Covered Bond & RMBS Comment – Basel Rules

by: Joost Beaumont

  • Stakeholders finally reached agreement on new Basel Rules
  • They propose global risk weight of 10% for covered bonds
  • This will benefit all non-EU covered bonds, and could help in Brexit
  • However, nominal OC needs to be at least 10%
  • Capital requirements will increase for Dutch banks
  • But they seem well positioned to absorb the increase
  • Long phase-in period also helps in this respect

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Covered bonds get global risk weight of 10%

The new Basel framework (or the update of Basel III) has finally reached agreement among all stakeholders. For covered bonds, the Basel report is rather favourable. It notes that actually all covered bonds with a rating of at least AA- will become eligible for a 10% risk weight treatment (please see table from BIS report below). Currently, non-EU covered bonds with such ratings have a risk weight of 20%. So, this is likely to support demand for non-EU covered bonds from bank treasury desks, although this will also only be effective from January 2022 onward. What is more, the non-EU treatment of covered bonds is also very timely considering the Brexit negotiations

However, to be eligible for a 10% risk weight treatment, nominal OC should be at least 10%. In case, national regulators have set the OC requirement below 10% (e.g. the Dutch requirement is 5%), the covered bond issuer need to show on a regular basis that nominal OC is indeed at least 10%. The BIS has also set requirements on the assets in the pool, but these merely mirror already existing legislation. This is also the case for reporting requirements.

 Basel rules will increase capital requirements for Dutch banks

The main conclusion from the new Basel rules is that internal based risk models will still allowed to be used, although they will be bound to an output floor of 72.5% of the external based models. Furthermore, one of the hottest potatoes for Dutch banks were the new risk weights for residential mortgages. As expected, these will increase, albeit slightly less than the proposals in earlier drafts. Using a whole-loan approach, risk weights for residential mortgages will be the following:

The new Basel rules will become effective from 1 January 2022, while the phase-in period of the output floor will take until January 2027 (i.e. the output floor will rise by 5% per year from 50% in 2022 to 70% in 2026, before being fixed at 72.5% in 2027). Overall, this will provide sufficient time for banks to prepare for the new rules, limiting any impact.

The Dutch central bank welcomed the new rules and noted that they will result in a significant increase in capital requirements for Dutch banks, and the larger banks in particular. However, the central bank expects that banks can meet the higher capital requirements by using retained earnings in coming years. This also reflects the already strong capital position of Dutch banks.

Indeed, the Dutch Banking Association echoed the view of the central bank by saying that Dutch banks should be able to absorb the increase in capital needs. However, it still pledges for some reduction in risk weight requirements now that the new Basel rules need to be implemented in European Law. This provides EU policymakers with the opportunity to change the Basel rules somewhat regarding EU banks. The Association writes that ‘Dutch banks still have concerns about an international level playing field for banks. When implementing the proposals, the European Union should take differences between countries and sectors into account.’

So, overall, it seems that Dutch banks are well positioned to implement the new Basel Rules, and we have to wait for the final implementation of the rules in EU law to see whether requirements will be slightly eased in the end. The long phase-in period will provide banks with sufficient time to comply with the rules.

Covered bond market moving in Christmas mode

Activity in the euro benchmark covered bond market seems to slow by the day. There was no activity in the primary market, while we saw some investors selling semi-core as well as peripheral paper in the 5y to 10y tenors in the secondary market.

This was the last comment of this year. We would like to take the opportunity to thank you for your support and to wish you all a happy festive season and a prosperous 2018. We will be back early next year.

 

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