LONDON: A draft laying out what could be the final rules for covered bonds and asset-backed securities under the Liquidity Coverage Ratio has made concessions to both sides.
But some market players are fighting against rating criteria to allow more assets into the liquidity bucket before the European Commission blows the final whistle.
In its latest adaptation of the LCR, which requires banks to hold enough liquid assets to cover a 30-day cash shortfall, the commission's market unit has ratified the inclusion of covered bonds as Level 1 assets, and the broader range of ABS that will be accepted as Level 2B buffers.
In less than three weeks, SME, auto and consumer ABS will finally earn the official status of "highly liquid assets" that RMBS (and now fully guaranteed residential loans too) enjoy, just days before the European Central Bank begins shopping for "real economy" assets.
But the draft, seen by IFR, also adds criteria beyond ratings for assets to qualify. And it's here that national players still hope to influence regulators to accept even more assets as highly liquid.
In addition to being rated Double A or higher, covered bonds must now be overcollateralised by at least 2 percent to qualify for the top-tier bucket, subject to a 7 percent haircut.
And level 2A, in which a 15 percent haircut applies, requires 7 percent overcollateralisation on top of a minimum Single A rating.
Moreover, covered bond eligibility requires banks to post information every six months on the type of the underlying assets and the value and maturity of the pool and bond.
The commission has added "features that can ensure that the right assets are included," a senior source said.
Although the text doesn't scrap the rating requirement, it spells out minimum criteria that could, in future, grant access to the liquidity buffer in the absence of a minimum rating.
"There is a general policy to try to move away from rating agencies, but you have to have workable alternatives in place before that," the senior official said.
For securitisation, the criteria include portfolio granularity (single loan exposures capped at 0.5 percent), tranche seniority regardless of rating, underwriting standards and a EUR100m minimum size.
The text also splits haircuts on Level 2B securitisation, subject to a minimum Double A requirement, to 25 percent for RMBS and auto loans and 35 percent for SME and consumer ABS.
The addition of the "most senior tranche" clause, which aligns the LCR definition of high-quality securitisation with that of the insurance capital requirements law, may disappoint participants hoping for high-quality subordinated tranches to be considered sufficiently liquid.
But it has an upside, according to Boudewijn Dierick, head of ABS and covered bond structuring at BNP Paribas.
It would avert the risk of geographical discrimination, as a Double A or Single A rating may mean a mezzanine tranche on a core deal, but senior on a peripheral trade.
"Why should they allow mezzanine tranches of core deals and not allow mezzanine tranches of peripheral ones if this is purely driven by sovereign rating caps?" Dierick said.
And it does underpin the broader move away from linking regulation to pure rating criteria, he added. The good news for covered bonds is that the commission has ditched the "double rating" requirement on both the bond and its originator added in a previous draft.
This would have resulted in a loop back to sovereign risk, which is what the LCR tries to safeguard against, said Luca Bertalot, secretary general of the European Covered Bond Council.
"Reducing the overreliance on ratings could indeed play a pivotal role in creating a more resilient banking sector," he said. The inclusion of transparency requirements would underpin this effort, he said.
Sources familiar with the negotiations believe it unlikely that the LCR will see any further easing of rating rules this time around.
"The text now is fairly balanced, so this should be it. But one can never exclude that there will be some changes for reasons that are not purely technical," another senior source said.
The draft will now be reviewed by group of high-level representatives of the 28 member states, before the commission finalises it at the end of September or beginning of October.
This is when a bloc of Southern European countries - where lower sovereign ratings restrict ABS and covered bond rankings - pushing for lower rating requirements may get its voice heard, a source said.
"There is pressure among regulators to ensure equal treatment across countries, which may mean that there could, in theory, be some changes on the rating requirement," Dierick said. For example, the ABS requirement could be lowered from a minimum Double A to Single A, conditional on a higher haircut, he added.
But "chances of this happening are very small as the LCR text is close to its final form," he added. The general expectation is that there won't be any substantial change, at least for ABS.
Due to using crisis-era data to assess ABS liquidity, the commission was constrained in how far it could go to start repairing securitisation's reputation which means it continues to treat covered bonds as "more secure and generally liquid assets" the senior source said.
But both the commission's LCR and Solvency II rules will quickly become outdated once the European Banking Authority's report on High Quality Securitisation comes up in the first half of October.
This is set to outline more generous criteria to define top-tier securitisation, which can grant them better capital and liquidity treatment.
The original LCR proposal "landed more or less at the same time as policymakers started to realize the quality of HQS," said Ian Bell, head of the industry group Prime Collateralised Securities.
The commission seems to have made as many last-minute changes as it could to treat securitisation more favourably, but came hard against deadlines set out under the Capital Requirement Directive, of which the LCR is part, Bell said.
"They are recognising that they'll have to do much more fixing in the review, because the rules are no longer compatible with their longer term view on securitisation," he said.
The sources said the commission will review the law two or three years after it enters into force, and that it "stays as open as necessary" to adjust the treatment of ABS.
So even if the rules are passed as proposed in the current draft, the ABS market can still hope for bigger victories.
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