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The Prudential Regulation Authority doesn’t do clickbait, so you’d be forgiven for skipping a rulebook update from the UK banks regulator based on its headline alone:
Modification by consent of the Liquidity Coverage Ratio part of the PRA Rulebook — Third Country Covered Bonds
It’s now a dead link, but if you’d clicked through yesterday you’d have been served a paragraph of legalese about how the modification allows “a firm that has incorrectly applied a rule regarding third country covered bonds’ inclusion in Level 2A High Quality Liquid Assets (HQLA) of the Liquidity Coverage Ratio (LCR), to recognise these bonds on a limited and declining basis.” The change took effect immediately, on April 8.
What does it mean? The subject – bank capital buffers – is important enough to warrant clarity. The asset class, covered bonds, is widely held. The phrase “incorrectly applied a rule” suggests a mechanism for any firm that counts the wrong thing towards its buffer to correct the mistake.
Where it gets confusing is the rule. People told us the change was a retrospective action by the regulator to erase a rule that had been impossible for any firm to apply correctly.
We asked the PRA. A person familiar with its workings agreed with the above reading, telling us that its rule on covered bonds was invalid because the regulator has never tested the quality of those bonds. Soon after, the person told us to ignore that guidance and promised an update that never came. Repeated requests to the regulator over several days provided no more clarity.
This morning, the PRA posted an update saying it had pulled the change:
The PRA has received a number of technical comments and requests for clarification. As a result, the PRA has decided to pause the process and withdraw the modification, in order to consider and address the points raised appropriately. Once that process is complete, the PRA will clarify its approach.
In the interim, the PRA considers firms do not need to amend their approach to recognising third country covered bonds under the Liquidity Coverage Ratio (CRR) and Liquidity (CRR) Parts of the PRA Rulebook
Here’s things worked before April 8.
Banks must hold enough high-quality liquid assets to cover net cash outflows over 30 days of severe stress. Most of the buffer has to be made of cash, central bank reserves, certain sovereign-backed securities, or “extremely high quality covered bonds”, which are called Level One assets. Lower-quality covered bonds go alongside riskier stuff in Level Two, which is split into A and B, like this:
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The PRA had previously said it would count covered bonds issued by third countries as Level 2A assets. They had to be regulated to at least the UK standard, the cover pool exceeded the amount required to meet claims, and bondholders had priority if the issuer defaulted.
But according to a person briefed on the rule, the PRA had never taken a view on which of the lower quality non-UK covered bonds were equivalent to UK ones, so none could count towards Level 2A.
The original plan was to allow firms to roll off non-UK covered bond holdings that were bought before the end of January. These would be counted towards liquidity buffers under the old rules, though their value is capped and they can’t be replaced like-for-like on sale, maturity or redemption. In effect, holdings should roll off gradually towards zero.
The more disruptive effect was to push big buyers out of a small market. Per the below chart from SocGen, sterling-denominated covered bonds are a niche relative to the total . . .
. . . and tend to be bought by UK investors . . .
. . . but are only sometimes issued by UK institutions:
By changing the rule, the PRA would shrink the available investor base for sterling covered bonds, giving firms in Canada and Australia little incentive to continue issuance. Liquidity would suffer.
“While this would improve demand for sterling-denominated assets and/or gilts in the UK, it would also concentrate UK sovereign risks across UK bank treasuries and local investors,” said SocGen analyst Anamika Misra in a note published last week. She compared the PRA’s change to favour UK issuers with Trump-like protectionism.
Sterling covered bond pricing over the past week appears to have baked in some of that uncertainty. But perhaps the most surprising thing was the timing.
The European Commission is due to deliver its own report by July on how to approach third-country equivalence when counting capital buffers, with legislation expected to follow next year. With the EC widely expected to take a more collegiate approach, the PRA’s now-reversed move put it on a collision course with Europe, as Misra wrote last week:
Fair treatment in exchange for fair treatment? Well, in an ideal world, we would expect this. If Europe opens its door to third-country equivalence, we would expect the equivalent countries to treat its covered bonds on a par with their domestic covered bonds. The UK seems to disagree with this ideology. The EU is a big market for covered bonds, and we believe it will not incorporate policies like the UK. We believe it will stick to its policy of including covered bonds issued by EEA or non-EEA G10 countries
Can the PRA get its revised guidance out before the EC report lands? Or will the suggestions of UK protectionism continue to hang over talks? Either way, it’s a wholly unnecessary mess.
