Fitch on a brave new (bank funding) world

Posted by Tracy Alloway on Jun 16 14:04. 2 comments | Share

Here it comes. The first rumbling from a rating agency on secured funding.We’ve been harping on about it for months now — but what the heck. Here’s some more. And specifically, extracts from Fitch Ratings in their special report on trends in bank funding profiles: More…

Here it comes. The first rumbling from a rating agency on secured funding.

We’ve been harping on about it for months now — but what the heck. Here’s some more. And specifically, extracts from Fitch Ratings in their special report on trends in bank funding profiles:

Following the collapse of Lehman Brothers in Q308, bank debt yields rose dramatically … The crisis affected some banks’ ability to issue in senior unsecured debt markets, and also in covered bond markets, where new issuance fell by 24% in 2008. Since then, the covered bond market has been quicker to recover, with annual issuance growth of 10% and 14% in 2009 and 2010 respectively, while issuance of senior unsecured debt continued to trend downwards. From a broader ratings perspective, Fitch will continue to monitor the level of secured liabilities for a given financial institution relative to its overall funding mix. Fitch believes that a high dependence on secured sources of financing such as asset-backed securitisations, repurchase agreements, covered bonds or secured bank loans could constrain ratings. Fitch also believes that an over-reliance on secured financing could encumber most assets on the company’s balance sheet, reducing overall financial flexibility. In addition, a high concentration of secured financing increases the risk that unsecured creditors could be adversely affected as secured creditors may have priority claims to higher‐quality assets. If the industry shifts to a significantly higher level of secured funding versus historical levels, Issuer Default Ratings (IDRs) could come under pressure and unsecured debt ratings could fall below the IDR due to lower recovery expectations.

Of course, Fitch reckons we’re far from that point.

Banks have been issuing record amounts of covered bonds and increasing their reliance on repo funding, mostly from the world’s central banks. But not in sums significant enough to warrant the rating agency’s concern just yet. Indeed, Fitch notes that the use of secured funding — or bank credit with recourse to specified bank assets and collateral — is on the rise, but is expected to tail off as investors reacquaint themselves with bank risk and central banks withdraw liquidity measures.

It’s worth, though, taking a look at why Fitch thinks secured funding is on the rise — all of which have been covered on FT Alphaville at one time or another:

1. Investor risk aversion to the banking sector
2. Limited transparency of the risk underlying banks’ debt instruments
3. Dearth of safe financial assets
4. Central bank emergency measures
5. Regulatory reform

But again — Fitch isn’t worried.

Banks’ use of covered bonds is unlikely to reach dangerous levels … investors’ preference for a more favourable regulatory treatment of regulated covered bonds over contractual covered bonds, coupled with the limited availability of quality assets eligible under various covered bond legislative frameworks and regulatory limits to the proportion of covered bonds allowed, if properly monitored and enforced, would prevent banks from issuing excessive amounts of covered bonds.

Which is true of course. Though we’d caution that, per their legal structure, covered bonds require a continuous stream of quality collateral (and ongoing refinancing), as banks have to replace assets that no longer meet the bonds’ requirements (for instance — soured mortgages) with new ones.

In other words, covered bonds can act as a giant asset-gobbling millstone around banks’ necks, right when you wouldn’t want one, as well as an additional source of diversified post-crisis funding.

Some Fitch charts, to finish up with:

Related links:
Use of covered bonds by banks triggers warning – FT
The covered bond craze – IndexUniverse
Towards the limits of covered bond bank funding… – FT Alphaville
Covering up the capital structure – Deus Ex Macchiato

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