RECOMMENDATION OF THE EUROPEAN SYSTEMIC RISK BOARD

of 20 December 2012

on funding of credit institutions

(ESRB/2012/2)

2013/C 119/01

THE GENERAL BOARD OF THE EUROPEAN SYSTEMIC RISK BOARD,

Having regard to Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board (1), and in particular Article 3(2)(b), (d) and (f) and Articles 16 to 18 thereof,

Having regard to Decision ESRB/2011/1 of the European Systemic Risk Board of 20 January 2011 adopting the Rules of Procedure of the European Systemic Risk Board (2), and in particular Article 15(3)(e) and Articles 18 to 20 thereof,

Whereas:

Funding conditions for credit institutions have been significantly affected by the current crisis. Credit and interbank markets have remained impaired as a result of the strong links between credit institutions and sovereigns as well as the uncertainties over asset quality and the sustainability of some credit institutions’ business models. Credit institutions have responded to this situation by making changes to their funding structures and asset portfolios.

On 29 June 2012 the euro area summit took an important step towards breaking the negative link between sovereigns and credit institutions. It envisaged a single supervisory mechanism and the direct use of European funds from the EFSF and ESM for bank recapitalisation/bailout and resolution. However, certain credit institutions still weigh negatively on sovereigns, and vice versa. This vicious circle needs to be broken in order to bring about the better functioning of the funding markets.

In order to improve funding conditions it is necessary to re-establish the resilience of credit institutions and confidence in them. The recommendation of the European Banking Authority (EBA) for a minimum 9 % Core Tier 1 capital ratio for credit institutions (3) has partly contributed to this aim. However, the current macroeconomic outlook imposes further strains on credit institutions’ balance sheets.

The ongoing reform of the European Union regulatory regimes governing credit institutions (CRD IV package (4) , in particular its provisions regarding the liquidity regime and the framework for recovery and resolution (5) ) remains at the negotiation stage. The date on which the proposed packages will receive final approval and enter into force remains uncertain, as does the nature of the interrelations among the different instruments. Achieving clarity as to the regulatory framework would be beneficial not only for the credit institutions subject to it but also for investors.

While public authorities, in particular central banks, have used extraordinary measures to reduce funding strains and create the conditions for credit institutions to strengthen funding structures in the future, credit institutions also need to actively strive to achieve sustainable funding structures.

The monitoring and assessment of credit institutions’ funding risks and funding risk management by national supervisory authorities is fundamental to the evaluation of the institutions’ capacity to execute their own funding plans and reduce reliance on public sector funding sources. Likewise, the monitoring by national supervisory authorities of the recourse to innovative instruments and to the provision of uninsured deposit-like financial instruments may contribute to the timely detection of risks, allowing for further supervisory actions to be taken whenever necessary.

The introduction of risk management policies on asset encumbrance is vital to ensure that credit institutions follow their own encumbrance levels and are therefore better able to cope with possible stress situations.

The monitoring of asset encumbrance by the national supervisory authorities should cover encumbered assets and unencumbered but encumberable assets, as well as the sources of encumbrance, and the policies and contingency plans developed by credit institutions.

Market transparency contributes to addressing asymmetric information. Information which is clear, simple and easy to compare is required in order to allow market participants to better differentiate risk profiles in terms of encumbrance.

Market participants are subject — when applicable — to disclosure requirements based on International Financial Reporting Standard (IFRS) 7 (6) . It would be appropriate at the same time to broaden the range of credit institutions disclosing information, to widen the disclosure to all means of encumbrance, to enhance the terms of disclosure and to create more uniform practices.

The proposed terms for disclosure aim at preventing credit institutions from being subject to stigma effects and for this reason, central bank operations should not be disclosed in any way.

The identification of best practices by the European and national supervisory authorities facilitates comparison of different issuances of covered bonds and contributes to better-informed risk analysis. The identification of best practices in respect of other financial instruments that generate encumbrance can contribute to similar improvements in these other markets. The acquisition of both types of instrument will be more appealing for investors as the costs involved in understanding the regulatory framework governing them would be lowered. Accordingly, it is desirable to incentivise the use of best practices at the highest quality standards.

The Commission proposal for the establishment of a single supervisory mechanism (7) (as agreed by the Council on 12 December 2012) envisages conferring specific supervisory tasks necessary for supervision of credit institutions on the European Central Bank (ECB). For the purposes of carrying out these tasks, the ECB will be considered the competent authority under the relevant acts of Union law and have the powers and obligations which competent authorities have under those acts.

The Annex to this recommendation analyses the significant systemic risks to financial stability within the Union arising from the funding of credit institutions.

In accordance with recital 29 of Regulation (EU) No 1092/2010, the observations of the relevant private sector stakeholders have been taken into account in preparing this recommendation.

This recommendation is without prejudice to the monetary policy mandates of the central banks within the Union.

Recommendations of the European Systemic Risk Board are published after informing the Council of the General Board’s intention to do so and providing the Council with an opportunity to react,

HAS ADOPTED THIS RECOMMENDATION:

SECTION 1

RECOMMENDATIONS

Recommendation A — Monitoring and assessment of funding risks and funding risk management by supervisors

monitor the level, evolution and behaviour of uninsured deposit-like financial instruments, which are sold to retail customers, and their potentially negative effects on traditional deposits.

monitor the development of funding structures in order to identify innovative instruments, request information on such instruments and analyse the information obtained to understand how risks may shift within the financial system;

assess the funding plans provided by credit institutions and their feasibility for each national banking system, on an aggregated basis, taking into account the business model and risk appetite of each institution;

National supervisory authorities with responsibility for banking supervision are recommended to intensify their assessments of the funding and liquidity risks incurred by credit institutions, as well as their funding risk management, within the broader balance sheet structure, and should in particular:

National supervisory authorities with responsibility for banking supervision are recommended to monitor credit institutions’ plans to reduce reliance on public sector funding sources and to assess the viability of such plans for each national banking system, on an aggregated basis.

National supervisory authorities and other authorities with a macro-prudential mandate are recommended to assess the impact of credit institutions’ funding plans on the flow of credit to the real economy.

The EBA is recommended to develop guidelines on harmonised templates and definitions, in accordance with its established consultation practices, in order to facilitate the reporting of funding plans for the purposes of the recommendations contained in paragraphs 1 to 3 above.

The EBA is recommended to coordinate the assessment of funding plans at Union level, including credit institutions’ plans to reduce reliance on public sector funding sources, and to assess the viability of such plans for the Union banking system, on an aggregated basis.

Recommendation B — Risk management of asset encumbrance by institutions

National supervisory authorities with responsibility for banking supervision are recommended to require credit institutions to:

Put in place risk management policies to define their approach to asset encumbrance, as well as procedures and controls that ensure that the risks associated with collateral management and asset encumbrance are adequately identified, monitored and managed. These policies should take into account each institution’s business model, the Member States in which they operate, the specificities of the funding markets and the macroeconomic situation. The policies should be approved by each institution’s appropriate management bodies.

Include in their contingency plans strategies to address the contingent encumbrance resulting from relevant stress events, which means plausible albeit unlikely shocks, including downgrades in the credit institution’s credit rating, devaluation of pledged assets and increases in margin requirements.

the amount, evolution and credit quality of unencumbered but encumberable assets, specifying the volume of assets available for encumbrance;

the level, evolution and types of asset encumbrance and related sources of encumbrance, such as secured funding or other transactions;

Have in place a general monitoring framework that provides timely information to the management and the relevant management bodies on:

Recommendation C — Monitoring of asset encumbrance by supervisors

monitor the level, evolution and types of asset encumbrance and related sources of encumbrance, such as secured funding or other transactions;

review the monitoring frameworks, policies and contingency plans put in place by credit institutions in terms of encumbrance and collateral management;

National supervisory authorities with responsibility for banking supervision are recommended to closely monitor the level, evolution and types of asset encumbrance as part of their supervisory process, and should in particular:

National supervisory authorities with responsibility for banking supervision are recommended to monitor and assess risks associated with collateral management and asset encumbrance, as part of the supervisory review process. This assessment should take into account other risks, such as credit and funding risks, and mitigating factors, such as capital and liquidity buffers.

The EBA is recommended to issue guidelines on harmonised templates and definitions in order to facilitate the monitoring of asset encumbrance, in accordance with its established consultation practices.

The EBA is recommended to closely monitor the level, evolution and types of asset encumbrance, as well as unencumbered but encumberable assets at Union level.

Recommendation D — Market transparency on asset encumbrance

a voluntary narrative, by which credit institutions provide the users with information that may be useful to understand the importance of encumbrance in the credit institutions’ funding model.

based on the experience gained until 31 December 2014, including in implementing Recommendation C, the guidelines should be amended to require information to be provided on a semi-annual basis and supplemented by a requirement to disclose a breakdown by asset quality, provided that the EBA deems that such additional disclosure offers reliable and meaningful information;

for the first year following the adoption of the guidelines, this information should include a breakdown by asset type, provided on an annual basis;

The EBA is recommended to develop guidelines on transparency requirements for credit institutions on asset encumbrance. These guidelines should help ensure that the information disclosed to the market is clear, easy to compare and appropriate. In view of the limited experience in disclosing reliable and meaningful information on asset quality, the EBA should follow a gradual approach, with a view to moving to a more extensive disclosure regime after one year. The guidelines should request credit institutions to provide:

For the purposes of paragraph 1(a), the EBA is recommended to specify in the guidelines the features of the disclosed data, in terms of units and lag of disclosure.

ensure that the level and evolution of assets encumbered to central banks, as well as the amount of liquidity assistance given by central banks, cannot be detected.

take into account relevant developments in related topics, in particular, those relating to the liquidity regulatory framework; and

cooperate with ESMA, in order to build on the existing requirements included in IFRS with regard to asset encumbrance;

Recommendation E — Covered bonds and other instruments that generate encumbrance

National supervisory authorities are recommended to identify best practices regarding covered bonds and encourage harmonisation of their national frameworks.

The EBA is recommended to coordinate actions taken by national supervisory authorities, particularly in relation to the quality and segregation of cover pools, insolvency remoteness of covered bonds, the asset and liability risks affecting cover pools and disclosure of the composition of cover pools.

The EBA is recommended to consider whether it is appropriate to issue guidelines or recommendations endorsing best practices, after monitoring the functioning of the market for covered bonds by reference to these best practices for a period of two years. If the EBA identifies the need for a legislative proposal in this regard, it should report to the European Commission and inform the ESRB.

The EBA is recommended to assess whether there are other financial instruments that generate encumbrance which would also benefit from the identification of best practices in national frameworks. If the EBA concludes that such instruments exist, it should: (i) coordinate the identification and encourage the harmonisation of the resulting best practices by the national supervisory authorities; (ii) act as defined in paragraph 3 regarding covered bonds, in a subsequent stage.

SECTION 2

IMPLEMENTATION

1. Interpretation

‘sustainable funding structure’ means a funding structure that can be perpetuated without public intervention and in respect of which the cost of funding does not affect the viability of the institution.

‘uninsured deposit-like financial instrument’ means a financial instrument that may resemble a deposit, but which entails risks different to those of a deposit, as this financial instrument is not covered by a deposit guarantee scheme;

‘innovative instrument’ means an instrument in respect of which, due to its novelty, little information is available about its behaviour, particularly in a stress event, thus exposing credit institutions to hidden risks, such as liquidity and funding crunch and legal or reputational risks;

‘encumbered asset’ means an asset which is, either explicitly or implicitly, pledged or subject to an arrangement to secure, collateralise or credit-enhance any transaction;

‘national supervisory authority’ means a competent or supervisory authority as defined in Article 1(3)(f) of Regulation (EU) No 1092/2010. Whenever a national supervisory authority is not the competent supervisory authority, the ECB acting within the single supervisory mechanism is deemed the addressee of the relevant recommendation;

The Annex forms an integral part of this recommendation. In the case of conflict between the main text and the Annex, the main text prevails.

2. Criteria for implementation

specific criteria for compliance with Recommendations A to E are set out in the Annex.

due regard should be paid to the principle of proportionality in the implementation, with reference to the particular systemic significance of the funding and encumbrance risks within each banking system and taking into account the objective and content of each recommendation;

an assessment of the functioning of the actions undertaken in terms of the objectives of this recommendation;

Addressees are requested to report to the ESRB and to the Council on the actions undertaken in response to this recommendation, or adequately justify any inaction. The reports should at minimum contain:

3. Timeline for the follow-up

Addressees are requested to report to the ESRB and the Council on the actions taken in response to this recommendation, or adequately justify any inaction, in compliance with the timelines set out below.

by 31 March 2015: the EBA is requested to deliver a final report on the implementation of Recommendation A(5) to the ESRB and to the Council.

by 30 September 2014, the EBA is requested to deliver to the ESRB an interim report containing a first assessment of the result of the implementation of Recommendation A(5);

by 31 December 2013, the EBA is requested to deliver the guidelines referred to in Recommendation A(4) to the ESRB and to the Council;

by 31 March 2015 national supervisory authorities and other authorities with a macro-prudential mandate are requested to deliver a final report on the implementation of Recommendation A(3) to the ESRB and to the Council;

by 30 June 2014, national supervisory authorities and other authorities with a macro-prudential mandate are requested to deliver to the ESRB an interim report containing a first assessment of the result of the implementation of Recommendation A(3);

by 31 January 2015, national supervisory authorities with responsibility for banking supervision are requested to deliver a final report on Recommendation A(1) and (2) to the ESRB and to the Council;

by 30 June 2014, national supervisory authorities with responsibility for banking supervision are requested to deliver to the ESRB an interim report containing a first assessment of the result of the implementation of Recommendation A(1) and (2);

Recommendation A — National supervisory authorities with responsibility for banking supervision, national supervisory authorities and other authorities with a macro-prudential mandate, and the EBA are requested to report according to the following timeline:

Recommendation B — by 30 June 2014, national supervisory authorities with responsibility for banking supervision are requested to report to the ESRB and the Council the actions taken in response to this recommendation.

by 30 September 2015, national supervisory authorities with responsibility for banking supervision are requested to deliver to the ESRB and the Council a final monitoring report on the actions taken in response to Recommendation C(1) and (2).

by 30 June 2014, national supervisory authorities with responsibility for banking supervision are requested to deliver to the ESRB a first monitoring report on the actions taken in response to Recommendation C(1) and (2);

by 31 December 2015, the EBA is requested to deliver to the ESRB and the Council a final monitoring report on asset encumbrance for the purposes of Recommendation C(4);

by 30 September 2014, the EBA is requested to deliver to the ESRB a first monitoring report on asset encumbrance for the purposes of Recommendation C(4);

by 31 December 2013, the EBA is requested to deliver to the ESRB and the Council the guidelines referred to in Recommendation C(3) and an interim report containing a proposal on how it intends to fulfil Recommendation C(4);

Recommendation C — the EBA and national supervisory authorities with responsibility for banking supervision are requested to report according to the following timeline:

by 30 June 2015, the EBA is requested to deliver to the ESRB and the Council an additional report on the implementation of Recommendation D(1)(a)(ii).

by 31 December 2013, the EBA is requested to deliver to the ESRB and the Council the guidelines;

Recommendation D — the EBA is requested to report according to the following timeline:

by 31 December 2016, the EBA is requested to deliver a final report to the ESRB and to the Council containing an assessment of the functioning of the framework for the other financial instruments that generate encumbrance under the best practice principles, if they were identified in the interim report to be delivered under paragraph (b) of this timeline, and its view on recommended further action if deemed desirable.

by 31 December 2015, the EBA is requested to deliver a final report to the ESRB and to the Council containing an assessment of the functioning of the framework for covered bonds under the best practice principles and its view on recommended further action if deemed desirable;

by 31 December 2014, the EBA is requested to deliver to the ESRB an interim report setting out the principles of best practices for other financial instruments that generate encumbrance, if they were identified in the interim report mentioned in paragraph (b) of this timeline;

by 31 December 2013, the EBA is requested to deliver to the ESRB an interim report setting out the principles of best practice in relation to covered bonds which it has identified together with national supervisory authorities, and an assessment of the existence of other financial instruments which generate encumbrance in respect of which best practices need to be identified;

by 31 December 2013, national supervisory authorities are requested to report to the ESRB and to the Council on the actions taken in response to Recommendation E(1);

Recommendation E — the EBA and national supervisory authorities are requested to report according to the following timeline:

4. Monitoring and assessment

verifies the follow-up by the addressees, including by assisting them on request, and reports on the follow-up to the General Board via the Steering Committee.

assists the addressees, including by facilitating coordinated reporting, providing relevant templates and detailing where necessary the modalities and timeline for the follow-up;

The General Board assesses the actions and the justifications reported by the addressees and, where appropriate, decides whether this recommendation has not been followed and if the addressees have failed to adequately justify their inaction.

(1) OJ L 331, 15.12.2010, p. 1.

(2) OJ C 58, 24.2.2011, p. 4.

(3) EBA Recommendation on the creation and supervisory oversight of temporary capital buffers to restore market confidence (EBA/REC/2011/1).

(4) Proposal for a directive of the European Parliament and of the Council on the access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms and amending Directive 2002/87/EC of the European Parliament and of the Council on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate (COM(2011) 453 final), and proposal for a regulation of the European Parliament and of the Council on prudential requirements for credit institutions and investment firms (COM(2011) 452 final).

(5) Proposal for a directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directives 77/91/EEC and 82/891/EEC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EU and Regulation (EU) No 1093/2010 (COM(2012) 280/3).

(6) In Europe these standards are adopted by means of Commission Regulation (EC) No 1126/2008 of 3 November 2008 adopting certain international accounting standards in accordance with Regulation (EC) No 1606/2002 of the European Parliament and of the Council (OJ L 320, 29.11.2008, p. 1).

(7) Proposal for a Council regulation conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions (COM(2012) 511 final).

(8) OJ L 177, 30.6.2006, p. 1.

(9) OJ L 135, 31.5.1994, p. 5.

ANNEX TO THE RECOMMENDATION ON FUNDING OF CREDIT INSTITUTIONS

CONTENTS

EXECUTIVE SUMMARY

INTRODUCTION

I. EVOLUTION OF FUNDING STRUCTURES AND ASSETS

I.1. Secured versus unsecured funding

I.2. Evolution of secured funding

I.2.1. Covered bonds

I.3. Evolution of unsecured funding

I.3.1. Customer deposits

I.4. Innovative funding

I.4.1. Liquidity swaps

I.4.2. Structured products and ETFs

I.5. Public support in the current distressed conditions

I.6. Drivers for the development of funding structures

I.6.1. Impact of new and upcoming regulations on bank funding

I.7. Leverage and asset decomposition

II. ASSET ENCUMBRANCE: INPUT FROM THE SURVEY

II.1. Overall levels of asset encumbrance

II.2. Impact of over-collateralisation on levels of encumbrance

II.3. Contribution of the different transactions to encumbrance

III. RISKS

III.1. Risks from asset encumbrance

III.1.1. Structural subordination of unsecured creditors

III.1.2. Issues related to future access to unsecured markets

III.1.3. Issues related to transparency and correct pricing

III.1.4. Increased funding and liquidity risks

III.1.5. Contingent encumbrance

III.1.6. Other risks from asset encumbrance

III.1.7. Other risks related to specific products or transactions

III.1.8. Triggers for the materialisation of risks

III.1.9. Sustainability of asset encumbrance

III.1.10. Impact of asset encumbrance on the real economy

III.2. Risks from innovative funding

III.2.1. Transparency, confidence, difficulty of management and supervision

III.2.2. Interconnectedness

III.2.3. Litigation and reputation risks, consumer protection

III.2.4. Specific risks relating to liquidity swaps

III.3. Risks from concentration

III.4. Risks from deleveraging pressure

IV. SUSTAINABILITY OF FUNDING STRUCTURES (MEDIUM TO LONG-TERM PERSPECTIVE)

IV.1. Stronger role for customer deposits

IV.2. Role of wholesale unsecured and secured funding

IV.3. Features of a sustainable funding structure

IV.4. Demand and supply effects of funding

V. POLICY

POLICY OBJECTIVES

PRINCIPLES FOR THE IMPLEMENTATION OF THE RECOMMENDATIONS

FOLLOW-UP COMMON TO ALL POLICY RECOMMENDATIONS

RECOMMENDATIONS

V.1. Recommendation A — Monitoring and assessment of funding risks and funding risk management by supervisors

V.1.1. Economic reasoning

V.1.2. Assessment, including advantages and disadvantages

V.1.3. Follow-up

V.1.4. Communication on the follow-up

V.2. Recommendation B — Risk management of asset encumbrance by institutions

V.3. Recommendation C — Monitoring of asset encumbrance by supervisors

V.3.1. Economic reasoning (Recommendations B and C)

V.3.2. Assessment, including advantages and disadvantages (Recommendations B and C)

V.3.3. Follow-up (Recommendations B and C)

V.3.4. Communication on the follow-up — Recommendation B

V.3.5. Communication on the follow-up — Recommendation C

V.4. Recommendation D — Market transparency on asset encumbrance

V.4.1. Economic reasoning

V.4.2. Assessment, including advantages and disadvantages

V.4.3. Follow-up

V.4.4. Communication on the follow-up

V.5. Recommendation E — Covered bonds and other instruments that generate encumbrance

V.5.1. Economic reasoning

V.5.2. Assessment, including advantages and disadvantages

V.5.3. Follow-up

V.5.4. Communication on the follow-up

V.6. The ESRB takes note of other initiatives

VI. RESULTS OF THE SURVEY ON ASSET ENCUMBRANCE AND INNOVATIVE FUNDING: METHODOLOGICAL AND STATISTICAL NOTE

VI.1. Methodological note

VI.1.1. General description of the data set

VI.1.2. Some methodological aspects

VI.1.3. Data quality control

VI.2. Encumbrance

VI.2.1. Encumbrance levels

VI.2.2. Maturity of encumbered assets and matching liabilities

VI.3. Secured funding

VI.4. Counterparties

EXECUTIVE SUMMARY

Banks’ funding structures have undergone significant change in recent years. This Annex presents the developments in Union banks’ funding sources and structures, the risks stemming from such developments and a set of policy proposals to address such risks.

The most notable development has been the increase in the relative importance of secured funding as a consequence of investors’ risk aversion and of regulatory developments, notably the Basel frameworks for capital and liquidity and Solvency II. These developments have set the scene for rising demand for collateral (including from public sector funding sources) with a tightening supply of quality collateral, at a time when banks need stable funding sources to maintain their lending into the real economy. The heightened investor uncertainty associated with the current sovereign debt crisis has led banks to rely increasingly on public sector funding sources, while central banks have responded with extraordinary measures that have included longer-term operations and extended lists of collateral.

Banks have also increased reliance on, and competition for, customer deposits. Increased reliance on deposits has been partially successful; it has also been accompanied by risks, as deposits may become more volatile with competition and customer offerings have become more innovative and not always well understood. Finally, a few banks have moved to innovative products, notably liquidity swaps, in order to obtain funding at competitive prices. In an attempt to review these phenomena comprehensively, the Annex contains an assessment of the sustainability of funding structures as well as of their impact on the financial sector and on the real economy.

The Annex highlights and reviews three sources of risks in greater depth: (1) asset encumbrance; (2) innovative funding; and (3) concentration.

Secured funding has proved to be a lifeline for banks during the current period of stress, as it allows for diversification of funding sources and decreases counterparty risk. While recognising the benefits derived from secured funding during the crisis, the Annex also assesses the risks of an excessive encumbrance level. First, it implies further subordination of other creditors, in particular depositors, which has consequences in terms of potential usage of funds from deposit guarantee schemes. High levels of encumbrance may also negatively affect future access to the unsecured markets and create challenges in pricing risks correctly, with implications for efficient resource allocation. In addition, contingent encumbrance tends to be pro-cyclical since it increases in stress periods as a result of automatic increases in collateralisation requirements. More broadly, system-wide increases in encumbrance create difficulties in liquidity and funding management and reinforce the risks related to collateral reuse. Further difficulties are associated with the effective management and oversight of institutions with high encumbrance.

Innovative funding tends to be less transparent and, as a result, more difficult to manage and supervise. Given the potential opaqueness, there are also increased chances of the materialisation of litigation and reputation risks, primarily if these products are sold to retail consumers. Risks from concentration are analysed from four different perspectives: the investor base, instruments, maturity profiles and geographical scope.

Viewing funding structures from a holistic perspective, it is argued in the Annex that a well-diversified funding structure is crucial to guaranteeing credit institutions’ capacity to withstand stress events. This implies avoiding over-reliance on individual funding sources and, in particular, on secured funding. Furthermore, it requires that institutions also take account of the actions of other institutions in determining their capacity to implement their funding plans, in particular with regard to reliance on customer deposits, which, owing to increased competition, may become a less stable funding source. There is already evidence of credit institutions resorting to retail funding instruments, which may look similar to deposits but which entail different risks as they may not be covered by deposit guarantee schemes.

On the basis of the analysis undertaken, several policy recommendations are made.

In the short run, given the still impaired market conditions and credit institutions’ need to develop robust funding plans, national supervisory authorities and the European Banking Authority (EBA) are recommended to monitor and assess funding and liquidity risks and the viability of funding plans, on aggregate, at national and Union levels respectively. At this juncture, authorities are, in particular, recommended to assess institutions’ plans to reduce reliance on public sector funding sources. When analysing funding and liquidity risks, authorities are advised to pay special attention to the use of innovative instruments that may pose systemic risks and to consider the risks of uninsured deposit-like instruments when sold to retail customers and their possible negative effects on traditional deposits.

A key thrust of the proposals is to address issues of encumbrance with a comprehensive strategy. In the short run, it is suggested that a concerted effort be made to further improve credit institutions’ management of liquidity and funding risks where encumbrance is involved. Supervisors are also recommended to be more consistent in their monitoring and assessing of the levels, evolution and types of encumbrance, as well as of the effect on encumbrance of stress events. Importantly, a recommendation on market transparency is included to address the supply of funding by facilitating the better pricing of risks, in particular those related to encumbrance.

Considering the relative importance that covered bonds have assumed in banks’ funding structures and the risks identified for these instruments, for instance in terms of legal uncertainties in some Member States and differences in disclosure habits, national supervisory authorities are recommended to incentivise the implementation of best practices, either public or private. Following this first stage, the European Banking Authority is recommended to coordinate such initiatives and to identify best practices as well as to consider the functioning of the marketplace in accordance with the principles identified. It should also consider whether it is appropriate to use its own powers as formal mechanisms for imposing such best practices or to refer the matter to the European Commission for potential further action, taking into account the potential impact on otherwise well-functioning markets. In a second phase, it is recommended that the EBA consider whether there are other financial instruments that also encumber assets that would call for a similar approach.

Without proposing formal recommendations to stimulate other funding markets, the ESRB takes note of some private initiatives, for instance with regard to the labelling of securitisation and covered bonds, as these may help to restore confidence in certain financial products.

INTRODUCTION

The recent crisis has its roots in the events of 2007-08 when developments in wholesale and retail markets exposed the vulnerabilities inherent in some asset classes (e.g. subprime residential mortgages in the United States and elsewhere) and in some business models (e.g. reliance on short-term wholesale funding). The crisis has subsequently morphed and extended over a lengthy period. In the Union and, in particular, in the euro area, the current vulnerabilities of some sovereigns, together with fragilities in some banking systems, have negatively reinforced themselves in a context of poor economic growth. In this setting, the strong link between bank and sovereign funding costs, combined with uncertainties over the asset quality of some banks and the sustainability of their business models, mean that credit and interbank markets have remained impaired and that banks have faced difficulties in managing their balance sheets.

Against this background, public authorities have intervened, with central banks implementing decisive measures to allow banks to fund themselves and with supervisors taking steps to shore up capital levels, improve transparency and tackle asset quality.

To cope with this situation, banks have also responded by making changes in their funding structures and in their asset portfolios. This Annex also devotes attention to changes in banks’ funding sources and structures and assesses whether such developments pose systemic risks.

This Annex reviews the funding structures of EU banks and how they have evolved in recent years and focuses on the increasing role played by secured funding and by other collateralised transactions and their consequences in terms of asset encumbrance. Potentially in response to the crisis, a few banks have also turned to more innovative funding sources, which are frequently opaque and in some cases can have an impact on asset encumbrance. Finally, the Annex examines more broadly the consequences of these developments in relationship to the sustainability of banks’ funding structures.

The Annex contains an assessment of whether and how these developments warrant policy attention. It concludes that some of these risks are significant and therefore presents policy options. These options take due account of the nature of the current situation, which is still one of crisis and market instability and therefore requires special care.

This analytical exercise makes use of several different data sets in order to better depict the evolution and current state of affairs. Although banks’ balance sheets are monitored by supervisors and other public authorities and are subject to market transparency rules, it was necessary to conduct an ad hoc survey to obtain information, particularly on the levels and types of encumbrance and on innovative funding sources.

This Annex is organised into six sections. Following the introduction, Section I presents the evolution and current state of EU banks’ funding structures. Section II is devoted to the analysis of the data on asset encumbrance collected by the ESRB. The analysis of the risks entailed in such evolution is discussed in Section III. Section IV addresses more broadly the issue of the sustainability of funding structures and Section V concludes with the ESRB’s policy recommendations. A methodological and statistical annex on the ESRB survey on asset encumbrance and innovative funding is included (Section VI).

I. EVOLUTION OF FUNDING STRUCTURES AND ASSETS

The evolution of funding sources and structures in recent years cannot be analysed separately from the context of the current, long-lasting crisis. In response to severely impaired credit and interbank markets and in a context of vulnerabilities in both sovereigns and financial systems, particularly in the euro area, banks have adapted both their funding structures and their asset portfolios.

If the funding structure of the balance sheets of euro area banks (1) as of the end of 2011 is compared with that prevailing before the financial crisis (as of the end of 2005), it can be concluded that deposits, excluding intra-monetary financial institutions (MFIs), still represent the largest percentage of banks’ liabilities (see Chart 1). Moreover, since 2008, the percentage of customers’ deposits in banks’ liabilities has been increasing, as have the maturities of those deposits (2) (see Section I.3.1).

Chart 1

Liabilities breakdown: 2005 vs 2011

Since 2005 liabilities have been restructured increasing the share of intra-MFI deposits. In fact, on the basis of financial transactions data, deposits have increased by 12 % since the end of 2005.

However, it should be pointed out that this statistical component encompasses central bank funding. Following the policy response by central banks and other public authorities to the impairment of credit and interbank markets, recourse to central bank funding and to the Eurosystem in particular, as well as reliance on state-guaranteed debt, have increased significantly in recent years (see Section I.5).

The third most relevant item is long-term debt securities, which accounted for 14 % of total bank liabilities. In terms of debt securities, in the past few years there has been a shift in banks’ funding structures towards secured funding, including covered bonds (see Sections I.1 and I.2). Deteriorating market confidence has also led to a significant reduction in cross-border interbank transactions, which has been reflected in shorter maturities and higher borrowing rates. This resegmentation within national boundaries is still ongoing.

It is possible to conclude that, for a small sample of surveyed banks (3), the recomposition of liability structures is dependent on the banks’ rating (and inherently on the sovereigns’ rating), with more vulnerable banks or banks in more vulnerable sovereigns experiencing a higher increase in secured funding (which includes central bank funding) and a decrease in the reliance on unsecured debt instruments. These banks also seem to have strengthened their deposit base more than the higher rated banks (see Chart 2).

Chart 2

Structure of funding for groups of banks with different ratings, end-2007 and end-2011

These changes in banks’ liabilities are also a reflection of a change in business models. Before the crisis, EU banks mostly pursued asset-driven strategies, leading to excessive leverage, as funding was readily available at low prices, especially in wholesale markets. The crisis and its implications for the availability of liquidity and funding forced a strategic turnaround for banks, which have shifted to liability-driven strategies.

I.1. Secured versus unsecured funding

Issuance of medium and long-term debt by banks has been significantly down from late 2007 onwards compared to the pre-crisis decade. While the financial crisis adversely affected both unsecured and secured funding markets, the issuance by Union banks of covered bonds has proved much more resilient over the past few years than that of senior unsecured debt (see Chart 3), resulting in a shift towards more secured issuance (see Chart 4). This increasing trend reversed in 2012, partly due to the fact that market access for peripheral issuers, which accounted for a significant part of the increase in covered bond issuance in 2010 and 2011, was restricted for most of the year.

Chart 3

Change in the issuance of covered bonds and senior unsecured debt (2007-11; index 2007 = 100)

Chart 4

Share of secured and unsecured debt issuance (2009 — Sep. 2012; percentages)

This broad trend conceals differences in developments across countries and across banks. In the past few years, the issuance of banks in more vulnerable countries has suffered more than in other countries. Banks in those countries also resorted more significantly to secured instruments (frequently retaining the instruments to use as collateral) and to guaranteed instruments (in particular those guaranteed by the state). Lower rated banking groups, even when located in stronger sovereigns, faced more difficulties in obtaining wholesale funding in private sector markets.

Turning to interbank funding, euro money market survey data (4) show that, after years of continuous growth, total activity in the unsecured markets started to fall in 2008 and dropped significantly further in 2009-10 as a result of heightened counterparty risk concerns. While unsecured borrowing increased somewhat in 2011, it still remained well below pre-crisis levels. The decline in the relative share of unsecured lending also continued in 2012, when the turnover in the unsecured markets contracted by 36 %. The decline in unsecured interbank borrowing was offset to some extent by an increase in repo funding, which, after a drop in 2008, started to grow in 2009; however, it declined again by 15 % in 2012. The relative resilience of secured market activity can be attributed, in part, to the increased use of electronic platforms and, in particular, of trading facilities with central counterparties (CCPs) for secured transactions. According to survey data, activity in the secured market cleared through CCPs has increased markedly since 2008; in 2012 it already accounted for 55 % of secured market transactions (compared with 51 % in 2011).

I.2. Evolution of secured funding

The amount of EU banks’ secured debt outstanding (excluding Germany) was relatively stable between the end of 2009 and the first quarter of 2012, although this masked the difference in developments across the Union, with increases in several countries (e.g. Spain, Italy and Sweden) contrasting with declines in others (e.g. Ireland, the Netherlands and the United Kingdom) (5).

At the same time, some banks started increasing the issuance of retained securitisation or covered bonds in order to use those instruments as collateral, in particular for refinancing operations with central banks (see Section I.5 for further details). In particular, between 2011 and 2012, lower-rated institutions resorted more to this type of operation.

Securitisation was heavily employed at the beginning of the process: in 2008 a record EUR 711 billion in issuance volume was observed but only 5 % of total issuance was not retained by banks. The share and volume of retained asset backed securities (ABS) far exceeded that of retained covered bonds in 2008-11.

In the first nine months of 2012, retained covered bond issuance picked up and accounted for more than one-third of total covered bond issuance (see Chart 5). However, the share of retained securitisation issuances remained significantly higher, at least in the first quarter of 2012.

Chart 5

Retained securitisation and covered bond issuances by year in the EU

I.2.1. Covered bonds

Covered bonds assume an important role in terms of secured funding. They have shifted from being a funding source in only a few countries to becoming an important source of long-term funding for banks in a much broader group of countries (see Chart 6). In 2003, 95 % of all covered bonds outstanding were issued by banks and mortgage banks located in only four countries (Denmark, France, Germany and Spain), whereas in 2010 only 66 % of all covered bonds outstanding were issued by those four countries (see Chart 7).

Chart 6

Covered bonds outstanding

Chart 7

Share of covered bonds outstanding, by country, in total of the EU

In both primary and secondary markets, covered bond spreads have remained tighter than the equivalent senior unsecured debt, thus making covered bonds more attractive as funding instruments, in particular for residential mortgages. The fact that rating agencies rate covered bonds significantly higher than the senior unsecured liabilities of the same issuer has also contributed to higher investor appetite for these instruments.

I.3. Evolution of unsecured funding

While the amount of unsecured debt outstanding was relatively stable in 2009 and 2010, it started to decline in the first quarter of 2011. The same is true for the share of unsecured debt outstanding of total debt outstanding, which was around 40 % in 2009 and 2010 and started to fall in the first quarter of 2011, reaching 30 % most recently. This development was heterogeneous across Union countries but the most significant decline in this share was seen mainly in countries on which the crisis had a pronounced impact (notably Italy and Portugal). Banking groups with lower ratings domiciled in higher-rated countries also registered a decrease in the share of unsecured debt.

I.3.1. Customer deposits

In spite of a generalised increase in customers’ deposits in banks’ liabilities (see Chart 1), banks’ attempts to maintain a larger deposit base have so far produced mixed results (see Chart 8), largely because of tighter competition in an already overbanked market and some savers’ relative reluctance to tie up funds in low-interest deposits.

Chart 8

Share of domestic non-financial private sector deposits as a percentage of total assets

In fact, the loan-to-deposit ratio remained relatively flat between 2009 and 2012 (see Chart 9): after a contraction in the first quarter of 2011, it increased again and remained relatively stable over the last quarters, at about 150 %. Overall, unlike the situation for market funds, deposit stocks have shown stability throughout the crisis, with the exception of a few countries at times of stress. To an extent, this is because of the existence of Union-wide harmonised deposit guarantee schemes. There have, however, been some movements of wholesale deposits in some countries, starting in the second half of 2011, some of which were of a cross-border nature (see Chart 10).

Chart 9

Loan-to-deposit ratio for a sample of large EU banking groups

Chart 10

Cross-border deposits by EU non-MFIs

I.4. Innovative funding

Besides the traditional types of bank funding, banks use, to differing degrees, other types of instruments in order to improve their funding or liquidity situation.

I.4.1. Liquidity swaps

Liquidity swaps can take several forms but are in general a type of secured lending whereby a lender provides a borrower with highly liquid assets (e.g. cash and government bonds) in exchange for a pledge of less liquid collateral (e.g. asset-backed securities), performing a liquidity upgrade in the process.

Information provided in the ESRB survey on asset encumbrance and innovative funding indicates that the funding obtained by liquidity swaps with cash collateral (repos) and by pledging collateral received in reverse repos (‘matched repos’) accounts for 7 % of total assets. If 2007 and 2011 data are compared, it can be seen that no significant change was reported regarding this share, other than that banks tended to prefer matched repos over repos in 2007 (6).

According to the same survey, securities lending transactions remain marginal for the majority of institutions. Indeed, the funding received in those transactions represents on average only 0,7 % of banks’ total assets and does not exceed 3,5 % for any of the reporting banks. However, securities lending transactions are highly concentrated, mainly at larger banks. In total, such transactions were reported by only 19 banks (out of 47), with four banks accounting for a 67 % share of funding received. In addition, the market is highly dominated by a few countries, namely United Kingdom (44 % of total funding received), Germany (22 %) and France (19 %), followed by the Netherlands, Italy and Sweden.

I.4.2. Structured products and ETFs

The crisis had an impact on the market for structured products (7). The annual turnover of structured securities listed on Euronext (Amsterdam, Brussels, Lisbon and Paris) increased significantly in the mid-2000s but dropped significantly following the onset of the crisis (see Table 1).

Table 1

Turnover in structured products; billion EUR

2005 2006 2007 2008 2009 2010 11,5 23,6 34,0 28,9 23,0 26,1 Source: NYSE Euronext.

The use of structured products for bank funding (8) varies widely among European countries, according to the size of the market (Belgium, Germany, France and Italy account for two-thirds of structured products outstanding, with EUR 226 billion, EUR 157 billion, EUR 84 billion and EUR 82 billion respectively at the end of 2011) and the patterns in domestic bank funding structures. However, it should be noted that structured products are not innovations introduced after the crisis.

The use of exchange traded funds (ETFs) as an innovative funding instrument has been widely publicised. However, the use by banks of traded funds to obtain funding goes beyond the scope of ETFs, as other UCITS could be used as well by resorting to total return swaps and securities lending. From the information gathered through the ESRB survey, ETFs are very seldom used to obtain funding; only a couple of banks reported using this instrument for funding purposes. However, this does not mean that this activity will not pick up again in the future. This is one of the reasons why supervisors are continuing to monitor this activity. Moreover, the European Securities and Markets Authority (ESMA) published guidelines on ETFs and other UCITS issues in July 2012.

I.5. Public support in the current distressed conditions

Following the onset of the financial crisis and particularly after the Lehman collapse, central banks and public authorities intervened decisively. Given the difficulty for banks to fund themselves in unsecured credit markets, banks within the Union increased their recourse to secured funding (see Section I.2) and to central bank funding.

Moreover, EU Member States took several measures to support their banking systems. The bulk of public support measures can be classified into three broad categories, capital injections, guarantees on bank liabilities and asset relief measures (9). Notably, Member States agreed to a system of national state guarantees for liquidity, which was revised in 2011, in an attempt to allow viable banks to obtain funding. In January 2012, 17 EU Member States had granted guarantees on new bond issuances for a total of EUR 580 billion (EUR 480 billion in the euro area), which was down from a peak of EUR 930 billion (EUR 720 billion in the euro area) in the last quarter of 2009. The situation at country level is mixed (see Chart 11). The amount of contingent liabilities stemming from guarantees on bank liabilities declined in most countries as a result of bonds maturing, but it increased in countries such as Belgium, Greece, Italy, Portugal and Spain.

Chart 11

Guarantees on bank liabilities: country breakdown, in billion EUR

With the crisis evolving into a sovereign crisis in some euro area countries, conditions for funding worsened significantly for banks in such countries. In this context, the Eurosystem intervened with a broad range of measures, which included, inter alia, establishing longer-term refinancing operations (LTROs) at full allotment and fixed rates, broadening eligible collateral and decreasing the minimum reserves requirement. On 22 December 2011 and 1 March 2012, the ECB conducted two LTROs with a maturity of three years, which together amounted to more than EUR 1 trillion (see Chart 12 and Chart 13).

Chart 12

Operations with the EU NCBs

Chart 13

Operations with the EU NCBs

Naturally, recourse to central bank funding is correlated with sovereign fragilities, with banks from Cyprus, Greece, Ireland, Italy, Portugal, Slovenia and Spain being more reliant on financing from the Eurosystem (see Chart 13). In some countries, banks have resorted to retained securities, in particular covered bonds, in order to gather eligible collateral for operations with central banks (see Chart 5).Some banks have resorted to state guarantees for issuing debt, which was in some cases used in refinancing operations with the central bank.

I.6. Drivers for the development of funding structures

The change in the composition of banks’ liabilities is the result of several concurrent factors. Following the multi-notch downgrades of debt issued by several peripheral euro area sovereigns, which were previously highly rated and perceived to be low risk, there was an increase in demand by fixed income investors for safer assets. This led to a bias towards secured assets and, in particular, covered bonds as the cover pools consisting of relatively safer assets as a second source of repayment provided some further reassurance. Moreover, specific legal frameworks for covered bonds offer additional investor reassurance.

As regards developments in the cost of secured and unsecured debt, based on the respective iBoxx indices, the differential between senior unsecured debt and covered bond spreads showed changing pricing patterns during the crisis. Until around mid-2010, the average cost of senior unsecured debt remained well above that of covered bonds but subsequently the difference largely disappeared and the relationship even reversed in the first half of 2011. Increased risk aversion in credit markets due to the intensification of the sovereign debt crisis, coupled with fears about the possible impact of bail-in proposals on the cost of senior unsecured debt, led to the reappearance and the rewidening of the positive spread differential between senior unsecured debt and covered bonds in the second half of 2011.

Chart 14

Swap spreads on iBoxx indices for euro-denominated senior unsecured debt and covered bonds (Jan. 2010-Oct. 2012; basis points)

Following the Eurosystem’s three-year LTROs, senior unsecured spreads tightened significantly in early 2012 and average spreads on secured and unsecured debt moved relatively closely together for much of the first half of the year. In late June 2012, however, the average spread on senior unsecured debt fell below that of covered bonds.

As regards the cost of interbank funding, following the Lehman default, unsecured transactions became much more costly relative to repo funding, as illustrated by the sharp widening of the EURIBOR-EUREPO term spreads, which reflected a significant rise in counterparty credit risk. While spreads significantly narrowed following the implementation of the ECB’s large-scale liquidity support measures, they remained well above pre-crisis levels. The intensification of the sovereign debt crisis from mid-2011 onwards again led to rewidening of the spreads on secured versus unsecured transactions. In the first half of 2012, the rate differential between repo and unsecured transactions narrowed again after the implementation of the Eurosystem’s three-year LTROs.

It should also be noted that since the beginning of the crisis, EU banks have been focusing on strengthening their funding base by making deposit-gathering a key strategy. Retail deposits are considered by the Basel proposal for the liquidity regime as ‘stickier’ than other instruments, which may also have contributed to banks engaging in such strategies.

I.6.1. Impact of new and upcoming regulations on bank funding

I.6.1.1. Background

Several legislative initiatives that have been or will be implemented in the near future may have an impact on banks’ funding options, especially on the trade-off between secured versus unsecured funding sources but also on recourse to new sources of funding. Of these initiatives, the most important are the Capital Requirements Directive and Regulation (CRR/CRD IV), the Solvency II/Omnibus II Directive, the proposals for the Bank Recovery and Resolution Directive and the European Market Infrastructure Regulation (EMIR).

In summary, as covered bond issuance will have a potentially favourable treatment under future Basel III and Solvency II rules compared with securitisations, banks might have further incentives to opt for such instruments. At the same time, the ‘bail-in’ debt provisions included in the proposal on bank resolution have contributed to investor perceptions that recovery rates for unsecured creditors are likely to be lower in the future. The fact that, in the current proposal regarding the Liquidity Coverage Ratio, unsecured debt instruments issued by banks are not considered liquid assets may also negatively affect banks’ interest in holding other banks’ unsecured debt (10).

The impacts of the referred regulations are not restricted to bank funding and the potential negative effects should be considered in the wider context of the benefits not only in terms of funding and liquidity but also in terms of increased resilience of the system, decreased moral hazard, limiting contagion etc.

I.6.1.2. Details of relevant upcoming or already implemented legislation

CRR/CRD IV. Two of the elements of the CRD IV that could have significant effect on bank funding patterns are those related to the liquidity framework: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Requirement (NSFR). The main purpose of the NSFR is to require banks to establish more stable, long-term sources of funding. The main purpose of the LCR is, in turn, to create a pool of easily disposable assets consisting mostly of high quality, liquid assets, including covered bonds but excluding ABSs.

An additional impact on bank funding stemming from the Capital Requirements legislation comes from the treatment of covered bonds. The CRR/CRD IV does not introduce new treatment for covered bonds in terms of capital charges as compared with the past, since it maintains the main asset classes that can be eligible for collateral to back covered bonds, as established by the previous capital requirements directives.

Solvency II Directive. The Directive aims at harmonising the regulation of insurance and reinsurance firms. Solvency rules stipulate the minimum amounts of financial resources that insurers and reinsurers must have in order to cover the risks to which they are exposed. One of the main criticisms of Solvency II is that it will incentivise investment in short-term rather than long-term debt because of the design of the capital requirements for spread risk. However, this criticism is based on a simplistic view of Solvency II, comparing parameters of the spread risk module with CRD IV parameters. This approach also fails to take account of diversification effects and the effect of interest risk submodules in the final capital requirements.

Other elements currently under discussion in the Omnibus II negotiations may preserve or enhance incentives for long-term investments. One example is the ‘long-term guarantees package’, which is designed to deal with issues arising from the impact of artificial volatility on insurance products with long-term guarantees.

Another key criticism is that the Solvency II approach penalises investment in bank participations. Again, this is based on the European Insurance and Occupational Pensions Authority (EIOPA) fifth quantitative impact study (QIS5) approach, in which participations in financial and credit institutions were deducted from own funds. Current draft delegated acts will reflect an approach similar to that of the CRD IV, in accordance with which the value of the participation in banks is deducted from the corresponding tier only where certain thresholds are exceeded. It is unlikely that this approach could have a significant effect on the reallocation of assets for insurers.

It could still be possible that Solvency II will change the asset allocation for some undertakings, given that it captures diversification effects.

Bank Recovery and Resolution Directive. The draft Directive sets out the necessary steps and powers to ensure that bank failures across the EU are managed in a way that avoids financial instability and minimises costs for taxpayers. The proposed framework contains a ‘debt write-down’ or ‘bail-in’ resolution tool. Under this tool, resolution authorities would be able to write down equity, subordinated debt and any other unsecured senior liabilities or convert them into equity. According to the Commission’s proposal, secured funding, deposits covered by deposit guarantee schemes (DGS), funds with a maturity of less than one month, trade/commercial credit, liabilities to employees or tax/social security authorities and derivatives are excluded from the bail-in regime.

While bail-in would not change the position of unsecured creditors in the creditor hierarchy, it would contribute to investor’s perceptions that recovery rates for unsecured funding are likely to be lower in the future. All in all, given a higher risk premium, ‘bail-in-able’ liabilities (e.g. unsecured funding) might be more expensive in the future. Nevertheless, impact assessments carried out by the European Commission have shown that the expected impact is contained. The Commission’s Impact Assessment (11) accompanying the draft Directive anticipates that the cost of bank funding will increase overall by between 5 and 15 basis points, whereas the change in the funding costs of ‘bail-in-able’ liabilities ranges between 15 and 40 basis points. The banking industry’s estimates of the change in the funding costs of ‘bail-in-able’ liabilities, however, range between 55 and 100 basis points (12).

Overall, the increase in the risk and funding costs of liabilities subject to bail-in should be considered in the context of the beneficial effects of the bail-in tool on bank funding. The new Regulation on the European market infrastructure (EMIR) aims at introducing greater transparency and better risk management to the ‘over the counter’ (OTC) derivatives market, as well as making this market safer by reducing counterparty credit risk and operational risk.

To reduce counterparty credit risk, the new rules introduce (i) stringent requirements for prudential (e.g. how much capital CCPs need to hold), organisational (e.g. role of risk committees) and conduct of business standards (e.g. disclosure of prices) for CCPs, (ii) mandatory CCP clearing for contracts that have been standardised (i.e. they have met predefined eligibility criteria), (iii) risk mitigation standards for contracts not cleared by a CCP (e.g. exchange of collateral). For further details on risks from CCPs, see Section III.1.6.

I.7. Leverage and asset decomposition

In the run-up to the financial crisis, banks’ leverage increased, with banks’ balance sheets expanding substantially. In the post-crisis period, in response to elevated funding costs, particularly on unsecured funding, banks aimed at decreasing their leverage, both by increasing capital and limiting asset growth, as can be seen in Chart 15. The trend was more pronounced for banks outside the euro area, but this fact was driven by banks resident in the United Kingdom.

Chart 15

Leverage multiple of EU banks

In the euro area, banks decreased their assets by approximately 10 % in 2009, with changes in 2010 and 2011 being less pronounced (see Chart 16). EU banks outside the euro area experienced, on aggregate, few adjustments in the size of assets until 2010, but these started growing again in 2011. From 2008 onwards, banks tried to recapitalise, and equity increased substantially throughout the EU by almost EUR 400 billion, albeit with a decrease of around 5 %, for the euro area banks in 2011. Total assets of banks in the euro area have increased by 14 % since 2007 but asset decomposition has also changed. Holdings of equity securities fell by 6 %, while loans to households increased by just 9 % and loans to MFIs by only 6 %. By contrast, other assets, loans to governments and debt holdings increased by more than 20 %. These figures give some evidence of weakened lending by the interbank sector as well as a relative decline in lending to households and corporations.

Chart 16

Changes in EU banks’ equity and assets

II. ASSET ENCUMBRANCE: INPUT FROM THE SURVEY

Asset encumbrance takes place when assets are used to secure creditors’ claims. These assets are therefore not available to general creditors in the event of a bank failure. This collateralisation can either be used for funding purposes (e.g. ABS, covered bonds and repos) or for trading and risk management (e.g. derivatives and securities lending). In some of these operations, banks do not encumber assets directly with their counterparty but rather with CCPs in operations which are cleared through those institutions. An encumbered asset is an asset that is, explicitly or implicitly, pledged or subject to an arrangement to secure, collateralise or credit-enhance any transaction.

Following the increased reliance on secured funding and the move towards collateralisation of other transactions (such as derivatives), asset encumbrance has expanded since the onset of the crisis. While this increase is fairly widespread, it is more significant for vulnerable banks and banks in vulnerable sovereigns. In fact, asset encumbrance cannot be disentangled from the crisis and its impact in terms of impairment of credit and interbank markets. Apart from these market constraints, the amount and types of secured debt are driven by many factors, first and foremost prices, collateral availability, over-collateralisation and maturities.

II.1. Overall levels of asset encumbrance

In the remainder of this Annex, the level of asset encumbrance is calculated as the ratio of encumbered assets to total assets (13). For methodological details, see Section VI.

The distribution of the level of encumbrance, for 2007 and 2011, is presented in Chart 17 (14). This ratio refers to all encumbered assets, including those assets received in a reverse repo (matched repos), measured against total assets. However, due to some uncertainties associated with the exact reporting methodology at some banks, intervals of encumbrance levels are presented instead of single figures. The data show that the median value of the encumbrance level for the sample of banks covered in this data collection exercise is around 25 % (or around 23 % when matched repos are excluded).

Chart 17

Distribution of the ratio of encumbered assets (including matched repos) to total assets, end-2011 (blue shading) and end-2007 (grey shading)

The levels of encumbrance have increased for almost all banks in the sample if the 2007 and 2011 data are compared (15). Taking a subsample of 28 banks reporting in both years, the median increased from 7 % to 27 % and the average, weighted by total assets, increased from 11 % to 32 % (when including matched repos).

Despite the widespread nature of this tendency, the significance of the increase in encumbrance levels varied depending on the banks’ characteristics. In fact, banks with lower credit ratings (lower than A) (16) systematically presented more striking increases in the level of encumbrance (Chart 18) (17).

Chart 18

Increase in encumbrance levels between 2007 and 2011 for groups of banks with different credit ratings ([percentage points) (18)

In 2011, higher rated banks (up to A) presented, on average, significantly lower levels of encumbrance (Chart 19) (19). While this is not a surprising conclusion, it should not be seen separately from the link between banks and their sovereign, as some of the banks that present higher levels of encumbrance are weighed down by sovereign risk. This difference in encumbrance patterns depending on banks’ and sovereigns’ resilience may be understood as a corroboration of the thesis that increased encumbrance is (at least partly) a consequence of the crisis.

Chart 19

Distributions of encumbrance levels for groups of banks with different credit ratings (percentages), end-2011

II.2. Impact of over-collateralisation on levels of encumbrance

Encumbrance levels depend on the type of transactions on which the asset pledge was made, notably on the inherent over-collateralisation requirements (see Chart 20). Repos, matched repos and securities lending are the type of secured funding which involves less use of collateral, as haircuts exercised are usually lower. However, higher rated institutions are those that are best positioned to take advantage of such transactions, since counterparties are more willing to engage in these operations with more resilient institutions (see also Chart 21). On the contrary, central bank funding, covered bonds and other collateralised securities require higher amounts of collateral.

Chart 20

Distribution of the over-collateralisation ratio by types of funding, end-2011

Chart 21

Distribution of the over-collateralisation ratio by collateral type, end-2011

The case of covered bonds requires further clarification. The level of over-collateralisation of covered bonds depends, broadly, on three factors: (1) regulatory requirements; (2) rating agencies’ requirements; and (3) institutions’ strategic choices regarding the over-collateralisation buffer that they wish to hold. Some national regulations require covered bonds to maintain significant minimum over-collateralisation levels (e.g. Spain (20)), some have over-collateralisation requirements which are fairly low (21) and another group requires the whole portfolio of eligible assets to be set apart for collateralising covered bonds (e.g. Slovakia), while others have no such requirements. This different treatment has non-negligible consequences in terms of over-collateralisation and therefore on levels of asset encumbrance. Whereas over-collateralisation can be partially justified by the regulatory regime, it also depends on the rating that institutions desire to achieve for their secured debt instruments, as higher over-collateralisation offers extra security for investors and thus permits higher ratings. Moreover, institutions decide on the buffer that they wish to hold on top of regulatory and rating agencies’ requirements. This is a strategic decision and practices differ among banks and across Member States as to whether this buffer is held inside or outside the cover pool.

II.3. Contribution of the different transactions to encumbrance

Unsurprisingly, more vulnerable banks (when assessed by their credit rating) tend to rely more heavily on secured funding and particularly on central bank funding, while higher rated banks have a more diversified structure of secured funding, with repos, securities lending and collateralised debt securities playing a very relevant role among funding sources. It should also be noted that while banks with a speculative rating appear to have only slightly higher levels of secured funding than banks with ratings up to BBB, given the amount of retained assets already ‘packaged’, but not yet used to obtain funding, by speculative-rated banks, those levels may rise.

Chart 22

Breakdown of secured funding for groups of banks with different credit ratings, end-2011

This leads to a relatively high encumbrance level at banks with the lowest rating; there are several reasons why this occurs. First, central bank funding involves a high amount of encumbered assets due to more pronounced over-collateralisation than for other types of funding (see Chart 20). Second, banks with the lowest rating may be excluded from private sector unsecured markets but may be able, in some cases, to issue secured funding instruments if they can post good quality collateral. Third, these banks have already exhausted a large portion of their assets that are eligible as collateral in central bank refinancing operations (see Chart 24, middle panel) and are increasingly using their own retained covered bonds and other collateralised securities as collateral to obtain funding from central banks. Fourth, such collateral nonetheless implies slightly higher haircuts than for banks with the highest rating (see Chart 24, left-hand panel).

III. RISKS

This section analyses the risks involved in (1) asset encumbrance; (2) innovative funding; and (3) concentration. The table below summarises the main risks and conclusions.

Table 2

Main risks stemming from funding developments

Asset encumbrance Innovative funding Concentration 1. Structural subordination of unsecured creditors, e.g. depositors 1. Transparency, confidence, ease of management and supervision 1. Investor base 2. Future access to unsecured markets: (1) crowding-out of unsecured creditors; (2) retaining market access and market discipline; (3) increased sensitivity of senior unsecured debt spreads to fundamentals 2. Interconnectedness 2. Funding instruments 3. Issues related to transparency and correct pricing 3. Litigation and reputation risks; consumer protection 3. Maturity profiles 4. Increased funding and liquidity risks 4. Specific risks on liquidity swaps 4. Geographical scope 5. Contingent encumbrance 6. Other risks from asset encumbrance: (1) collateral scarcity and reuse; (2) risk management of a bank with high encumbrance 7. Other risks related to specific products or transactions: (1) covered bonds; (2) CCPs

III.1. Risks from asset encumbrance

Risks arising from asset encumbrance can be broadly divided into the following groups: (1) structural subordination of unsecured creditors; (2) issues related to future access to unsecured markets; (3) issues related to transparency and correct pricing; (4) increased liquidity risks; (5) issues related to contingent encumbrance; (6) issues related to pro-cyclicality; and (7) other risks. In this section reference is also made to specific risks related to covered bonds and to operations with CCPs.

III.1.1. Structural subordination of unsecured creditors

One of the effects of asset encumbrance is that it shifts risks among investors. The claims of unsecured creditors, such as senior unsecured bondholders or depositors, tend to become riskier as a result of increased asset encumbrance, becoming increasingly subordinated as more secured debt is positioned above them. The magnitude of the risk shifting between creditors depends, among other things, on the degree of over-collateralisation (i.e. the extent of protection of more senior creditors), the type of other creditors, the business models and the general asset quality, as well as on the relative sizes of secured vs. unsecured debt and on the probability of default. The extent to which risk-shifting is a risk for unsecured creditors depends on their capacity to price that risk. Consequently, unexpected changes more than absolute levels of encumbrance are more problematic for existing unsecured creditors, since they do not have an opportunity to price such encumbrance changes.

III.1.1.1. Structural subordination of depositors

Since deposits are a form of senior unsecured funding for banks, encumbrance also increases the riskiness of deposits and ultimately the liability of deposit insurance funds (22). Structural subordination of deposits can be less of a concern in countries where deposit insurance funds are ex ante financed by premia paid by covered institutions. In such cases, the risk of increased tax-payers’ liabilities from asset encumbrance is partly reduced. To compensate deposit insurance funds for increased riskiness, premia paid by covered institutions could be risk-sensitive, namely with regard to risks stemming from encumbrance and subsequent subordination of depositors.

The increased riskiness of deposits is of particular concern in Member States without special depositor preference laws. Such laws grant seniority to deposit insurance funds, reducing a possible burden to tax-payers in case of credit institutions’ insolvency (23). Increased riskiness of deposits is also less of a concern in Member States where asset encumbrance tends to be low because of regulatory limits. Some Member States have placed direct limits on encumbrance due to covered bonds, while others have separated deposit-taking and mortgage lending. From the viewpoint of unsecured depositors and investors, it is important to analyse whether the remaining unencumbered assets could cover the unsecured liabilities. According to the survey conducted by the ESRB, for a majority of banks, this is still the case (see Chart 23), although two issues should be raised. First, the unencumbered assets do not sufficiently cover the unsecured funding for some reporting banks. Second, this coverage is lower among banks with lower ratings.

Chart 23

Distribution of the ratio of unencumbered assets to total unsecured funding for groups of banks with different credit ratings, end-2011

III.1.2. Issues related to future access to unsecured markets

1. Crowding-out of unsecured creditors

High levels of asset encumbrance, both for institutions whose levels are already high or for those with potential future increases, may feed expectations of further encumbrance. Such expectations may increase the cost of unsecured funding to levels that banks are unable or unwilling to meet. Moreover, as a result of strict criteria, the quality of encumbered assets is likely to be better than that of unencumbered assets. In the extreme case, banks’ funding may be skewed significantly towards secured debt, with over-collateralisation funded either by retail deposits (the only source of unsecured debt) and/or own funds.

Based on the ESRB survey, there is some evidence that the credit risk related to encumbered assets is generally lower than the credit risk related to unencumbered assets, once assessed by the risk weights. Conversely, there is no significant difference between encumbered and unencumbered assets when assessed by distribution into loan-to-value (LTV) buckets. The data show that this conclusion is also robust across individual reporting banks. Nevertheless, the different composition of assets in the two categories may cause some distortion in the comparison.

Such a development undermines financial stability since it worsens the structural subordination of depositors and banks’ liquidity position. This risk is less likely to materialise in a banking system with a liability set-up in which there is little subordination of other creditors or which has sufficient capital to deal with high encumbrance (e.g. the Nordic banking systems).

2. Retaining market access and discipline

High asset encumbrance can also reduce the variety of counterparties willing to invest in bank debt, potentially over-concentrating the market. Given that some institutions have limits on how large an exposure to a counterparty can be, this could add further limitations to their funding management.

With regard to market functionality, finance theory relies on the premise that unsecured debt investors have the right incentives to carry on monitoring activity and adjust prices accordingly. A bank that increases its reliance on secured funding (and consequently its encumbrance) would pay less attention to the discipline that unsecured creditors would try to impose via pricing of unsecured debt, as it would be less reliant on them.

3. Increased sensitivity of senior unsecured debt spread to fundamentals

In a low default environment, default is remote and the resulting structural subordination has limited or no real consequences for unsecured creditors. However, as the probability of default starts to increase, the effect of structural subordination should be rationally factored into spreads. Unexpected negative events could therefore lead to sharp jumps in the cost of unsecured funding, increasing the potential for disturbances in unsecured markets.

III.1.3. Issues related to transparency and correct pricing

Models and information used by rating agencies and others to factor in asset encumbrance and potential structural subordination deviate from actual empirical conditions and require continuous changes and updates. As models and information are updated and improved, there is a risk that senior unsecured debt may be downgraded, which in turn may also trigger the downgrading of secured funding (due to the current link between issuer rating and covered bond rating).

Moreover, asset encumbrance risks are also difficult to quantify, because of lack of disclosure or of precedents. There is much opacity around contingent encumbrance risks (see Section III.1.5) and encumbrance due to activity in the repo market and with central banks as well as due to over-collateralisation. Poor disclosure on encumbrance can result in situations where asset encumbrance is not fairly priced in by unsecured creditors. In such cases, asset encumbrance can surprise the market as risks materialise, adding to banks’ funding pressures.

In a resolution situation, secured investors have incentives to force the banks to sell collateral, potentially at distressed prices (fire sales) regardless of market impact as they are relatively protected by over-collateralisation (and dual recourse in the case of covered bonds). This could potentially penalise other stakeholders such as unsecured investors and depositors but would be very difficult to factor into market prices.

In addition to price movements driven by fundamental factors such as default risk, herd behaviour in times of stress can also contribute to mispricing, in particular in flight-to-quality and flight-to-liquidity situations. Furthermore, mispricing could also arise due to different regulatory treatment of instruments. In particular, since covered bonds have lower capital requirements, banks — also as counterparties — can favour investing in them; by increasing the supply of funds for these instruments, this may induce a decrease in yields.

III.1.4. Increased funding and liquidity risks

Asset encumbrance increases banks’ general funding and liquidity risks in a normal environment since it may reduce the funding headroom of an institution. However, at the current juncture, secured funding with its associated encumbrance allows banks to operate when other avenues of funding are closed.

In particular, high levels of encumbrance already used for refinancing reduce the amount of assets that can be transformed into central bank eligible collateral, thus undermining central banks’ abilities to provide liquidity assistance (Chart 25). Consequently, the increased role of asset encumbrance in bank funding may reduce the effectiveness of the monetary transmission mechanism. Furthermore, high levels of encumbrance can lead to increased systemic risk in the banking sector and/or increased credit risk for central banks if central banks decide to widen the spectrum of acceptable collateral without applying appropriate haircuts.

As referred to above, according to the ESRB survey on asset encumbrance and innovative funding, lower-rated institutions present higher levels of encumbrance. Hence, their headroom for further central bank funding is narrower than for other institutions. In fact, a more specific analysis concludes that these lower rated banks have already pledged a substantial amount of their own retained debt securities (see Chart 24, left panel).

Chart 24

Central bank funding: Over-collateralisation, unencumbered assets eligible for central bank, share of central bank funding — distribution for groups of banks with different ratings, end-2011

The structure of unencumbered assets which are eligible as collateral for central bank funding varies for groups of banks with different ratings: for banks with lower ratings, the share of debt instruments issued by credit institutions (with the exception of covered bonds) and by corporate and other issuers compared with total unencumbered assets eligible for central bank funding is higher, whereas the share of cash and loans is lower (see Chart 25). Furthermore, this share of debt securities issued by credit institutions and corporates generally increases with the lower share of unencumbered assets eligible for central banks on total assets (see Chart 32). The higher share of debt securities issued by credit institutions partially supports the conclusion that the lower-rated institutions increasingly use retained collateralised securities to obtain funding. Moreover, the share of retained collateralised securities is the highest in case of banks with a non-investment rating, and these securities are mainly pledged as collateral in central bank operations (24).

Chart 25

Breakdown of unencumbered assets eligible as collateral for central bank funding for groups of banks with different credit rating, end-2011

Furthermore, banks in some countries have already encumbered a significant part of their loan portfolios, as can be seen in Chart 26. This conclusion should however be nuanced with the characteristics of, in particular, covered bonds that entail significant amounts of over-collateralisation that can however be drawn upon (for a detailed discussion, see Section II.2).

Chart 26

Ratio of encumbered loans to total loans for different countries, end-2011

Encumbrance may also increase potential outflows in certain circumstances. A fall in the value or quality of the existing collateral generally creates a need to post more collateral. Downgrading increases counterparty risks and can therefore result in additional margin calls (see also Section III.1.5 on contingent encumbrance).

III.1.5. Contingent encumbrance

Existing encumbrance tends to lead to further encumbrance after an adverse event, such as a downgrade, a fall in the value of collateral or a general loss of confidence. These adverse events can lead to increased haircuts or automatic margin calls that stem from the underlying contractual obligations or from perceived increases in counterparty risks. Investors can be caught unawares because the effect on encumbrance from some positions, such as derivatives, is hard to predict.

Moreover, in the case of covered bonds, a fall in the value of collateral could have negative consequences such as the need for the issuer to top up the cover pool to include more appropriate LTVs and quality. Severe devaluation of the cover pool would ultimately be an incentive for the bank to redeem its covered bonds, which could give rise to a large funding gap on the part of the issuer.

The ESRB survey also requested information on contingent encumbrance in three adverse scenarios. An analysis is shown in Chart 27. Taken separately, none of the three scenarios proposed seems to have significant impact on average encumbrance levels. However, some banks appear to be more vulnerable in scenarios with a potential increase in encumbrance of more than 10 % of total assets. These results should be viewed with due caution, as the impact of the scenarios was calculated by the banks themselves; hence methodologies and assumptions used can vary significantly from bank to bank.

Chart 27

Changes in the distribution of encumbrance levels in adverse scenarios (by bank), end 2011

III.1.6. Other risks from asset encumbrance

This subsection discusses other potential risks deriving from high levels of asset encumbrance: (1) collateral scarcity and reuse; and (2) management of a bank with high encumbrance.

1. Collateral scarcity and collateral reuse

Demand for collateral and more specifically for safe assets (see Diagram 1) has increased significantly over the past few years. Part of the demand is linked to secured funding and the use of collateral for OTC transactions. At the same time, the supply of safe assets has been affected by the uncertainty regarding the resilience of some sovereigns and the decline in securitisation. Simultaneously, according to Singh (25), the reuse of collateral, i.e. the ability to use pledged collateral for its own purposes, has declined, resulting in further pressures on the availability of collateral.

Diagram 1

Demand for good quality collateral

The risks associated with collateral scarcity are twofold. On the one hand, a reduction in the availability and the actual reuse of collateral may be an impediment to the funding of financial institutions. On the other hand, increased reuse implies longer and more complex intermediation chains, which would increase interconnectedness and may also be risky for final investors as they could find it difficult to redeem the collateral.

2. Risk management of a bank with high encumbrance

Another risk worth noting is that a bank with a high level of encumbrance is more difficult to manage and to supervise than an institution with a similar business model and/or funding need but with a lower encumbrance level. The greater difficulty relates notably to the fewer options available to management should shocks occur. Negative shocks may be transmitted throughout a bank with a high level of encumbrance more quickly than in a bank with low encumbrance.

All institutions should have adequate risk management systems for their liquidity and funding, in particular for monitoring encumbrance levels. Institutions with high encumbrance levels should give consideration in their management systems to the fact that they have less room for manoeuvre in response to a shock. Bank supervisors should be aware of the prevailing conditions and their implications for risk management.

III.1.7. Other risks related to specific products or transactions

1. Specific risks from covered bonds

Risks associated with covered bonds that are common to other types of secured funding and that relate more generally to encumbrance have been listed in the previous subsections.

First and foremost, there are legal uncertainties in some Member States in case of insolvency of the issuer of covered bonds. These are related, in particular, to the segregation of the cover pool from the issuer’s assets and to the creditors’ ‘time subordination’. Unsecured funding becomes due immediately on default, whereas, in general, covered bonds do not accelerate. Thus, if the cover pool subsequently turns out (contrary to earlier assumptions) to be unable to satisfy all secured claims, the entire insolvency proceeds might have already been given to the unsecured investors.

Given the lower capital charges for covered bonds (in comparison with other types of debt securities), their proposed eligibility as liquid assets for the purposes of the LCR and their proposed exemption from large exposures limits under the CRD IV (subject to national supervisory discretion), banks will have an incentive to swap covered bonds among each other to an extent that will increase interconnectedness within the banking sector, thus facilitating the transmission of shocks throughout the financial markets.

In addition, as the issuer is not obliged to disclose detailed information on the assets in the cover pool, this opacity could lead to a mispricing of the assets by the market.

Finally, another risk stems from the difference between the yield paid by covered bonds and the yield that certain investors, particularly insurance companies, need to obtain in order to fulfil their obligation to provide a guaranteed yield on their (life insurance) contracts. They might therefore be induced to buy riskier products. Alternatively, covered bond issuers might be prompted to lower the quality of covered bonds. However, such action leads to higher risks and allows for contagion from one covered bond market to another.

Box 1

Differences in national regulations regarding covered bonds

National regulations regarding covered bonds vary from one European country to another. This box focuses on the differences in national regulations that are of relevance from the perspective of systemic risk.

1. Who is allowed to issue covered bonds?

National regulations may permit all credit institutions, only special/mono-line institutions, or both to issue covered bonds. One distinct characteristic of special/mono-line institutions is the fact that they do not take deposits and that covered bonds constitute their main funding source.

2. Regulations regarding cover assets

Although covered bonds regimes are national in nature, the Capital Requirements Directive (hereinafter CRD) (26) also defines covered bonds for its own purposes (27). In particular, it defines which assets are eligible for cover pools. This includes, inter alia, (a) first ranking residential and commercial mortgages; (b) claims on or guarantees by other credit institutions; (c) public sector credits/guarantees — some national regulations operate with a minimum rating threshold; and (d) ship mortgages.

The wider the collateral eligibility criteria, the larger the potential for covered bond issuances. Therefore, a wide definition of assets eligible for cover pools can contribute to an increased level of asset encumbrance and consequently to structural subordination of other creditors. The CRD also imposes LTV limits for loans to be included in the cover pool. The permitted LTV limits are highest for residential (80 %) mortgages and lowest for commercial mortgages (60 %).

3. Subordination of creditors

In case of bankruptcy, holders of covered bonds are given preferential treatment as they are entitled to obtain the proceeds of the cover pool.

The level of subordination depends on the number and type of other creditors of each institution. Subordination is not relevant to specialised institutions that are only funded through covered bonds. For non-deposit-taking institutions in particular, creditors are investors who do not rely on deposit insurance. In deposit-taking institutions, depositors and other creditors are subordinated to covered bond holders.

4. Regulations regarding segregation of assets and bankruptcy

In case of bankruptcy the preferential rights given to covered bond holders are important, particularly as bondholders tend to have recourse to the institution’s insolvency mass (dual recourse). Dual recourse will contribute to increased structural subordination for other creditors. In addition, structural subordination will be increased if national regulation allows for acceleration in case of insolvency, for example if acceleration means that additional collateral can be required in case of insolvency.

5. Regulations regarding ALM of cover pools

Significant asset liability management (ALM) risks can occur between covered bonds and the assets eligible for the cover pool. This concerns the extent to which FX risk, interest rate risk, liquidity risk and option risk are allowed. All things being equal, strict regulation of ALM risks would imply that the issuing banks can only take minimal risks apart from the inherent credit risk, thus ensuring a closer match between the covered bonds issued and the underlying assets in the cover pool. Limiting the ability to take on risks other than credit risk reduces the risk of failure in the cover pool. It could also reduce requirements for over-collateralisation.

6. Regulations on asset encumbrance

In order to protect depositors and other ordinary creditors, some countries have frameworks in place that allow them to impose limits regarding asset encumbrance on the issuance of covered bonds. These countries include Australia, Canada, the United States, Italy, the Netherlands and the United Kingdom. In the latter two countries, the limit on asset encumbrance is determined on a case-by-case basis. Most countries, however, have no such limits. These countries include Denmark, Finland, France, Germany, Ireland, Norway and Sweden. Apart from any established regulatory limits with regard to asset encumbrance, rating agencies also operate with some thresholds for asset encumbrance in order to maintain a certain rating.

2. Specific risks associated with CCPs

While the push by regulators for greater use of CCPs can produce substantial benefits, in particular in terms of a decrease in counterparty risks and in interconnectedness, it is important to be aware of certain risks. Two types of risk call for careful monitoring.

First, CCPs can have an adverse impact on funding conditions and collateral availability by increasing asset encumbrance. Moving transactions to CCPs, when they would otherwise not be cleared through those institutions (28) may well increase demand for high quality collateral. Pledging increasing amounts of good collateral to CCPs means that less remains to be used elsewhere. If centrally cleared transactions are compared with those that are bilaterally cleared, the multilateral netting effect provided by CCPs is likely to decrease the collateral and capital needs that would be generated by bilateral