On 12 March 2018, the European Commission launched its long-awaited legislative proposal on covered bonds, in the form of a Directive on covered bonds and a Regulation on CRR exposures to covered bonds. The proposed Directive builds on detailed reports in 2014 and 2016 by the European Banking Authority (EBA).

The Directive specifies the core elements of covered bonds and provides a common definition as a consistent and sufficiently detailed point of reference for prudential regulation purposes, applicable across financial sectors. It will establish the structural features of the instrument, a covered bond specific public supervision, rules allowing the use of the “European Covered Bonds” label and competent authorities’ publication obligations in the field of covered bonds.

The regulation mainly deals with amending Article 129 of the CRR. The amendments add requirements on minimum over-collateralisation (OC) and substitution assets.

ICMA’s Covered Bond Investor Council (CBIC) has followed the progress of the European Commission’s deliberations with interest and has updated readers of the ICMA Quarterly Report through periodic articles in the asset management section. As investors we have been actively involved in the policy debate on covered bonds. We have worked with the issuers to deliver the Harmonised Transparency Template (HTT) which has successfully increased transparency of covered bonds for investors.

CBIC welcomes the development of a legislative framework for covered bonds as harmonisation will not only consolidate and codify high standards in Europe but could act as a spur for more non-EU countries to issue covered bond laws.

The CBIC published its position in early May 2018, focusing mostly on the Directive. The CBIC welcomed the European Commission’s legislation on covered bonds. Although CBIC may have expressed some concern in the past regarding the need for this legislation, the extensive preparatory work by the EBA and the Commission (consultation, impact assessment) laid the ground for a sensible proposal that should achieve the objectives sought.

Investors were pleased that in many of the areas that national traditions have developed a robust national covered bond framework can exist within this European framework. This flexibility should minimise disruption to well-functioning national covered bond frameworks that are relied on by issuers and investors.

However, this flexibility is in some areas of the text taken too far and risks lowering standards. The CBIC position paper covers concerns investors have in the following areas:

• lack of clarity on assets in the cover pool;

• lack of recognition of existing transparency requirements in the HTT;

• slow pace for recognising third country regimes as equivalent;

• lack of an explicit insolvency trigger in extendable maturity structures;

• lack of clarity on eligible assets for cover pool liquidity buffers;

• concerns about country ratings in group covered bonds;

• lack of clarity about cover pool monitors; and

• overly complicated OC calculation methods.

In August the European Parliament’s rapporteur, Bernd Lucke MEP, issued his first reports on the Directive and Regulation with suggested amendments to the Commission’s proposal. Among his main amendments, Bernd Lucke proposed to create a two-tier covered bond market.

This would be achieved by dividing covered bonds into UCITS and CRR Article 129 compliant “premium” covered bonds and only UCITS compliant “ordinary” covered bonds. For the “premium” covered bonds in Article 6, eligible cover assets are restricted to only those mentioned in CRR Article 129(1) (a)-(g) and does not include “other high quality assets” as the Commission had originally proposed. The restrictions on eligible cover assets for “ordinary” Article 6a covered bonds are that there should be a public register recording ownership and collateral rights, transparency of collateral value, risk mitigation and diversification in cover pools, which would seem to exclude SME exposures.

Another significant change to the Commission’s proposals comes in the form of capital penalties for extendable maturities. The report adds a definition and treatment for extendable maturity covered bonds. The report makes the case that extended maturities protect the value of the cover pool by avoiding fire sales, so maturity extensions of one year or less should not be penalised (because if asset prices have not recovered after one year they might never recover). But maturity extensions beyond one year should be penalised on the basis that the risk is shifting from the issuer to the investor. The risk penalty is applied on a sliding scale (5% for three years, 10% for five years, 15% for ten years, 20% for more than ten years).

While recognising that the rapporteur is trying to safeguard the high quality of traditional covered bonds, CBIC opposes the concept to create an “ordinary” and “premium” covered bond market in this harmonisation Directive. CBIC members would rather only have one (high quality) covered bond product and label. Other products using the same technique should not carry the covered bond name. It would also be better to have more time to prepare this separate debate, eg through the discussion on European Secured Notes (ESNs) which is going on in parallel to the Covered Bond Directive by the European Commission and the European Banking Authority (EBA).

The potential “de-harmonisation” of covered bonds through the proposal to create ordinary and premium covered bonds is a threat to the covered bond market and might deter investors from re-entering the covered bond market after the ECB’s Third Covered Bond Purchase Programme ends.

Furthermore, it remains essential that the original proposal’s concept of “other high quality assets” must be more carefully defined to stop the potential watering down of the covered bond label as it currently exists and is used. CBIC remains convinced that the EBA should be given an option to define other high quality assets.

Regarding the penalties for extendable maturities, CBIC believes that there is insufficient data currently on the long-term effect of very long maturity extensions. While CBIC agrees that there may be a benefit to short extensions in case of insolvency to avoid disorderly fire sales of cover pool assets, endless extensions could leave investors exposed to residual risk over a long period of time that could be unwelcome. However, significant capital penalties could destabilise the current conditional pass-through (CPT) market, so perhaps milder penalties or increased disclosure of CPT pools (monthly instead of quarterly) could be other potential solutions.

The debate in the European Parliament will intensify as other MEPs tabled amendments on 26 September to the Directive and Regulation. Compromise positions will now be negotiated between the political groups. The Council, for its part is also negotiating a compromise position on the Commission’s proposal and is expected to publish a public draft in October. Both institutions would need to start trilogue negotiations as soon as possible to facilitate an agreement before the end of this parliamentary period in March 2019.

CBIC will continue to contribute to the debate on the appropriate level of harmonisation of the covered bond framework in Europe as deliberations take place in the coming months. This legislation presents an opportunity to consolidate and codify the current practices on covered bonds and ensure the continued success of this important funding tool for European banks and popular asset for European investors.

Contact: Patrik Karlsson

patrik.karlsson@icmagroup.org