Structural subordination
Differences in recovery expectations are another main determinant of the relative value between covered bonds
and senior unsecured. Against this backdrop, rising concerns from senior unsecured investors about structural
subordination have been a factor supporting the covered bond market. The increased use of covered bond funding
by banks over the last several years means that more assets were ring-fenced. As assets in the cover pool are not
available to cover the claims of senior unsecured investors in case of issuer insolvency
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, market participants have
started to worry about the growth in covered bond issuance and the subsequent reduction of assets available to
unsecured investors in an insolvency scenario. This problem has been exacerbated by rating agencies’ demands
for higher over-collateralisation levels, which in most cases significantly exceed the legal over-collateralisation
requirements and further reduce the amount of assets available for investors outside the cover pool.
While we understand the concerns in the market, we think asset encumbrance discussions often tend to over-state the problem arising from structural subordination through covered bonds while ignoring other sources of
encumbrance (including contingent encumbrance when a bank’s financial situation deteriorates) such as central
bank repos/liquidity assistance as well as ignoring offsetting factors. The use of covered bonds usually results
in lower funding costs for the banks and significantly broadens the investor base allowing issuers to tap rates
investors such as central banks. In addition, it is a more stable funding base. Even if the unsecured market
is closed for an issuer, the bank may still be able to access the wholesale markets by the means of covered
bonds or, in a worst case scenario, it can retain the bonds to use them for repo transactions with central banks
such as the ECB. Moreover, the potential issuance volume of covered bonds is not unlimited. The availability of
eligible assets is a restricting factor for covered bond issuance, putting a cap on the actual issuance potential.
Also the aforementioned requirements from rating agencies, of high over-collateralisation levels, further reduce
the available headroom for covered bond issuance.