Commission’s proposal to address the double count in liquidity rules for covered bond issuers is well intentioned. It is just the wrong way around.
Look, I know it’s a highly technical topic, and I know that I’ve spoken about it here before but I’m going to address it here one last time simply because people keep asking me the same question over and over again: what is wrong with the draft covered bond directive’s proposals for a double count of liquidity buffers?
Before I start on that I suppose I have to say what the problem that Commission is trying to solve is. Banks, all banks, need to hold assets against their net outflows of cash for the next month under the capital requirements rules, specifically the liquidity coverage ratio.
Banks, just covered bond banks, need to hold assets against their net outflows of cash for the next six months in their covered bond programme under the draft covered bond directive.
Unfortunately, ridiculously, for that last month banks have to hold cash under both rules and the cash can’t be the same cash. The cash for the liquidity ratio has to be fully accessible for whatever outflows the bank needs to cover. The cash needed under the covered bond programme has to be locked away in the cover pool away from other creditors. Upshot: they need to hold two euros for every one euro of bond about to mature. Obviously daft.
Now what Commission have proposed is that the requirement to hold cash under the covered bond programme is reduced by the requirement to hold cash under the LCR. I understand why they would do that – they were writing a covered bond law at the time, not an LCR rule. But they got it the wrong way round.
The 180 day liquidity requirement in the covered bond directive is, basically, just the regulation catching up with the economic reality as defined by the rating agencies – you need cash because it isn’t that easy to convert mortgages into cash in the middle of a crisis. But cash in the general ledger of a bank that is available as easily as is required by the LCR rules is useless. It is lost in the insolvency scenario that the agencies have to assume. You need the cash in the cover pool to make sure that the covered bond creditors get it. So if you have less cash in the cover pool because of the directive’s proposal, the rating agencies will mark you down for not having enough cash when you need it.
Turn it around.
If you allow a bank to reduce the liquidity that they hold under the LCR by cash held in a covered bond programme (that is, the opposite of the proposal) you don’t practically lose anything – that cash outflow is covered as the LCR wants it to be. It is just that it is covered by a specific pile of cash, not the general cash that other net outflows are covered by. And the covered bond pool gets the liquidity that the rating agency wants it to have.
Sorry, technical rant over.