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Germany plans for Brexit with rule change to preserve UK assets' eligibility

The German government will tweak a banking law to preserve the eligibility of U.K. assets as collateral for covered bonds after Brexit.

The planned amendment to the Pfandbrief Act is part of a larger draft proposal the German Finance Ministry released earlier in October that also includes changes to corporate tax and savings bank sector regulations. The proposal is aimed to ensure that all existing tax arrangements and investments involving the U.K. are preserved after the country leaves the EU.

In the case of the Pfandbrief Act, the amendment will guarantee that German banks can use real estate or public debt from the U.K. in the pool of assets backing their covered bonds, which otherwise would have not been possible post-Brexit, Moody's analysts said in a note Oct. 15.

Currently, only assets from the European Economic Area and the U.S., Canada, Switzerland, Australia, Japan, New Zealand and Singapore can be used as collateral under the Pfandbrief Act, the analysts said. The law limits the use of non-EEA collateral to 10%. After Brexit, the U.K. will gain third-country status.

Although assets in existing pools would not necessarily have to be replaced entirely, without the amendment U.K. assets would not have been eligible for future issues, the credit analysts said.

Germany is one of the biggest markets for euro-denominated covered bonds — a cheap, low-risk funding instrument backed by real estate and public debt. The country ranked fourth by outstanding volume of mortgage-backed covered bonds in Europe, with some €215.2 billion as of 2017-end, according to Hypostat.

In the first half of 2018, German banks were the second-biggest issuer of covered bonds, known as Pfandbrief, with a total volume of €15.5 billion. This exceeded their issuance for the previous year, which was €15.25 billion, according to research by lender LBBW. They are expected to ramp up new issuance to some €20 billion by the end of 2018, LBBW forecast.

Although the average amount of U.K. assets held in cover pools of German Pfandbrief banks is fairly low at 2.3%, holdings of individual lenders may go up to the mid-teens, Moody's analysts said.

UK collateral

German Pfandbrief banks held some €9.85 billion in U.K. assets as collateral as of June 30, according to the banks' association Verband Deutscher Pfandbriefbanken, or VDP. Collateral originating from the U.K. accounted for some 3.8% of the total €207.6 billion mortgage-backed covered bonds outstanding, and for around 1.6% of the total €124 billion public debt-backed covered bonds outstanding, according to VDP data.

However, the percentage for the €16.1 billion mortgage cover pool of VDP member Deutsche Pfandbriefbank AG stood at 15% as of Sept. 30, up from 14% as of June-end. With total covered bonds outstanding of around €29 billion, Deutsche Pfandbriefbank is one of the largest German issuers. After assets in its home market, U.K. assets are the second-biggest resource in its collateral pool.

Brexit has not driven German covered bond issuers away from the U.K. market, a spokesman for VDP said in an emailed comment. Although VDP members follow Brexit negotiations closely, their U.K. lending has not suffered and they are continuing business as usual, the spokesman said.

"At this stage, even a hard Brexit would not come as a surprise and should be reflected in market prices," a spokesman for Deutsche Pfandbriefbank said in an email. But short-term volatility cannot be ruled out, he said.

The German government has said it will transpose all of the proposed amendments into law by the end of 2018 regardless of the outcome of the Brexit negotiations.