EU Praises Danish Covered Bonds Amid Liquidity Status Review

The European Commission said it will take into account the particular strengths of Denmark’s covered bond market as it reviews a proposal by Europe’s bank regulator to give the securities second-class liquidity status.

“The Commission is aware of the crucial importance of the covered bond market,” Chantal Hughes, spokeswoman for the European Union’s financial services chief Michel Barnier, said in a Jan. 10 e-mail. “The Commission also recognizes the long tradition and solidity of Danish covered bonds, in particular, and their good liquidity characteristics, even in times of acute stress.”

Denmark’s $555 billion mortgage-backed covered bond industry has been in shock since it emerged in November that the European Banking Authority would advise against giving the securities the highest liquidity status. In doing so, the London-based EBA is going against the findings of its own technical report, published a month earlier. Instead, the EBA recommends that the top grade be reserved for government debt, including bonds from bailed out nations such as Greece and Portugal.

The EBA’s guidance is advisory and the commission will prepare standards that should “specify which assets qualify as being of high and extremely high liquidity/credit quality,” Hughes said in the e-mail.

Schaeuble Meeting

The commission, the EU’s Brussels-based executive arm, is due to decide in June.

Europe’s willingness to “take a closer look” is welcomed, said Jesper Berg, head of regulatory affairs and senior vice president at Copenhagen-based Nykredit Realkredit A/S, Denmark’s largest mortgage lender.

“This is an issue that has very serious implications for the way Denmark functions as a country,” Berg said. Any decision would have consequences “not only in relation to housing finance, but also to the financing of the small and medium-sized enterprises, to the unique prefunded pension system and to the fixed exchange rate policy,” he said in an e-mail in response to questions.

Economy Minister Margrethe Vestager has arranged meetings with lawmakers elsewhere in the EU to argue Denmark’s case. On Jan. 14, she is scheduled to speak with German Finance Minister Wolfgang Schaeuble to discuss the merits of the Danish covered bond market, her office said.

Completely Off

“It would be completely off if” mortgage-backed covered bonds “couldn’t be used to meet banks’ liquidity needs,” Vestager said in an e-mailed reply to questions on Jan. 11. “We will do everything to ensure that the EU Commission, which has been tasked with formulating the final rules in this area over the coming months, understands this.”

The EBA wants Europe’s banks to limit holdings of covered bonds to 40 percent of their liquid assets, and to book them at only 85 percent of their market value, echoing 2010 rules set by the Basel Committee on Banking Supervision. Denmark has argued such a requirement would trigger a sell-off of the nation’s mortgage bonds and send shock waves through the world’s biggest home-loan market per capita.

“I’m deeply troubled by what happened at the EBA as officials ignored the evidence and started to politicize the matter,” Bendt Bendtsen, a Danish member of the European parliament and a former deputy prime minister, said in a phone interview. “Directors at the EBA are all previous Basel III people and they’re doing this as they’re afraid covered bonds will retain the same rating as government debt.”

Liquidity Traps

Danish banks hold about 34 percent of the country’s mortgage market. The securities make up as much as 75 percent of banks’ liquidity buffers in part because the amount of government debt available is low, industry estimates show.

Denmark’s covered bond market is almost four times the size of its stable AAA-rated government debt market, and more than 1 1/2 times the nation’s $340 billion gross domestic product, central bank figures show. Denmark’s public debt will reach 43.7 percent of GDP this year, compared with a euro-zone average of 95.9 percent, the EU Commission said Nov. 5.

Because most Danish government debt is long-term, the securities are “not well suited as liquidity risk management instruments,” the central bank said in comments submitted to the EBA’s consultation web page and published Jan. 10. “Requiring financial institutions to hold a large proportion of the government bonds in circulation in a liquidity buffer would in itself negatively impact the liquidity of these bonds.”

If the commission follows the EBA’s advice, Denmark’s mortgage industry says it will try to apply for an exemption allowing nations with small government debt markets to exceed the 40 percent cap on covered bonds in banks’ liquidity buffers.

40% Cap

Economy Minister Margrethe Vestager said last month the government will fight to ensure the EBA is sidestepped, while Denmark’s financial watchdog told banks to disregard the EBA for now. Central bank Governor Lars Rohde predicted the European Commission will pay greater attention to studies showing covered bonds are as liquid as sovereign debt than to the EBA’s proposal.

Denmark isn’t alone in lobbying the commission to ignore the EBA. The mortgage bond industries of Norway and Germany, the European Covered Bond Council and the Covered Bond Investor Council have all aligned themselves with the Nordic country.

Before it's here, it's on the Bloomberg Terminal.