As I’m asked about the optimal choice of covered bond model quite frequently, I thought I’d share a few thoughts, starting with the oldest.
‘Special bank’ always used to sound good, didn’t it? Until ‘special’ increasingly became a euphemism (special measures, special needs, special situations), now it sounds like a polite way of saying a bad asset work-out bank.
Which of course it is not, at least in the covered bond usage of the word.
The special bank is certainly the oldest model. Those of us over a certain age will remember that the association of Pfandbrief issuing banks used to be called the association of mortgage banks – they were more or less synonymous with one another. But what happened in Germany is an indication of the reason for the special bank model’s fall from dominance to its current (dare I say it?) unfashionable status.
Before I get complaints about that comment lets reiterate the strengths of the model. We already know that special banks combine the bankruptcy remoteness of an SPV with day to day practical stuff, like capital and the ability to function independently. The traditional special bank model cost-benefit analysis has recently been augmented by greater clarity of treatment in the bank recovery and resolution directive and, in many countries exemption from onerous rules and costs that less special, deposit taking banks suffer.
The other, frequently overlooked and growing advantage of the model is that in some (not all) countries the special banks are better placed to refinance bonds via central bank repo, a useful tool that segregated covered bond pools don’t have (and by that I mean both the SPV model and the direct issuance model after the issuing bank has failed and the ringfence round the assets enforced. In both cases investors end up with an orphan asset pool to refinance).
This all comes at a cost. As anyone that has ever structured one of these knows that is in terms of both time and financial costs. This is one of the two biggest drawbacks of the model. High upfront costs effectively close out issuers with smaller financing needs over which they can amortise the expense. In one country that operates the special bank model last year I heard some very strong arguments against covered bonds in general from an issuer who was excluded by the costs of the model chosen there.
As so many of the countries that have come on line in the last decade or so are either smaller or have a smaller expected use for covered bonds, the cost consideration becomes more significant.
The other objection to special banks, and a cause for it’s decline in some existing cases is mission creep. Quite simply, the origination of very narrowly defined assets and their funding in very heavily regulated markets is just too dull – so can be livened up only by stretching the boundaries. With those boundaries unfenced the special bank can start to look like a universal bank, which requires the creation of special extra protection like a credit ringfence around the assets. Which leads on to model 2…