Side effects

In periods of high financial market volatility or affected by strong external shocks (think of the 2008 financial crisis or, more recently, the first wave of the Covid pandemic), banks are exposed to the problem of obtaining liquidity on a stable and continuous basis.
For European banks, the use of covered bonds represents a source of financing that is available even in periods of extreme financial tension, both as a method of funding appealing to institutional investors and as a source of guarantee for ECB refinancing operations.
In fact, covered bonds are bonds that guarantee payment of interest and principal to investors, not only on the basis of the issuer's ability to generate cash flows, but also thanks to the existence of a pool of high-quality assets reserved for the exclusive benefit of investors (so-called encumbered assets). When the solidity of the bank is not enough, the cash flows produced by the pool of reserved assets will intervene.

If, on the one hand, this double repayment guarantee generates a bond with high credit ratings and therefore a financial asset with low risk of default, on the other hand, the segregation of assets in a dedicated pool - and mind you, high-quality assets – creates significant problems for the bank's other creditors, depositors, other creditor banks and holders of unsecured senior bonds. In fact, these investors could incur in larger losses if the bank goes down. A smaller volume of remaining assets would be available for their reimbursement. This would generate what in jargon is defined as the effect of structural subordination of creditors with respect to subscribers of covered bonds. In turn, structural subordination could have another unintended effect. The bank's management could have the incentive to increase the risk of the assets not included in the pool warranting covered bonds, so that uncovered assets can generate higher yields to repay the structurally subordinated creditors. Clearly, this is an effect that is not particularly welcome by regulators who, if on the one hand have repeatedly reiterated the importance of covered bonds as a funding instrument for the banking system, on the other hand are careful to avoid the repetition of moral hazard phenomena which could jeopardize the stability of banks themselves and their ability to resort to financial markets for its funding needs.
Together with Emilia Garcia-Appendini and Giacomo Nocera, we have studied a large sample of covered bonds issued by listed European banks in the 2005-2016 period.
Data analysis indicates that the increase in the portion of assets reserved as collateral for covered bonds (the so-called degree of encumbrance) does not have a significant impact on the total risk of banks included in the sample. However, the data demonstrate the existence of a negative effect caused by the structural subordination of creditors unassisted by encumbrance consisting of the increase in the spread on the Credit Default Swap (CDS), i.e. the price of the guarantee against bank default. It follows that unsecured creditors should have a greater incentive to monitor bank management to reduce their expected losses in the event of default.

The analysis of the sample also indicates that the effect of asset encumbrance on the bank's risk exposure depends on the proportion of non-retail institutional investors able to closely monitor management: for banks with a smaller proportion of such creditors, an increase of assets segregated for the benefit of covered bonds' underwriters leads to an increase in the total risk of the bank.
A further result of the analysis is that the relationship between asset encumbrance and banking risk depends on the bank's liquidity. The higher liquidity , the lower the risk is that the bank could face fragility issues due to repayment requests coming from creditors in the event of emerging difficulties.

Overall, the evidence collected raises the issue that regulators and monetary authorities should be wary of the potential side effects of regulatory interventions that lead to an increase in banks' levels of asset encumbrance, something which has already happened, for example, following the launch of the ECB program precisely devoted to the purchase of covered bonds (Covered Bond Purchase Program – CBPP).