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The devil is in the cliché (3): not liquidity buffers again?

10 May 2019
Richard Kemmish

The covered bond directive has a surprisingly large number of paragraphs that make normal people question the intent. The new rules on liquidity buffers have provoked the most questions of any article in the entire directive.

Before I say anything: this is not another rant about double count between covered bond liquidity buffers and bank LCR buffers. That’s (sort of) solved now. Paragraph 4 lets you off the hook – you don’t have to implement the rest of article 16 until the EBA gets around to amending the LCR rules to allow netting of cover pool liquidity from LCR requirements.

No. But there are plenty of other aspects of the liquidity rules that are potentially problematic.

The article requires that the liquidity assets are in the cover pool so thinks that they must be safe until at least the date of the liquidity outflow that they are there to cover. Whilst in most cases assets in a cover pool are secure and can only be removed with various safeguards there are situations where that isn’t necessarily the case. Derivative counterparties, for example, typically have to post assets into cover pools to cover the value of their derivative exposure. If these assets meet the criteria for use in the liquidity buffer they can be used in this calculation, even though they can be removed at the swap counterparties whim if the value of the derivative falls.

Also, I’m guessing that the collateral letter in support of the swap probably doesn’t typically require that collateral posted meets the requirements of the covered bond directive. Whilst that’s fine in a ‘business as usual’ scenario – the issuer will simply put other liquidity assets in the bucket – it fails in the scenario where the derivative counterparty suddenly decides to switch from posting eligible assets to posting ineligible ones.  It isn’t difficult to think of scenarios where that would be correlated with the sort of period of market instability that liquidity buffers are supposed to be there for.

Secondly, liquidity buffers were designed for, and work best in countries with a high proportion of relatively small bonds and a lot of fixed amortisation assets. In those cases both the outflows and inflows from the programme are likely to be quite well matched.

The rules don’t work so well in most of the newer covered bond regimes for two reasons. Most countries have mortgages with a right to (and practice of) early amortisations. Pay down rates are relatively predictable, even if they aren’t compulsory. But that means that they can’t be relied on when calculating liquidity needs. Furthermore, most of the newer jurisdictions don’t have access to as many small ticket private placement investors – ‘your’ friendly local Sparkasse for example – so have lumpier repayment profiles. In the extreme case of a programme with a single bond (and there are some), the entire cover pool will need to be liquid assets for the last six months of the bond. Expensive.

Before the directive these issuers, along with their rating agencies and their supervisors came up with more efficient ways to mitigate the liquidity risk. Only one of these is still available, and that is the third concern raised about the new liquidity rules: extendible maturities.

But that warrants an entire post for itself. 


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