Covered Bond Fight Sidelines Basel’s Bank Goals: Nordic Credit

A 3 1/2 year lobbying tour de force by Danish bankers and politicians is bearing fruit as Scandinavia’s smallest economy looks poised to persuade the European Union to sidestep Basel III liquidity rules.

At stake is Denmark’s $550 billion mortgage-backed covered bond market, the world’s largest per capita, which the government in Copenhagen says would be penalized by Basel rules that limit bank holdings of the securities. Denmark has argued it doesn’t have enough government bonds, favored by Basel, to make up for the shortfall in banks’ liquidity buffers.

On Friday, Denmark said the European Commission had listened to its concerns and will now recommend letting banks hold 75 percent more in covered bonds than Basel rules allow. Though the commission still has until June 30 to reveal its final decision, the development marks a victory for Denmark, which doesn’t hold a seat on the 27-member Basel Committee for Banking Supervision.

“There’s probably a conflict with Basel,” Economy Minister Margrethe Vestager said in a phone interview. “I’m sure they’d like to see implementation closer to what they laid down.”

‘A Surprise’

Banks will be allowed to book the most liquid covered bonds -- securities backed by pools of mortgage assets --at 93 percent of their market value, compared with Basel’s target of 85 percent, Denmark’s economy ministry said Friday. Lenders will also be free to use the bonds for as much as 70 percent of their liquidity buffers, versus 40 percent under Basel III rules. The plan applies to all European covered bonds that meet “certain criteria,” according to the ministry, which cited an EU commission proposal.

“It comes as a surprise and shows that the lobbying works,” Joost Beaumont, a fixed income strategist at ABN Amro Bank NV in Amsterdam, said in a phone interview. “The process clearly shows that covered bonds are important to European banks.”

Denmark’s drive to shape EU liquidity requirements leaves the region with rules that “are clearly against Basel, but on the other hand Basel rules aren’t binding,” Jesper Rangvid, a professor of finance at Copenhagen Business School, said by phone. “The U.S. largely ignored implementing Basel II much to the dismay of Europeans, but it didn’t have any practical implications.”

Reduces Risk

The European Commission “has not yet brought forward its proposal,” Chantal Hughes, spokeswoman for the EU’s financial services chief, Michel Barnier, said in an e-mail. “The process is ongoing,” she said.

The EU’s proposal, as presented by Denmark, “reduces the largest downside risk that we’d seen previously for mortgage-backed covered bonds,” Jan Weber Oestergaard, a senior analyst at Danske Bank A/S, said in a note. “We recommend staying overweight in relation to government bonds.”

The yield on Nykredit A/S’s 2 percent mortgage note due October 2016 eased to about 0.44 percent on Friday, its lowest since April 16, and traded at 0.45 percent today. The spread relative to the government yield curve was little changed at 29 basis points today, its smallest since April 24.

“It will be good for prices and spreads, in general,” Beaumont said. “It comes as a surprise and if it ends up going through in this form, it could lead to a narrowing of spreads.”

Lobbying Continues

The Danish government is continuing its efforts to lobby other European Union members to ensure the commission’s proposal is passed, it said. Doing so will help “ensure that Danish mortgage bonds are treated appropriately, also in the final rules,” the ministry said.

“Basel is a good thing but it’s necessary that rules also work in reality,” Vestager said. “Banks and financing works very differently in Europe and the U.S. and the regulation must be implemented to fit both. Rules shouldn’t be applied for the sake of just regulating but for regulations to work in real life.”

To be included in the top liquidity bracket, covered bonds must carry a high credit rating and be issued in sizes of at least 500 million euros ($692 million), the ministry said. The bonds also need to be over-collateralized, it said.

Basel III rules had reserved the top liquidity status for bonds sold by governments, even those bailed out during Europe’s debt crisis. The so-called Level 1 designation allowed banks to hold unlimited stores of sovereign debt at market value.

‘A Problem’

“The commission’s proposal, if passed in its current form, would mean that Danish financial institutions on the whole will be able to keep mortgage-backed covered bonds on their books to the same extent to which they hold them today,” the ministry said.

Still, Nykredit Realkredit A/S, Denmark’s biggest mortgage bank, said the concessions won aren’t enough.

“Under normal circumstances, 70 percent ought to be enough,” Jesper Berg, a member of the executive board at Nykredit Bank and head of regulatory affairs at Nykredit Realkredit, said in an e-mail. “But it leaves the Danish mortgage market vulnerable. In times of stress, it will limit banks’ ability to act as buffers in the bond market. And that’s a problem.”

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