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Sound and fury signifying nothing?

05 December 2018
Richard Kemmish

The covered bond directive is the story of the year in our market. As it approaches its final stages, it occupies a huge amount of the attention of many people in the market. But five years from now will we be wondering what all the fuss was about?

Remember the beginning of the process? Incredibly it was over three years ago that the European Commission asked the first questions: is the covered bond market fractured? And could it be improved by harmonisation? They thought they would get the same answer to both of those questions, but they were wrong. 

No, there was nothing wrong with the covered bond market – the phrase of the year was ‘if it ain’t broke, don’t fix it’, but that didn’t mean it couldn’t be made better by a harmonised framework. The problem was that the limited upside of harmonisation was overshadowed by the risks of getting the harmonisation wrong. Those two themes – trying to find an upside whilst avoiding a downside have dominated the conversation ever since. There is a trade-off. The more you avoid doing damage, the less you actually do. ‘Principles based’ and ‘rules based’ are not binary concepts – they are two ends of a continuum. 

It feels like we are moving towards the maximum benefit compatible with absolutely no damage to existing markets. Whilst that feels like an inevitable outcome, it isn’t. In the securitisation market they have clearly gone much further towards ‘benefit’ at the expense of ‘damage’ – hence the headline in GlobalCapital ‘European Authorities scramble rescue attempt as securitisation regulation looms’. The securitisation regulations which come into force on 1st January are such a high standard that it is impossible for many programmes to meet them. Good for the long-term health of the market but massively disruptive in the short term.

The securitisation market is clearly starting from a very different place, and it doesn’t have the political support, goodwill or (being controversial) systemic importance that would have made an outcome like that unthinkable for the covered bond market.

But is the benefit, limited by the ‘do no harm’ principle, actually worth all of the effort to get there? How will we feel about the process in five years time?

A problem with that question is that the benefits are more difficult to measure than the costs. Legal bills, payments to bond holders to consent to programme changes, passing laws through parliament all have costs which are obvious, and in many cases quantifiable. 

The benefits? Harmonisation, market confidence, standardisation are all tricky things to quantify. The way that I look at it though is this: what would be the benefit if the directive saved just one basis point? I’ve done the maths for you, assuming a €2.5trillion market with a duration of 6, it works out at about €1.5bn.  Of course, an issuer’s basis point saved is an investor’s basis point lost. But if investors require one basis point less to invest then the market must be one basis point better.

Now, two totally unverifiable hunches. Firstly, that unquantifiable benefit will be more than one basis point. Secondly, those upfront costs will be less than €1.5bn. So probably, in five years time we will be better off for having done this, but we might not be able to measure that.

There is also the risk that when we assess the directive we will compare the covered bond market in 2023 with the covered bond market in 2018 and see little change. But that is the wrong comparison. Better to compare the covered bond market in 2023 with what the covered bond market would have looked like in 2023 without the directive. I suspect that, with the emergence of new technology, issuers and asset classes, that comparison will justify the directive even more.

Perhaps then, we aren’t wasting our time.

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