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    EBA Examines Asset Encumbrance in Banking Sector

    July 21, 2021

    The European Banking Authority (EBA) published its annual report on asset encumbrance in banking sector. As COVID-19 spread across Europe, banks made extensive use of central bank facilities to strengthen their liquidity buffers and maintain the flow of credit to the real economy. The report highlights that this has resulted in the largest yearly rise in the asset encumbrance ratio so far. Amid wholesale funding tensions in the first half of 2020, banks made an extensive use of secured funding to maintain their support to the real economy. The substantial increase in total assets was outpaced by the rise in encumbered assets and collateral.

    The following are the additional key findings presented in the report:

    • Different banks’ business models might explain the differences in encumbrance. These differences are observed in the proportion of encumbered assets and collateral, the types of assets that are encumbered or the sources of encumbrance.
    • Central bank funding has become the main source of asset encumbrance. The extensive use of central bank liquidity facilities has driven up the share of central bank funding over total sources of encumbrance. Thus, more than half of central bank eligible assets are already encumbered. In contrast, banks have reduced their reliance on covered bonds, given the favorable conditions of central bank facilities, an increasing deposit base, and focus on the issuance of Minimum Requirement for Own Funds and Eligible Liabilities (MREL) eligible instruments.
    • After a sharp rise, the average overcollateralization level of banks’ secured funding returned to pre-COVID levels. Amid market tensions in the first quarter of 2020, banks were requested margin calls and had to pledge additional collateral to obtain secured funding. As market instability receded and ECB eased collateral requirements, overcollateralization levels returned to pre-pandemic levels. Nonetheless, this metric remains higher for certain funding categories such as derivatives.
    • Increasing encumbrance ratios might pose prudential risks. Although banks exhibit comfortable liquidity buffers, as encumbrance subordinates unsecured creditors, the latter might demand higher spreads. Moreover, secured creditors may apply larger haircuts on collateral or make margin calls. This could lead to an adverse feedback loop of higher encumbrance and higher funding costs.

     

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    Keywords: Europe, EU, Banking, Asset Encumbrance, Credit Risk, Collateral, Covered Bonds, Central Bank Liquidity, MREL, EBA

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