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After 4%: what should replace it?

01 March 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, a couple of pieces on this limit. Secondly, if 4% is to be dropped, what next?


In my previous article I discussed why Singapore felt an urge to impose a cap of 4% on covered bond issuance and decided that most of the possible reasons depended on the institution in question rather than the market as a whole. But whether the 4% limit should be relaxed for all Singaporean banks or just for a select few, the next question is, what should replace it?

The easiest (lamest?) replacement for a too strict and arbitrary cap is a less strict but still arbitrary cap. Let’s say 4% is replaced by 8%. There has to be a better alternative.

One possibility, which follows on from my previous article, is that issuance caps should be issuer specific and should be a function of the credit worthiness of the bank in question and their current levels of encumbrance. If a bank has a tier 1 capital of at least X% and can demonstrate unencumbered assets that are eligible for repo of at least Y% of it’s balance sheet then it can issue covered bonds equal to Z% of it’s balance sheet.

Couple of problems with this. Firstly, the limits all feel a bit arbitrary until someone (smarter and less lazy than I) creates a model to calibrate X, Y and Z. If such a model can be devised, is it and therefore the calibrations of X, Y and Z published? Or are banks notified of their issue limits privately?

Secondly, what happens when a bank falls from one category to another? If an ability to issue covered bonds is inversely related to creditworthiness there is a risk that such a rule becomes pro-cyclical. No regulator wants to introduce a rule like that.

Another alternative, that achieves a similar effect, is that issuance should be unlimited, but that issuance above a given level should be reflected by higher pillar 2 capital requirements. We avoid the procyclicality in the previous case but create an incentive for banks with more covered bond funding to become safer banks. Then it’s a commercial decision for each bank what their optimum level of covered bond funding / incremental capital charge is. This reflects their cost of capital and the saving from covered bond issuance. To my knowledge this hasn’t been tried anywhere but it feels like a rational answer.  

An alternative to changing the level of the cap is changing the way that it is calculated. Outstanding covered bonds as a percentage of total balance sheet is a simple measure. But it is also a measure that ignores the relative level of over-collateralisation in the programme which – arguably – should be the real concern for other creditors. If bank A borrows 100 using 120 of mortgages and Bank B borrows the same but with 110 of mortgages, the current method of calculation would treat them in the same way. But Bank A’s creditors are clearly in a far worse position in insolvency.

Could total issuance capped at 4% of balance sheet be replaced by total over-encumbrance of 1% of balance sheet? Again, hasn’t been tried bit feels like it should be.

I have no answers. But I’m interested to hear the thoughts of market participants in Singapore at the Euromoney Asian Covered Bond Forum on 12th March.

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