FSA's interest in covered bond issuance – the supervisory response

The covered bond market in the UK has recently developed significantly. The first covered bond was introduced to the UK in July 2003 by HBOS. This was quickly followed by issues from both Northern Rock and Bradford & Bingley. Covered bonds offer significant funding advantages for issuing banks through increased investor and funding diversification, easier access to international capital markets and lower cost of funding. Much has been said, both at European and domestic level, about the capital treatment of covered bonds held in the banking book and the appropriate risk-weighting that should attach to such exposures (where the lower the risk weighting assigned, the more attractive the investment is from an investor's point of view).

In its interim policy response to the British Bankers' Association (the "BBA"), the Financial Services Authority (the "FSA") has now turned its focus on another prudential matter inherent in the structural features of covered bonds, namely the additional risk that they may pose to depositors of the issuing bank. A covered bond structure requires that a pool of eligible mortgage assets of a certain quality be ringfenced to back the covered bonds. The covered bondholders have a preferential claim on the assets used to secure the covered bonds and this could result in a lower quality and smaller pool of assets potentially being available to meet the claims of depositors of the issuing bank. It is this additional inherent risk that the FSA has focused on recently, and is proposing to "manage that risk" through adjusting (where necessary) the issuing bank's Individual Capital Ratio ("ICR") (the minimum capital ratio which the FSA considers a particular bank should maintain) if the bank's issuance of covered bonds becomes "material" to address the potential change resulting in the issuing bank's risk profile. The FSA acknowledges that such a "material issuance" would only be one of the many factors in determining an issuing bank's appropriate ICR and would not necessarily result in an automatic increase in each case (once the new proposed EU Capital Adequacy framework implements the new Basel II proposals, this risk is expected to be dealt with within the Pillar 2 regime (i.e. the supervisory review process of capital adequacy)).

The FSA does not propose a hard and fast rule for "material issuance", instead supervisors will discuss issuing banks on a case by case basis taking into account, for example, the proportion of the issuing bank's mortgage portfolio as against its total assets. Currently, issuing banks have been able to issue covered bonds equating to around 4% of total assets without this being considered material. However, the FSA has stressed that this should not be relied upon as a conclusive guide to materiality.

The BBA has indicated that it intends to work with the FSA closely on the subject as it considers that formal guidance on covered bond issuance is important.

Should you require further details or advice please contact Jason Harding on +44(0) 207 367 3138 or at [email protected] or Stephen Hewett on +44(0) 207 367 297 or at

[email protected]