In the modern day world, with technology and global markets expanding, the need for credit is a constant issue for economies to monitor. Liquidity rationing has been most relevant since the GFC, when the credit market essentially froze, sending financial markets in turmoil. Therefore finding ways to increase liquidity at a time when markets are volatile requires instruments of low risk. Covered bonds have recently gained momentum as a popular tool for banks to increase their liquidity whilst taking on very limited risk.
A Credit Crunch also known commonly as liquidity rationing, is the reduction in general availability of loans or credit, or a sudden limitation of conditions required to obtain from a financial institution. A credit crunch is therefore independent of interest rate movements. This does however result in the relationship between credit and interest rates to change so that, credit becomes less available at a given interest rate, or there ceases to be a clear relationship between credit availability and interest rates. These events of a liquidity rationing are often the result of reckless lending management, which leads to bad debt for institutions. Consequently, when these loans take a turn for the worse and the investors cannot reimburse their loan payments, banks are forced to take sudden action and tighten the availability of loans or credit. The Financial Crisis is a prime example of a credit crunch that resulted in a near collapse of the global financial markets; in which case was saved by a sovereign bailout to ensure liquidity was restored.
Covered bonds are debt securities backed by cash flows from mortgages or public sector loans. They are similar in many ways to asset-backed securities created in securitization, but covered bond assets remain on the issuer’s consolidated balance sheet. A covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. (Rosen, 2008) For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's financials, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer. In addition, because asset’s remaining on the balance sheet covers the bond, means that it was essentially risk free when investing in a covered bond. This risk free sentiment surrounding covered bonds issued by institutions, have made covered bonds one of most successful and popular investment instruments since their creation in Denmark back in 1795. (Bujalance, 2010) The issue with covered bonds is if institutions can accurately evaluate the assets within their asset pools. Past events like the GFC have shown assets being falsely rated, which contributed to the decline in global financial markets. The difference between a covered bond and an unsecured bond is that an unsecured bond is dependent on the rating by the issuer, which means the structural enhancements and overcollateralization enables covered bonds to achieve higher ratings above the issuers of unsecured bonds. Furthermore, because a pool of assets does not back unsecured bonds, this results in greater volatility for unsecured bonds especially during downturns in the credit cycle. Asset back securities are therefore different to covered bonds as they are a security backed by a loan, lease or receivables. They operate under securitization. Often a separate institution, called a special purpose vehicle, is created to handle the securitization of asset-backed securities. The special purpose vehicle is responsible for "bundling" the underlying assets into a...