Expand Limit on Covered Bonds, but Know the Risks

By C.D. Howe Institute —— Bio and Archives August 20, 2015

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Although few outside of financial circles have heard of covered bonds, they have emerged as an important and efficient funding channel for Canadian mortgage lending, according to a new report released today from the C.D. Howe Institute. In “How to Make the World Safe for (and from) Covered Bonds,” author Finn Poschmann addresses the fact that covered bond issuance in Canada has a regulatory limit of 4 percent of bank assets, a rate that is lower than in most advanced economies, and explores the case for expanding that limit.

“Covered bonds have come to occupy a place near the heart of the Canadian financial system, housing finance in particular,” says Poschmann. “Issued by banks, these high-quality bonds are fully backed by the issuing bank and ‘covered’ by underlying mortgage assets held by a guarantor,” he adds. The mortgage assets are out of the reach of creditors and the federal deposit insurer in the event of a bank failure, thereby increasing certainty for bond investors. According to Poschmann, “the rub, however, is that rules set in place by the Office of the Superintendent of Financial Institutions (OSFI) limit covered bond issuance to 4 percent of bank assets.” He elaborates that “while banks are not yet fully constrained by that limit, it will begin to bind, particularly owing to the Canadian government’s policy goal of restraining government or taxpayer support for home lending.” Potential pressure on funding provides a motive for raising Canada’s limit, which is one of the most stringent among jurisdictions involved in this market. From a stability perspective, low loan-to-value residential mortgages are a reliable backing for covered bonds, and covered bonds are an efficient funding source – one that could be seen as partially displacing the government-backed funding streams that currently are being squeezed. Raising the limit to 6 percent, for example, currently would increase the potential private funding channel by $87 billion worth of bond issuance, and at an 8 percent cap that number would double to $173 billion. Simply raising the limit, however, would impose some costs on depositors whose funds are insured by the Canada Deposit Insurance Corporation (CDIC), and those depositors may not benefit from the gains in lending and borrowing activity. The report addresses that concern by proposing a quid pro quo: a shift in CDIC’s deposit insurance assessment base from deposits to consolidated assets less tangible equity. A shift to assets as opposed to deposits, as the deposit insurance assessment base, would favour those institutions that are less leveraged, or otherwise have a lower asset-to-deposit ratio, rather than larger and more complex institutions, whose borrowing and lending activities are large relative to their deposit-taking activities. The mechanism would make deposit insurance less a tax on consumers who make deposits, and more a tax on size, leverage, or bank complexity. Poschmann concludes that raising the OSFI limit on Canadian covered bond issuance would likely drive benefits that exceeded the costs, conditional on a proper assessment of, and management of risks to, the deposit insurance system. For the report go to: www.cdhowe.org/