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Testing of a healthy ratio of covered bonds to disposable assets

Q&A

Question:

What is understood by the testing of a healthy ratio of covered bonds to disposable assets?

Published: 05 February 2015

Answer:

In view of the requirement contained in Section 40i of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), De Nederlandsche Bank after consulting the issuing bank determines whether the ratio between the total nominal value of covered bonds issued or to be issued and the issuing bank's consolidated balance sheet total can be considered healthy.

For the assessment of a healthy ratio, DNB weighs the total nominal value of the covered bonds issued or to be issued against the size, nature and composition of the assets serving as cover for the bonds and for the assets available for cover on the balance sheet of the issuing bank. The assets available as cover for bonds include assets commonly used as cover for covered bonds, liquid funds or other assets that may be used to substitute the assets or liquid funds mentioned. In its assessment DNB takes account of all relevant aspects such as the position of other creditors of the issuing bank (other than holders of the covered bonds), the financial position and, in particular, the solvency of the issuing bank, its risk profile and the risks inherent in the assets.

De Nederlandsche Bank analyses the stress tests used by the issuing banks on specific features of the underlying exposures and on how these assets can be affected by factors outside of or within the sphere of influence of the issuing bank. The stress test for a covered bond programme with residential mortgages as its collateral should at least include the following scenarios. 

  • A substantial price shock in the residential property market based on historical data; a deterioration of the credit risk on the underlying portfolio as a consequence of a significant economic turnaround and/or tax measures, such as the termination of mortgage interest income tax relief.
  • A strong increase in foreclosure losses. 
  • A downgrading of the issuing bank's credit rating and its possible impact on the derivatives positions that the covered bond company has entered into with the issuing bank.

For each of the above scenarios, the analysis takes account of what is referred to as 'second-round effects'. For instance, a scenario of a (sharp) drop in house prices may affect the issuing bank in a second round through adverse effects on the issuing bank's credit rating.

The analysis of the justification for the minimum surplus value may indicate that, under the circumstances prevailing in the stress scenarios, the freely disposable assets on the balance sheet of the issuing bank will be used to reduce the surplus value to a level sufficient to meet the obligations applicable to registered covered bonds.

This analysis impacts the required size of the freely disposable assets on the balance sheet of the issuing bank and consequently the assessment of what constitutes a healthy balance sheet structure. In addition, the issuing bank's other creditors are also important for determining healthy balance sheet ratios, as the transfer of freely disposable assets in a stress scenario means that if the bank fails, its other creditors will not have access to the assets transferred to the covered bond company.

There can be no question of healthy balance sheet ratios if the issuing bank has insufficient freely disposable assets to comply with possible recourse to these assets, or if freely disposable assets must be transferred to the covered bond company in such numbers that in a stress situation, the position of the other creditors of the issuing bank deteriorates significantly.

When testing for a healthy ratio, DNB uses conservative assumptions in order to safeguard the interests of both bond holders and other creditors of the issuing bank.

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