Does Asset Encumbrance Affect Bank Risk? Evidence from Covered Bonds

Theories suggest that asset encumbrance, the ring-fencing of certain assets for protected debtholders, can affect banks’ risk taking and lead to funding instability. We test these hypotheses using a unique, hand-collected dataset on outstanding covered bonds issued by a sample of listed European banks. Our results suggest that the effect of asset encumbrance on risk depends on the proportion of debtholders exerting market discipline and on the bank’s liquidity buffers. We deal with concerns regarding omitted variables and reverse causality using several fixed effects estimations and an instrumental variables approach.