Since 2022, European banks have been rethinking and adapting their funding models. This has come about in the new interest rate and monetary policy environment. Repaying central bank facilities and seeing flat growth in customer deposits has prompted banks to seek alternative funding sources, and for some, covered bonds have become an instrument of choice. S&P Global Ratings views covered bonds as a cheap and relatively stable source of market funding for European banks, and a valuable resource for accessing contingent funding. Furthermore, after the banking turmoil in 2023, regulators have been tightening their scrutiny of banks' contingency funding plans. In this context, a bank's ability to issue covered bonds--which can be pledged at the central bank--for funding, is a positive.

Covered bonds play a meaningful role in European banks' funding profiles.  For large EEA banks, they represent about 6% of total liabilities, far behind customer deposits. In the majority of Nordic countries and for certain specialized issuers, however, covered bonds account for 20%-50% of total bank funding. In the last two years, we have seen the volume of investor-placed covered bond issuance increase, mainly driven by the end of the ECB's targeted long-term refinancing operations (TLTROs). At the same time, investor demand for covered bonds has been strong, supported by comparably attractive spreads.

We see covered bonds as an additional source of funding that brings diversification benefits to banks.  They have also proved a reliable source of market funding and we expect they would remain open as a funding avenue in more challenging market conditions. That said, we are mindful that covered bond funding, together with other sources of secured funding such as repos, increases an issuing bank's level of asset encumbrance. This can create risks for other (unsecured) creditors of banks in extreme stress and lead to potential complications in a resolution or liquidation scenario.

We typically assess systemwide funding risks as adequate in European banking systems that have a particularly high reliance on covered bond funding.  Our view balances the market nature of this type of funding and its track record of relative stability. We recognize positively a bank's capacity to access a stable funding source that matches well with its assets. As such, we typically see covered bond programs as a valuable source of funding strength and diversification, especially in countries where investments in covered bonds are driven by structural features such as prefunded pension systems. As for asset encumbrance, we do not have specific thresholds that would lead to negative pressure on our bank ratings, but we could see a material increase in asset encumbrance as a sign of a potential reduction in future funding flexibility.

Covered Bonds Are On The Rise As A Cheap And Stable Funding Source

Over the last two or so years, European banks' issuance of investor-placed covered bonds has been significant (see chart 1). While the ECB's TLTROs had led to a surge in retained covered bond issuance, which banks used to access TLTRO facilities, the end of them and their accelerated repayments have encouraged banks to turn to investor-placed covered bond issuance as an alternative source of term funding.

Chart 1

Despite the recent uptick in covered bond issuance, deposits continue to be the dominant source of European banks' overall funding in most countries. Secured funding, which mainly includes covered bonds and, more marginally, asset-backed securities, increased by 8% for the large EEA banks to €1,603 billion at year-end 2023. This only increases their proportion in total liabilities to 6.34%. That said, covered bonds comprise a more material portion of bank funding in some Nordic countries, reflecting their importance in funding the mortgage market and demand mainly from local pension funds (see chart 2). European outstanding covered bonds' total issuance was estimated at around €2,733 billion in 2022 (European Covered Bond Council data; see chart 3), a significant share of outstanding market funding for banks in many jurisdictions.

Chart 2

Chart 3

Changes In Monetary Policy Influence Covered Bond Issuance

Banks issue covered bonds either as traditional secured funding instruments or, to a lesser extent, as self-retained instruments to access central bank refinancing operations (see box below) or, more recently, to repo with other banks. As such, the volume and terms of central banks' refinancing operations influence the split between self-retained and investor-placed covered bond issuance. During the pandemic and the large TLTRO placements, we saw a notable shift. Privately placed covered bonds--which include self-retained ones--grew to around 44% of total covered bond issuance in 2020, up from an average of 26% over 2013-2019 within the EU (see chart 4).

We believe that this spike was mainly driven by self-retained covered bonds issued for TLTRO purposes. This increased the proportion of outstanding privately placed covered bonds to 37% by end-2022 from the previous 33% average. Since 2022, banks have repaid outstanding TLTROs, and central bank refinancing operations are limited; this curbs banks' incentives to self-retain covered bonds. At the same time, the European directive for covered bonds has created a comparable legal framework to encourage the issuance of premium European covered bonds. This has supported the increase in investor-placed covered bonds.

Chart 4

Central banks typically purchase covered bonds as part of a quantitative easing program.  At year-end 2023, we estimate the ECB held around €305 billion of secured securities (mostly covered bond instruments) which represented 19% of EEA banks' total outstanding secured securities. With its Pandemic Emergency Purchase Program, the ECB significantly influenced covered bond yields in 2020-2021. Today, given its passive quantitative tightening stance, the ECB is not replacing the bonds maturing on its portfolios and is therefore not adding to the market demand for covered bonds.

The ECB announced some revisions to its operational framework in March (see "Eurozone Banks: ECB's Operational Framework Review Backs The Status Quo," published March 14, 2024). It announced its intention to move toward a system of ample reserves, whereby it would maintain a structural bond portfolio. It did not detail the composition of this future bond portfolio, but we think it will likely include covered bonds. As such, we can expect the ECB to resume its purchases of covered bonds in the future, adding to the market demand for these instruments. Furthermore, the ECB said it would create new structural longer-term refinancing operations for banks. Again, it has yet to communicate terms and conditions in detail, but we think it likely that covered bonds will be accepted as collateral. This should once more encourage banks to issue self-retained covered bonds.

More broadly, we believe that last year's system stress will prompt central banks and supervisors to review and challenge banks' contingency funding plans.  The scale and speed of some banks' deposit outflows was such that they could not be covered by on-balance-sheet liquidity, and contingency funding preparations proved insufficient to meet failed banks' liquidity needs. Beyond a recalibration of liquidity requirements, which in our view is a real possibility, the need to strengthen contingency funding plans will likely move higher up the regulatory and supervisory agenda. As part of these discussions, we believe that bank treasurers and regulators will see covered bonds as a valuable resource to quickly generate liquidity from unutilized cover pool assets, either through the issuance of covered bonds in the market or the preservation of self-retained covered bonds on the balance sheet.

Covered Bonds Have Benefits, But Can Also Increase Asset Encumbrance

Regularly issuing covered bonds can benefit a bank's funding profile in several ways, in our view:

Funding diversification, with the capacity to tap a specific investor base.  This is particularly so in markets where covered bonds represent a high share of the asset allocation in local currency for local pension funds (like in the Nordics and notably in Denmark). In our view, the importance of covered bonds in the Nordic market reflects large local investor bases (pension funds for example) seeking to invest in relatively safe assets amid a shortage of government bonds. Furthermore, the attractiveness of covered bonds has increased because of their inclusion in the ECB's asset purchase program.

Access to long-term funding at relatively lower prices.  Compared to other forms of term funding (such as senior unsecured bonds or fixed-term deposits) covered bonds have a significant positive price differential, especially as interest rates have risen.

Covered bond funding remains accessible, even in challenging markets.  The double recourse of covered bond holders to the bank and the asset pool makes them largely indifferent to the overall creditworthiness of the issuing bank, meaning that covered bond markets are likely to remain open for longer than those for unsecured issuance in a stress scenario. Also, covered bond structures now include a soft bullet repayment in all EU countries as well as Norway and Iceland--that is, an option to extend the maturity of the instrument by one year, which provides the issuing bank further flexibility. Finally, we assess the systemic importance of covered bond markets as very strong, meaning that sovereign support is very likely, in many European jurisdictions (see "Covered Bonds Criteria Sector And Industry Variables Report Updated," published April 18, 2024).

Access to contingent funding.  We see contingent funding plans as an increasingly important feature in banks' risk management toolkits. All else being equal, banks that are regular covered bond issuers and have available assets to place in a cover pool benefit from stronger contingency planning.

Like other forms of secured funding, covered bonds generally lead to higher asset encumbrance.  Asset encumbrance has trended down in the EU in recent years (from 29% of total assets to 25% since 2020). This decline was mainly driven by the repayment of TLTROs, a form of secured funding. As such, additional asset encumbrance generated by increased covered bond issuance will not likely be a source of rating pressure at the system level.

That said, we note that asset encumbrance levels vary greatly across countries and banks (see chart 5). For some countries such as Denmark, this reflects a reliance on covered bond funding, in particular for specialized mortgage banks. In other cases, such as large French banks, recourse to repo funding for market-making activities is a more prominent driver of asset encumbrance.

Chart 5

In A Stress Scenario, A Heavy Concentration On Secured Funding Could Complicate Things

In extreme stress, if a bank relies heavily on covered bonds, or other sources of secured funding, asset encumbrance can rise and in theory increase the risk of a run on the bank's unsecured liabilities. If there is an expected fall in the value of a bank's assets--as we have observed for certain German issuers that focus on commercial real estate--some unsecured debtholders (including depositors) might fear that this could disproportionately hit unencumbered assets.

First, this is because the dynamic replenishment feature of covered bonds and legal requirements--for example, loan-to-value limits for real estate covered bonds--can mean that, in cases of mounting losses, performing assets would be prioritized for the cover pool. Second, falling collateral values could force the issuing bank to post additional collateral in its covered bond program to maintain a specific covered bond rating, therefore leading to higher asset encumbrance. In a stress scenario, doubts about the valuation of unencumbered assets could therefore theoretically create confidence issues for unsecured creditors.

High reliance on covered bond funding could also lead to complications in a gone-concern scenario. We note, however, that there is no record of losses in covered bonds since their creation in the eighteenth century. Our analysis of the treatment of covered bond holders in a gone-concern scenario for the issuing bank rests mainly on the applicable legal bases.

Under the EU's legal framework, resolution authorities would assess, upon the failure of a bank, whether the conditions for resolution were met. Depending on this assessment, the failing bank would be either liquidated or resolved:

Liquidation of the issuing bank.  In this scenario, the covered bonds would be segregated and a judicial authority would be appointed to manage the associated cover pool. Covered bond holders would be served based on the assets in the cover pool (including mandatory and additional voluntary overcollateralization and derivatives registered in the cover pool), while remaining assets and derivatives outside the cover pool would be used to service unsecured creditors. Although this has never been tested in practice, we understand that overcollateralization, if any, would only be released once the last covered bonds mature. In such a bank liquidation scenario, insured depositors would be paid out immediately, but other unsecured creditors (uninsured depositors, unsecured bondholders, or the Deposit Guarantee Scheme itself, despite its super seniority) would not have recourse to the cover pool.

Resolution of the issuing bank.  In this scenario, a write-down of the bank's capital instruments would be automatic and, if needed, a bail-in of debt holders and/or depositors would be executed to recapitalize the bank based on the estimated resolution valuation. We understand that a resolution decision would not necessarily trigger a segregation of the covered bonds issued by the bank and the appointment of a judicial authority to manage the cover pool. EU legislation explicitly excludes resolution authorities from bailing-in covered bond instruments. As such, covered bond holders would remain in the resolved entity, be subject to a business transfer to an operating bank, or be placed in a bridge bank, depending on the resolution tools being applied.

In both cases, the treatment of the related derivatives portfolios that some banks hold to hedge covered bonds' asset pools (for example, currency or interest rate hedges) is untested and remains subject to interpretation. The cover pool is often not a legally segregated entity until the issuer defaults, which could raise questions about rights to terminate unless clarified legally. In the case of a resolved, and therefore recapitalized, bank, a counterparty could also very well decide not to terminate the contract. Potentially losing the benefits of the hedge could reduce the amount of effective overcollateralization available to the covered bond holders. Our covered bond rating analysis only considers derivatives that are registered in the cover pool and delinked from the insolvency of the issuer.

Funding Diversification Is A Rating Strength, While Asset Encumbrance Could Signal Reduced Funding Flexibility

In our credit analysis we view funding diversification positively, while high asset encumbrance does not automatically weigh on ratings. We assess systemwide funding risks as part of our analysis of industry risks in a given banking system (see "Banking Industry Country Risk Assessment Methodology And Assumptions," published Dec. 9, 2021). We assign our initial score based on two ratios: domestic systemwide loans to domestic core customer deposits, and net external debt to domestic systemwide loans. As such, banking systems that rely significantly on covered bond funding would typically achieve a weaker initial score than banking systems that rely more on core domestic customer deposit funding.

That said, as part of our adjustments to reach the final systemwide funding score, we recognize positively, by up to two notches, the capacity of a banking system to access funding from the capital markets, including covered bonds. Countries in which banks have significant reliance and proven access to a strong domestic covered bond funding market achieve adequate systemwide funding scores (see table 1).

Table 1

As part of our stand-alone assessment of a bank's credit profile, we value a bank's capacity to access stable funding sources that match well with its assets, and we view diversified, franchise-driven funding profiles positively. As such, when banks have a covered bond program we may see this as a valuable source of funding strength and diversification, supporting our assessment of the bank's funding profile. It might also support our liquidity assessment where covered bonds give a bank substantial capacity to monetize its asset base via contingent funding.

As for asset encumbrance, we do not have specific thresholds that would lead to downward ratings pressure. Importantly, our credit ratings are based on our assessment of the relative likelihood of default of an institution, rather than on the expected loss for creditors. As such, there is no automatic link between rising asset encumbrance (which shrinks the pool of a bank's assets available to help pay its unsecured obligations) and our ratings on a bank. That said, we could see a material increase in asset encumbrance as a potential sign of reduced future funding flexibility, given that collateral available for further secured funding is reduced and the bank may find that unsecured creditors' appetites have weakened.

For systemic banks flagged for resolution, the reliance on covered bond funding (and the resulting higher level of asset encumbrance) has no direct impact on our additional loss-absorption capacity (ALAC) notching. Our ALAC approach focuses on the amount of subordinated and senior nonpreferred debt issued by the bank and which supports the creditworthiness of senior debt instruments. Also, we see resolution strategies like share transfers and bail-ins as supportive of senior secured as well as senior unsecured preferred claims, irrespective of whether covered bonds are issued from the main bank or by a financing subsidiary.

For covered bond ratings, the degree of systemic importance of covered bonds for systemwide funding in a jurisdiction is key to our assessment of jurisdictional support. Systemic importance refers to whether, in our view, covered bonds play a significant role in an economy and financial system. We consider that covered bonds play a material role as a funding source for the financial system if the covered bond market represents at least 20% of GDP or bank capital market funding, which we also view as commensurate with very strong systemic importance.

Related Criteria

• Banking Industry Country Risk Assessment Methodology And Assumptions, Dec. 9, 2021
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• Global Covered Bond Insights Q3 2024: Issuance Still On Solid Footing, June 18, 2024
• Covered Bonds Criteria Sector And Industry Variables Report Updated, April 18, 2024
• Eurozone Banks: ECB's Operational Framework Review Backs The Status Quo, March 14, 2024