number of covered bonds outstanding. Overall access to the covered bond market is a good thing for a bank’s survival – in particular their ability to access emergency liquidity in the stormiest of conditions. But too many covered bonds and all the good assets have been taken away from the unsecured borrowers and depositors (or, more likely the deposit insurers) when the bank does fail.
And I’m not even going to discuss what I think the right number is. We can do that some other time.
The only question that I want to ask is, why do so many covered bond regulators around the world come up with the same number – 4%?
To answer that question you have to go way back in the mists of time to before the financial crisis, to a regulator who is no longer a bank regulator, an industry body that used to represent covered bond issuers and to an issuer that doesn’t exist any more.
In 2006 the Bank of England, as then regulator of British banks, wrote a letter to the British Banker’s Association, who then used to represent British covered bond issuers discussing the topic of over-encumbrance of assets due to over-zealous issuance of covered bonds. They recognised this as a theoretical concern but went on to note that no British bank had more than 4% of their assets currently in covered bond pools so this wasn’t a material risk. At a higher level it might be.
They said 4% because Bradford and Bingley – no longer with us – at that time had about 3.9% of its assets in its covered bond pool.
Sadly – ridiculously? – this was interpreted by people who should know better as a 4% cap on covered bond issuance.
Subsequently the Bank of England published a letter saying that this was not the intention of the first letter at all. They went on to say that a much higher number – like 20% - might start to become a material risk but obviously 4% wasn’t a problem (headline: “Bank of England relaxes 4% cap on covered bonds, now 20%”…someone in Bank of England communications department bangs head repeatedly on desk).
The damage was done. By the time the second letter came out it was widely accepted amongst covered bond supervisors (at least those in the anglosphere, the traditional European supervisors have largely ignored the discussion) that a 4% limit was an appropriate level.
4%: arbitrary, annoying, but appropriate.
It really was as unscientific as that. Don’t get me wrong, it is appropriate that regulators should be aware of the risk, should err on the conservative side when setting limits and should be particularly careful in the developmental years of a market. Their challenge now is to move on, in Canada and elsewhere, to a limit that is arrived at more objectively.
Time to start a debate?