Covered Bond Regulation

What is a covered bond?

Covered bonds are bonds issued by a credit institution in a member state, subject by law to special public supervision designed to protect bondholders. Sums from the issue of those bonds shall be invested in accordance with the law in assets, which in the vent of failure of the issuer, would be used to pay the principle and accrued interest.

How do banks allocate capital?

• Standardised approach – the risk weight of a covered bond of any given credit rating is one category better than a similarly rated non-covered bond. For example, a Triple A rated covered bond has a 10% risk weight, rather than 20%.
• Internal Ratings Based Approach – a formula is used to determine a bond’s risk weight. Covered bonds are allowed to use a preferential loss assumption of 11.25%.

Where does the capital saving, for a bank holding a covered bond, come from?

• There is a lower risk weighting of a covered bond compared to the right weighting of an unsecured bank bond
• Covered bonds provide a ratings uplift

What is the Liquidity Cover ratio?

Banks have to hold a pool of very liquid, high quality assets to cover their cash outflows over the next 30 days. According to the EBA, this typically is 10% or more of the bank’s entire balance sheet.

How are these assets split into categories?

• If a bond is rated at least Double A minus or has a minimum size of 500m euros outstanding, it is held in the highest – level 1 category of assets
• If it is smaller, down to 250m euros, or rated single A, it can qualify for the level 2A as long as it has a minimum over-collateralisation of 7% (if it is rated single A)
• Other covered bonds that don’t meet these criteria qualify for the lowest category – level 2B

What are the rules for insurance and mutual fund investors?

Insurance companies are subject to regulation under the Solvency 2 rules. It looks at the risks concerning credit risk. They look at how much an insurer might lose because of movements in credit spreads in the assets they hold. Covered bonds are also relevant to rules limiting concentration risks in an insurer’s portfolio.

For mutual funds (UCITS): for qualifying bonds, funds are exempt from the normal rule limiting them to 5% of their portfolio in the bonds of any one issuer. For covered bonds this can be up to 25%.

What are some other rules investors face?

• EMIR exempts covered bond swaps from clearing obligations
• Covered bonds are exempt from bail-in under the Bank Recovery and Resolution Directive