Healthy balance sheet conditions for covered bonds

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Question:

What does DNB mean by “healthy balance sheet ratios” in the context of the supervision of covered bonds?

Published: 20 September 2018

Answer:

Pursuant to Section 40(i) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft - Bpr), DNB oversees healthy balance sheet ratios. The information below explains how banks issuing registered covered bonds must demonstrate to DNB that their balance sheet ratios are healthy and will remain healthy in the future.

Background

Section 20h(1), under c, of the Regulation implementing the Wft (Uitvoeringsregeling Wft) stipulates that institutions must at least once a year provide DNB with the information it needs in its capacity as a supervisory authority pursuant to Section 40i of the Bpr (supervision of healthy balance sheet ratios). Consequently, institutions issuing registered covered bonds must submit the following information on an annual basis:

The indicators the institution uses to ensure a healthy balance sheet ratio between the total outstanding registered covered bonds and its consolidated balance sheet total. These indicators must at least enable the institution to mitigate the following risks.

Funding risk due to subordination:

Which entitlements do holders of unsecured (senior) bonds and deposits have on the liquidation assets in case of a bankruptcy? In other words: what is the degree of subordination of unsecured creditors?

What does this mean for (i) the costs of uncovered funding, in particular if the market prices in a higher bankruptcy risk?

What are the consequences of the degree of asset encumbrance for the institution's resolvability? In other words: to what extent can asset encumbrance form a hindrance to the use of resolution instruments? For instance, excessive asset encumbrance could stand in the way of a partial sale of the bank as part of its resolution. It may also complicate the funding of a bridge bank. It is therefore important that a bank issuing registered covered bonds has (i) sufficient unencumbered assets of high quality and (ii) sufficient assets to pledge as security for loans from the central bank. These securities must be considered pro rata to the deposit base.

Contingency funding risk:

How much leeway does the balance sheet offer for issuing additional covered bonds in the case of reduced access to, in particular uncovered, funding markets and to what extent is this necessary?

Margin call risk.

To what extent is additional collateral required and available (referred to as the “backbook”) to replenish the cover pool if the collateral quality deteriorates?

For each of the indicators mentioned under (1) we need a substantiated tolerance. It should at least include (a) the total encumbered asset ratio and (b) the backbook ratio. The bank must define these as follows:

Total unencumbered asset ratio = [(total encumbered assets /(total assets)]

Backbook ratio = [(total assets on the balance sheet of the issuing bank that are eligible to serve as collateral under the covered bond programme, but that are not registered as collateral in the covered bond company, calculated in accordance with Section 40(f), under 2, of the Bpr / (nominal value of outstanding covered bonds)]

In addition, institutions are expected to develop their own indicators, which match their vision and tolerance in respect of risks associated with unhealthy balance sheet ratios.

The outcome of the stress test referred to in Section 20(g) of the Regulation implementing the Wft, which establishes a direct link to the indicators as defined under (1) and (2).

Based on points (1) to (3) the bank must submit a proposal to DNB for setting an issuance cap (based on 1a indicators), the projected consumption thereof (based on 1b) and the minimum backbook (based on 1c). In the end, it is up to DNB to set the final issuance cap, appropriate consumption thereof and the minimum backbook for the issuing bank.

Within the context of its annual assessment of registered covered bond programmes, DNB will use this information to establish whether the bank meets and is expected to continue meeting the healthy balance sheet ratio requirement. DNB also determines whether healthy balance sheet ratios are sufficiently guaranteed in the bank's risk management (monitoring, risk control measures). DNB informs the institution about this as part of the outcome of its annual assessment cycle.

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