Rules pertaining to covered bonds
Norges Bank's letter of 28 February 2013 to the Ministry of Finance.
We refer to the Ministry's letter of 18 December 2012 in which the Ministry requests an assessment of the rules pertaining to covered bonds and of whether mortgage companies operating under a restricted banking licence may be given access to the central bank's lending facilities.
1. Assessment of the covered bond rules
Total volume outstanding of covered bonds is currently slightly more than NOK 830bn, approximately 550bn of which is in NOK. There was a rapid increase in the volume of covered bonds after the covered bond rules were introduced in 2007. The availability of collateralised bonds, secured primarily by a preferential claim on a pool of residential mortgage loans, has given investors and borrowers greater opportunity to diversify their portfolios. Banks have obtained access to new funding sources that have reduced their costs for funding residential mortgage lending, but there are considerable differences among banks in the share of the stocks of loans used as backing for covered bond issues. Under the swap arrangement, covered bonds helped to ensure banks' long-term funding during and after the financial crisis in 2008, when unsecured wholesale funding was difficult to obtain. Through jointly owned mortgage companies, covered bonds have also given smaller banks access to bond funding in both NOK and foreign currency. The covered bond market has also provided a basis for new benchmark interest rates in the Norwegian market and created liquid securities that banks will be able to use to meet the new liquidity requirements. In the period ahead, because of their low credit risk, covered bonds may be important for pension providers' adaptation to the coming Solvency II framework.
The global financial crisis in 2008 led in a number of countries to strong growth in secured bank funding, in the form of both covered bonds and central bank lending. Even though funding by central banks will be gradually reduced, there is reason to believe that the trend towards increased asset encumbrance will continue as long as it contributes to lower overall funding costs. At the same time, the introduction of requirements for the use of central counterparties for trading and settlement of financial instruments will increase banks' need for collateral. Extensive asset collateralisation weakens the position of unsecured creditors in a crisis and reduces the potential for using secured funding, from either central banks or other parties, in situations when institutions are experiencing liquidity problems.
Covered bonds have reduced banking groups' overall funding costs. To certain extent, this decline should have been moderated by a higher price for unsecured funding, as a larger proportion of banks' assets became pledged to covered bond creditors. A number of factors limit this effect, however. An expected government guarantee for systemically important banks may mean that their creditors will not seek compensation when a larger share of banks' assets is encumbered. Because the volume of encumberable assets has been reduced, the banking group's liquidity risk will rise, but market participants may assume that central banks or other authorities will bear this higher risk. Nor is the risk that payments from the Norwegian Banks' Guarantee Fund rise as encumbrance increases reflected in the premiums paid into the fund.
1.3 Possible measures to strengthen resilience
Undesirable portfolio adjustments prompted by implicit financial sector guarantees should be limited primarily by reducing these implicit guarantees. A new international crisis resolution system to wind down troubled banks, where also financial institutions' unsecured creditors face a real risk of losses, will be important. Requirements for more loss-absorbing capital in financial institutions will reduce undesirable adjustments to implicit guarantees. However, there is uncertainty regarding both the timing and impact of these measures.
The European Commission is proposing a new crisis resolution tool, so-called "bail-in", under which liabilities are written down or converted to common shares in lieu of liquidation. Making use of this tool requires a certain level of unsecured liabilities. The Commission is therefore proposing a requirement for the level of unsecured liabilities. Any restriction on collateralising residential and commercial property mortgages should be viewed in the context of the Commission's proposal.
Incentives to encumber ever more assets can also be limited by forcing banks to bear the real costs associated with it. Increased asset encumbrance has increased the risk to the Norwegian Banks' Guarantee Fund. To ensure that banks' guarantee fund premiums better reflect this risk, allowing premiums to take account of the encumbrance level of residential and commercial property mortgages should be considered.
There is currently little publicly available information regarding the extent of asset encumbrance in a banking group. Banks' creditors need more information to assess the risk in their claims on banks. It would be an advantage if banks disclose more information regarding the collateralisation of their assets. It is also important for supervisory authorities to closely monitor developments in asset encumbrance at credit institutions, as proposed by the European Systemic Risk Board 1.
Norges Bank endorses the view of Finanstilsynet and the Ministry of Finance that restrictions should be considered on funding residential and commercial property lending with covered bonds. Such a limit can help to ensure diversified bank funding and enhance crisis management, thereby improving the financial stability outlook. At the same time, Norges Bank points out that a number of new regulations are pending to mitigate risk in the banking sector. Any measures to limit banks' ability to encumber assets must be viewed in the light of other requirements applicable to banks.
2. Access to the central bank lending facilities by covered bond mortgage companies
2.1 Access to standing facilities
The Ministry of Finance is of the opinion that measures that can reduce the financial ties between owner banks and mortgage companies should be considered. The Ministry has therefore asked Finanstilsynet to assess whether covered bond mortgage companies should be granted a restricted banking licence (authorisation to extend loans, but not accept deposits from the public) to reduce the need for guarantees and drawing facilities from the owner bank to the mortgage company. Norges Bank has been asked to assess whether mortgage companies that could be eligible for a restricted banking license may be given access to the central bank's lending facilities (cf. Section 19 of the Norges Bank Act)2.
Norges Bank's standing facilities are instruments for managing liquidity in the banking system. By allowing banks to borrow or deposit funds, Norges Bank is able to manage the level of banks' total deposits with the central bank. The aim is to enable the key policy rate to feed through to short-term money market rates. Throughout the day, banks may borrow unlimited reserves interest-free against collateral (intraday D-loans). This ensures smooth functioning of interbank payment settlements. Banks redistribute liquidity to avoid having a shortfall of reserves when Norges Bank's settlement system closes at the end of the day. Such end-of-day shortfalls will automatically be converted to overnight D-loans at a rate higher than the key policy rate.
It is the crucial role that banks play in the payment system that is the reason why they are Norges Bank's counterparties in the Bank's liquidity management. As the volume of payment transactions is largely governed by banks' customers, there can be wide fluctuations in banks' liquidity and a need for banks to manage their liquidity on an ongoing basis. Another characteristic of banks is that they accept deposits from the general public, and unpredictable movements in deposits are a further reason for banks to be active in redistributing liquidity.
A covered bond mortgage company with a restricted banking license will neither accept retail deposits nor execute retail payments. If covered bond mortgage companies were given access to the lending facility, their role in liquidity redistribution in the money market would probably be limited. Regarding the need for access to the central bank lending facility, a Finance Norway (FNO) memo of 3 December 2012, "Oppfølging av status OMF-markedet høsten 2012" [Update on status of the covered bond market, autumn 2012] states, "This (i.e. access to the lending facility) does not matter for day-to-day operations, since mortgage companies' liquidity management is sound. The problem is to ensure refinancing, if the bond market should seize up again, as it did in autumn 2008." This assessment is confirmed by experience from Denmark. Danish mortgage companies have been eligible for central bank borrowing since 1999, but their contribution to liquidity redistribution in the money market has been very limited.
Mortgage companies' liquidity risk is particularly associated with the rollover of covered bonds. They can reduce this risk by ensuring minor differences in the timing of incoming and outgoing payments, longer maturities on covered bond funding or increasing their stock of liquid assets. Many have liquidity guarantees from their owner banks. This is important if a mortgage company is to obtain a high credit rating. In a memo of 27 September 2012, FNO writes that the purpose of any access to the lending facility is access to central bank liquidity in a crisis situation when markets seize up. There is reason to emphasise that Norges Bank's liquidity facilities are not intended to limit an individual institution's liquidity risk or function as a funding source but are instruments designed to implement monetary policy and payment settlement.
On this basis, the Bank concludes that covered bond mortgage companies should not be given general access to the central bank lending facility. A restricted banking licence does not appear to be a relevant argument in this context. Moreover, this argument is insufficient for Section 19 of the Norges Bank Act to apply, since the granting of liquidity loans is expressly restricted to commercial banks and savings banks.
2.2 Extraordinary liquidity provision
Norges Bank's ability to extend liquidity support to financial institutions in extraordinary cases is not limited by whether the institution has ordinary access to the lending g facilities. Norges Bank may make loans or extend other forms of credit to entities other than banks in the financial sector (cf. Section 22 of the Norges Bank Act). Covered bond mortgage companies are covered by this provision. In 2004, Norges Bank's Executive Board approved guidelines for extending extraordinary liquidity support under which such support should be restricted to situations where, in the opinion of the Bank, financial stability may be threatened if such support is not provided3. It is neither possible nor desirable to predefine situations where financial stability is being threatened. Section 22 of the Norges Bank Act has previously been invoked for extending extraordinary liquidity support in the form of S-loans to non-bank entities. For example, S-loans were extended to Realkreditt (a mortgage company) in April 1991 (before the new guidelines were issued) and to the Norwegian Banks' Guarantee Fund in October 2008.
1 )Recommendation of the European Systemic Risk Board of 20 December 2012 on funding of credit institutions (ESRB/2012/2), http://www.esrb.europa.eu/pub/pdf/recommendations/2012/ESRB_2011_2.en.pdf?5e80674581780b58821fcbbc2104cc04
2) Under Section 19, Norges Bank "may grant liquidity loans to, make deposits with, and extend credit in other forms to commercial banks and savings banks".
3) Financial Stability 2/2004, pp. 36-37.