Covered Bonds as Extremely High Liquid Assets (Level 1)
under the Liquidity Coverage Ratio
Brussels, February 2014
The European Covered Bond Council (ECBC) 1 represents the covered bond industry, bringing
together covered bond issuers, analysts, investment bankers, rating agencies and a wide range of
interested stakeholders. The ECBC was launched by the European Mortgage Federation (EMF) to
promote the interests of covered bond market participants at international level. As of February
2014, the ECBC brings together over 100 members from more than 25 active covered bond
jurisdictions representing over 95% of the €2.81 trillion outstanding covered bonds.
Executive summary
This paper is divided into two sections of which the first provides general comments regarding the
covered bond market and its impact on long-term financing, giving a brief overview on the
importance of covered bonds for the European economy. The second section tackles the question
of the qualification of covered bonds as Extremely High Liquid Assets (Level 1) under the definition
of the Liquidity Coverage Ratio (LCR), on the basis of the following texts and arguments:



The Capital Requirements Regulation (CRR) explicit reference to Covered bonds as extremely
high liquidity assets;
The empirical evidence presented in EBA studies; and
The risk of unintended consequences and drawbacks which may derive from incorrect use of
criteria based definitions.
Indeed, the ECBC advocates the inclusion of covered bonds in Level 1 assets under the LCR, in line
with:
1. Recital 100 of the Capital Requirements Regulation (CRR): “When making a uniform definition
of liquid assets at least government bonds, and covered bonds traded on transparent markets
with an ongoing turnover would be expected to be considered assets of extremely high liquidity
and credit quality”.
2. The preliminary results of the extensive empirical study assessing the impact of the
quantitative liquidity regulation and the uniform definitions of liquidity under Article 509 of the
CRR undertaken by the European Banking Authority (EBA2) and presented during the EBA
public hearing on Liquidity Reports, which took place in London on the 23rd of October 2013.
These results show that the ranking of covered bonds for liquidity metrics is very similar to that
of government bonds and that there is a clear differentiation with regards to other bond asset
classes (corporate, ABS) and equities. While the EBA did not so far draw any conclusions from
1
The European Covered Bond Council is registered in the European Institutions’ Transparency
Register under European Mortgage Federation ID Number 24967486965-09.
2
http://www.eba.europa.eu/
1
its study, the ECBC understands these results as evidence of the fact that covered bonds
should qualify as Extremely High Liquid Assets (Level 1), under the definition of the LCR.
The EBA also stressed that “In covered bonds, variables capturing the existence of regulatory
characteristics which reduce credit risk and enhance transparency are significant predictors of
liquidity”.3
Moreover, we believe that the inclusion of covered bonds in Level 1 would mitigate against the over
reliance on sovereign debt by the European banking sector and would facilitate the objective of
delinking the sovereign from the banking sector, which is one of the key inspiring principles for the
Bank Recovery and Resolution Directive (BRRD). Indeed, if the numerator of the LCR ratio is only
constituted of sovereign or central banks securities, it would be an obstacle to the financing of the
real economy by banks, whereas covered bonds have all of the required features to be eligible as
Level 1 assets.
Furthermore, the ECBC is concerned about the inclusion of rating triggers in European legislation,
which could cause unintended disruption to the level playing field that exists amongst European
countries. Therefore, the ECBC invites the EBA and the European Commission to consider the work
undertaken by the covered bond industry to enhance the transparency and consistency of the asset
class including, for example, the Covered Bond Label4 – aligned to Article 129 of the CRR as of the
1st of January 2014 – as an alternative means for identifying a qualitative segment of the covered
bond market, an alternative which is based on objective criteria in terms of transparency, credit
quality and liquidity.
Finally, the ECBC would like to highlight the positive rationale to include covered bonds in Level 1
that derives from the EBA empirical study. The covered bond asset class has indeed proved to be
the most reliable source of wholesale funding through adverse market conditions and has
significantly contributed to the financial stability of the European economy.
1. General Remarks
Covered bonds are one of the key components of European capital markets with the asset class
playing an important role as a robust long-term financing instrument contributing to the efficient
allocation of capital and, ultimately, economic development and prosperity.
Across time and crises, covered bonds have consistently increased their role in the financing of real
estate, public sector and ship assets. The crisis that began in 2007 brought about a number of
major changes as the G20 post-crisis reform agenda continues to reshape the banking sector’s
regulatory landscape. Central banks play a highly proactive role in providing liquidity and have now
become major stakeholders in the development of the covered bond asset class. Investors are
asking for more and more information, a demand which is being met by issuers through a major
initiative to deliver greater transparency: the Covered Bond Label. We are seeing new issuers enter
3
See presentation made by the EBA on 23 October 2013: http://www.eba.europa.eu/newspress/calendar?p_p_auth=dZz4x2tU&p_p_id=8&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&_8_stru
ts_action=%2Fcalendar%2Fview_event&_8_eventId=416329
4
http://www.coveredbondlabel.com/
2
the market and new covered bond frameworks being established in many countries around the
world.
With over EUR 2.81 trillion outstanding at the end of 2012, covered bonds continue, now more
than ever, to play a central role in banks’ funding strategies. The continued growth of the covered
bond market in 2012 evidences the ability of the asset class to provide essential access to longterm capital market funding, even during volatile market conditions, notably thanks to a stable
investor base. Covered bonds’ consistently strong performance and quality features have attracted
the attention of regulators and market participants worldwide, which, in turn, has led to an
increasing recognition of the macro-prudential value of the asset class.5
2. Covered bonds as Level 1 under LCR
The ECBC advocates the inclusion of traditional legally based covered bonds in the asset class of
extremely high liquidity and credit quality, i.e. Level 1 assets under the LCR. Covered bonds have
consistently performed well throughout crises, including the current financial crisis6, which makes
them a vital tool allowing the banking sector to provide credit on a continuous basis. The
recognition of the covered bond asset class as a stable source of long term funding has widened, as
has the support for their inclusion in the LCR at a level which correctly reflects their importance
and contribution to the growth of the European economy. Indeed, the liquidity performance of
covered bonds during the financial crisis clearly documents their robustness and justifies the
recognition of this asset class as Level 1 assets.
Moreover, we invite the European Commission to consider covered bonds as Level 1 asset class, as
this is more consistent with the Capital Requirements Regulation (CRR) philosophy, which is the
European transposition of Basel III recommendation. The Basel recommendation, which initially
proposed that covered bonds be in the Level 2 of High Quality Liquid Assets (HQLA) assets, should
not be taken literally in its European declination as it is very inspired by countries outside of the
European Union in which covered bonds are very slightly present, if any, and in which securitisation
is predominant.

Covered bonds mentioned in CRR as having extremely high liquidity
The above position is confirmed by the Capital Requirements Regulation (CRR) itself as it already
proposes covered bonds, traded on transparent markets with an ongoing turnover, as extremely
highly liquid assets (Level 1). This is actually stated in recital 100 of the CRR7 which points out the
intention to deviate from the Basel Committee on Banking Supervision (BCBS) standards on this
issue.
5
For further information on the importance of covered bonds as a long term funding tool, please refer to Annex
I.
6
This is also mentioned in the European Commission’s Green Paper on Long term financing in the European
economy:
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:52013DC0150:EN:NOT
7
“When making a uniform definition of liquid assets at least government bonds, and covered bonds traded on
transparent markets with an ongoing turnover would be expected to be considered assets of extremely high
liquidity and credit quality”.
3
In addition, the inclusion of covered bonds in Level 1 is considered necessary “to promote a
diversified and high-quality liquidity buffer consisting of different asset categories” as stated in
recital 100 of the CRR. In particular, including covered bonds as Level 1 assets will reduce the
correlation between sovereign crises and the robustness of the national banking sectors.

Empirical evidence in EBA studies
It is very important that the definition of liquid assets in the LCR is based on evidence, which is
achieved with the EBA’s own empirical studies on liquidity8 that show that covered bonds’ liquidity
ranks at the same level as government bonds and even outperforms them on a few criteria such as
price volatility.
These empirical studies also show that covered bonds outperform non-financial corporate bonds,
ABS/RMBS and equities. Hence, an equal treatment of covered bonds and other asset classes, like
non-financial corporate bonds, as Level 2 assets does not seem to be justified.
Moreover, the EBA highlights that “In covered bonds, variables capturing the existence of regulator
characteristics which reduce credit risk and enhance transparency are significant predictors of
liquidity”.
Covered bonds are subject to strict regulation, public supervision and are a highly transparent
asset class – not least thanks to the Covered Bond Label9. The CRR now introduces new
transparency requirements on the issuer for the covered bonds to qualify for a preferential
treatment10. In addition, covered bonds are secured by a cover pool of high quality assets, and
investors have a preferential claim on the assets in a default situation.
The fact highlighted by EBA, that two thirds of the observations on covered bonds in the EBA study
came from markets that did not experience a real estate crisis, should not prevent covered bonds
from receiving the Level 1 status. This rather shows that the one third of the covered bonds
coming from markets that experienced a real estate crisis were not affected by developments in
related markets as they maintained their liquidity levels. It also shows that the decision with regard
to their inclusion is not a binary decision (inclusion/non-inclusion) but that additional criteria can be
used to differentiate within the asset class.
In conclusion, all these elements strongly concur to evidence that covered bonds should qualify as
Extremely High Liquid Assets (Level 1).

Incorrect use of criteria based definitions can have unintended consequences and
drawbacks
We support the criteria based definition of liquidity outlined in the CRR and applied by the EBA in
the empirical studies. Nevertheless, we find that the EBA's recommendation regarding issue
specific requirements of liquid assets has a number of flaws.
8
EBA Report on definition of HQLA, December 23 2013
See information on the Covered Bond Label on: https://www.coveredbondlabel.com/
10
CRR (Regulation No 575/2013) art.129, 7a
9
4
For instance, the EBA recommends categorising covered bonds as liquid assets on the condition of
an issuance size of minimum 250 mn Euro, while RMBS could be categorised as liquid assets from
an issuance size of 100 mn Euro. Clearly, this means that if the European Commission were to
follow this recommendation, covered bonds would be put at a disadvantage compared to RMBS.
Neither this, nor the recommendation setting absolute minimum requirements on issue size for
covered bonds, is supported by the empirical results. The results on the relationship between issue
size and liquidity for covered bonds in the EBA’s analysis seem to be inconclusive11. As a matter of
fact, some results indicate that covered bonds with smaller issue sizes may be even more liquid
than bonds with larger issue sizes.
A working paper by Bank for International Settlements (BIS)12 examining the liquidity in Danish
market for government bonds and covered bonds finds that “benchmark covered bonds by and
large are as liquid as government bonds – including in periods of market stress”. The average issue
size in the data sample is larger for the government bonds than for the covered bonds. Therefore,
one should be careful to apply absolute measures as indicators of liquidity for financial instruments.
In addition, the EBA recommends that for some asset classes, minimum rating requirements are
applied when categorising the liquidity of an asset. Evidently ratings do change and the
implications can be substantial. Due to the large differences in haircut for the different liquidity
levels, the minimum rating requirements can produce cliff-effects, pro-cyclicality and systemic
disruptions. These consequences are also amongst the main reasons for the recent global emphasis
on reducing the regulatory reliance on ratings.
Finally, covered bonds have more characteristics in common with government bonds, which qualify
as Level 1 assets, than with the other instruments EBA identifies as Level 2 assets. Thus covered
bonds should be treated as Level 1 assets. When regulating across markets the characteristics of
the individual covered bond markets must be taken into account.
The ECBC stands ready to assist in its role of market catalyst and think tank with the identification
of appropriate criteria for defining Level 1 assets. We hope that you will take our remarks into
consideration. Please do not hesitate to contact us if we can be of any assistance or if you would
like further clarification or elaboration on our views.
11
EBA Report on definition of HQLA, December 20 2013, Results presented in table on p. 46
Dick-Nielsen, J., J. Gyntelberg and T. Sangill (2012): “Liquidity of Danish Government versus Covered Bonds
Markets”,
Bank
for
International
Settlements
(BIS)
Working
Papers,
No.
392
(2012)
http://www.bis.org/publ/work392.htm
12
5
Annex I

A long-term funding tool for the real economy
The covered bond industry shares the key objectives of the current legislative developments
undertaken in Europe, which aim to contribute to the long-term growth of the European economy
by designing a robust and efficient private financial sector able to ensure financial stability and
long-term financing.
The on-balance structure of covered bonds has been clearly identified, from a macro-prudential
perspective, as an efficient and simple alternative to complex originate-to-distribute products and,
therefore, as a key driver for a virtuous cycle in managing risks and ensuring financial stability.
Covered bonds are indeed an effective tool to channel long-term financing for high quality assets at
reasonable cost. They improve banks’ ability to borrow and lend at long-term horizons and, hence,
represent a stable source of funding for key banking function such as housing loans and public
infrastructure. In this regard, we believe that covered bonds represent a key funding tool for the
future European banking industry.

Public infrastructure and housing loans
Covered bonds are dual recourse debt instruments issued by credit institutions and secured by a
cover pool of financial assets, typically composed of housing loans or public-sector debt. In this
regard, covered bonds play an important role in financing long-lived capital in Europe and
investments with a wide public benefit.
For example, when it comes to housing finance, long-term financing is crucial. Building or
purchasing a home is the major investment for most of the European citizens, representing
typically 4 to 5 times their annual income. In absence of pre-existing wealth, they would have to
wait for 40 or 50 years if they had to solely rely on their individual savings.
Borrowing resources is therefore necessary to acquire a home and, more generally, to reactivate
the European economy. Given the size of the investment, their repayment must be spread out on a
long period to be compatible with annual savings capacity and, hence, requires long-term funding
tools for banks to avoid asset and liabilities mismatches. Covered bonds are typically designed for
mortgage lending, and it is important to recall that a mortgage-focused bank thus tends to have
more asset encumbrance than a bank with a non mortgage focus 13. Now more than ever,
considering the low appetite for risk, investors need reinforced security to lend for long-term
period.
In this context, with their key safety features, such as strict legal and supervisory framework,
asset segregation or a cover pool actively managed in order to maintain the quality of the
13
For specialised issuers, the level of encumbrance – given a broad definition – is close to 100%. For those
financial institutions which do not take any deposits, all senior investors are professional investors who are well
aware of their position in the priority ranking in case of insolvency. For such institutions, the high level of
encumbrance is therefore only a consequence of their business model and should not be interpreted differently.
6
collateral, covered bonds play an essential role in ensuring the flow of capital in financing longterm growth and the real economy.
The covered bond success also lies in the industry’s capacity to respond to the challenges of the
current crises and its ability to share best market practices, allowing a continuous fine-tuning of
European covered bond legislations and helping to significantly increase the level of transparency
of this asset class.
During recent turmoil, this has allowed governments in Europe to constantly channel private sector
funds to the housing markets and maintain a relatively efficient lending activity without additional
increase of the burden for taxpayers and public debts as it is the case for instance in the US, where
95% of the mortgage market is benefiting for a governmental guarantee after the federal takeover
of Fannie Mae and Freddie Mac. Other countries where their banking sector did not have the ability
to issue covered bonds such as Australia or New Zealand have in the meantime – mainly in
response to the recent banking crisis when many of their banks faced the funding problems –
introduce covered bond laws and have broaden the available funding channels for their financial
institutions.

Who invests on covered bonds
Through the crisis, covered bonds have reaffirmed their good track record from a number of key
angles: 1) less market volatility compared with sovereign or bank senior unsecured debt; 2) better
rating stability, although they were not immune from downgrades given their link to sovereign and
bank ratings; 3) the security provided by their cover pools, which are increasingly domestic
residential mortgages (although national differences are evident); 4) regulatory support from the
European Central Bank (ECB) Covered Bond Purchase Programmes or their preferential treatment,
notably in regulations such as ECB repo eligibility, Bank for International Settlements (BIS) capital
charges, Basel III Liquidity Coverage Ratio, Solvency II, Bank Recovery and Resolution Directive
(BRRD). As a result, covered bonds have attracted a widening range of investors by type and
across countries.
Banks and central banks remain major investors (see Figure 1) focusing, especially since last
summer, on the less volatile and highly rated names for liquidity purposes or to meet regulatory
criteria. Asset managers tend to prioritise yields/performance versus their benchmarks and, thus,
have been less restricted in terms of issuer names and geographical markets depending though on
their internal limits (rating, counterparty, etc). Life insurers and pension funds are active,
especially in the longer maturities for Asset and Liabilities Management (ALM) reasons, being
typically buy-and-hold investors. The presence of hedge funds in the primary and secondary
market over the last few years illustrates the hybrid characteristics of covered bonds (which can be
traded as both rates and credit products) and their relative attractiveness versus some other debt
instruments.
Investors are active in covered bonds across Europe, with Germany having the largest and most
internationally diversified investor base (see Figure 2). The increase of supply from a broader
range of countries over the last 5-10 years has led to more cross-border diversification, thus
reducing the domestic bias of the past. This has enhanced the depth of some markets. Asian
investors have also been more active, especially since the start of 2013, although not across deals
7
– more on an opportunistic basis. The successful penetration of new non-European banks (e.g.
Australian, New Zealand, Canada, etc.) and their regular issuance has contributed to the widening
of the investor base in the EUR-benchmark covered bond market.
While investors are increasingly investing in non-domestic countries, this has not translated into a
conflict of interest. Data show that the investor base across debt instruments is still
complementary. This is obvious when comparing senior unsecured debt with covered bonds, for
example, with a lower participation of banks and central banks and broader geographical
diversification in the former (see Figure 3 and Figure 4). The USD-benchmark covered bond market
also offers a different investor profile – both by geography and investor type – emphasising its
strategic importance in terms of investor reach including for European issuers.
Figure 1: Allocation of €-benchmark issuance by
investor type -- covered bond market
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Figure 2: Allocation of €-benchmark issuance by
country -- covered bond market
100%
80%
60%
40%
20%
0%
2009
2010
Banks
Pension funds and insurance
Retail
2011
Central Banks
Hedge Funds
Corporates
2012
2009
2013
Asset managers
Agencies
Others
Germany/Austria
Ireland/UK
Middle East / Asia
2010
Italy
Benelux
Switzerland
2011
2012
France
Nordics
Eastern Europe
2013
Iberia
North America
Others
Source: Bloomberg, The Cover, Bank of America
Merrill Lynch
Source: Bloomberg, The Cover,
Merrill Lynch
Bank of America
Figure 3: Allocation of €-benchmark issuance by
investor type -- senior unsecured market
Figure 4: Allocation of €-benchmark issuance by
country – senior unsecured market
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2012
Banks
Pension funds and insurance
Retail
Central Banks
Hedge Funds
Corporates
2013
Asset managers
Agencies
Others
Source: Bloomberg, Bank of America Merrill Lynch
2012
Germany/Austria
Ireland/UK
M.East & Asia
Italy
Benelux
Switzerland
2013
France
Nordics
Eastern Europe
Iberia
North America
Others
Source: Bloomberg, Bank of America Merrill Lynch
8
Figure 5: Allocation of US$-benchmark issuance
by investor type -- covered bond market
Figure 6: Allocation of US$-benchmark issuance
by country -- covered bond market
100%
100%
90%
90%
80%
80%
70%
70%
60%
60%
50%
50%
40%
40%
30%
30%
20%
20%
10%
10%
0%
2011
2012
2013
0%
2011
Inv estment Manager
Bank
Central Banks/ Agency
Insurance & Pension
Corporate
Others
Source: Bloomberg, IFR,
Lynch
Bank of America Merrill
2012
Europe
USA & Canada
Source: Bloomberg, IFR,
Lynch
2013
Asia
Others
Bank of America Merrill
9