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After 4%: when is it right to change issuance limits?

27 February 2019
Richard Kemmish

One of the features holding back the Singaporean covered bond market’s development is a prudent one – a limit on covered bonds at 4% of an issuer’s balance sheet. Ahead of the Asian covered bond forum in Singapore next month, a couple of pieces on this limit. Firstly, is it time to modify it?


We want our supervisors to err on the side of caution, particularly when new financial instruments are concerned, and particularly in a jurisdiction that has a good reputation to maintain. But the ‘2% of balance sheet’ cap on covered bond issuance that the Singaporean regulator initially proposed was clearly too cautious – it also looked like a highly arbitrary ‘strictest rule in the world, doubled’ - so 4% it was, and has been ever since. Now that the Singaporean covered bond market is approaching maturity, is it time to reconsider? And what boxes need to be ticked before we think again?

To answer that question, it is first necessary to ask why the limit is there in the first place?

Ostensibly, caps on covered bond issuance are designed to prevent excess subordination of unsecured creditors – who want fair access to the assets of the bank in an insolvency scenario. This doesn’t hold up to much analysis. The impact of 4% covered bond issuance on the expected loss given default for unsecured creditors is close to negligible and certainly far less than the positive impact for all creditors of that same bank having access to the crisis resistant funding from the covered bond market. That is a stronger argument in countries with weaker credit ratings than Singapore (that is, more or less all of them), as access to central bank funding – the alternative emergency funding - is more resilient in well rated countries in a crisis, so the PD benefits of having a covered bond programme, less. But even so.

But if this is the real reason for the cap then presumably it can be relaxed on an idiosyncratic basis – well rated banks can issue more covered bonds than weaker banks. This is essentially the Italian rule (even if subsequent events have since nullified it).

A related reason for a cap on covered bond issuance – and another one that doesn’t stand up to much analysis – is the requirement for a set amount of unencumbered assets to form the basis for emergency funding. Again, this would require limits to be relaxed on an idiosyncratic basis, but this time on the basis not of a bank’s creditworthiness but of the extent that it’s assets are in hock already.

The 4% limit has only been applied in newer jurisdictions. Older jurisdictions including many favoured by unsecured creditors frequently have far higher levels of covered bonds outstanding. Arguably, 4% is limiting the rate of increase in encumbrance – jumping from 0% to 4% covered bond funding could be symptomatic of the same sort of factors as a bank jumping from 50% to 54%. Like caffeine consumption, absolute levels don’t matter as much as the rate of change.

What sort of symptom? There are many potentially problematic ones – reducing reliance on  retail deposits or an over-rapid increase in mortgage lending were both been correlated with sudden increases in covered bond issuance before the crisis.

If rate of change is the rational for the cap then maybe a supervisor needs to consider the reasons for the increase in funding, but again it needs to be on an idiosyncratic rather than a systemic basis.

But not all of the ‘boxes that must be ticked’ before the 4% rule is changed are bank specific. Some might be about systemic considerations. 

It is fair to argue, for example, that the increase in Spanish house prices to unsustainable levels in the years immediately preceding the financial crisis was facilitated (if not actually caused) by covered bond funding – the increase in cedulas outstanding roughly matched the total expansion of credit to the sector from 2003 to 2007. The impact on Spanish house prices, you already know.

But there are surely better ways to regulate mortgage credit expansion than arbitrary limits on covered bond issuance; counter-cyclical capital buffers and/or higher risk weights for residential mortgages for example.  

Perhaps the strongest argument for the 4% rule, and the one that has so clearly gone away though, is the need for an orderly market. In a culture that values order and consensus, a free for all of banks issuing as many covered bonds as they can get away with would have been, at best, unseemly, at worst detrimental to Singapore’s reputation and spread levels. Now that Singaporean covered bonds have reached maturity and are so well regarded internationally, I think it is safe to say that this risk has passed.

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