Bail-In and Asset Encumbrance: Implications for Bankss Asset Liability Management

Abstract

In response to the financial crisis the European union proposed bail-ins as a new regulatory instrument. For banks this mechanism affects the funding costs which now depend on the amount of assets under encumbrance. Deriving an optimal level of asset encumbrance from the bank’s perspective, however, does not need to be optimal for it’s senior unsecured investors. We propose a simulation setup to access the effects of the regulation and its effect on costs of banks and investors. Analysing major EU banks’ funding structure we find funding cost should be up to 49 basis points higher to reflect the increased risk for senior unsecured investors. All of the banks in our sample could lower their overall cost level by up to 15 basis points by increasing the level of asset encumbrance. We discuss the use of structured covered bonds as a vehicle to reduce funding costs and diversify the funding base.