Is there a market for European Secured Notes?

The name alone doesn’t really reveal very much about the structure of this new instrument. At first glance it suggests that it lies somewhere between unsecured bonds and a securitisation. In fact, European Secured Notes (ESNs) are to be based on covered bonds. However, the cover pool is to consist of more risky assets such as loans to small and medium-sized enterprises (SME loans) and infrastructure loans. When it published the drafts for a new standardised legal framework for covered bonds (proposal of 12 March 2018, see FSNews 5/2018 of May 2018), the EU Commission made it clear that it considered these loans more risky compared with the mortgage loans normally used to cover covered bonds, which is why these would not comply with the requirements on covered bonds specified in the new directive. It went on to stay that a new instrument was to be developed instead that had the same structural characteristics as a covered bond. Therefore, ESNs in particular are also to have a dual recourse mechanism regarding the issuers and cover pool, which is protected from insolvency. The EBA was asked to comment on feasibility, potential structuring recommendations and any conceivable impact of launching ESNs.

Regarding the Recommendations on the Call for Advice on European Secured Notes published following the public hearing on 26 June 2018, the EBA has come to the conclusion that SME loans would be suitable for ESNs but it doesn’t believe infrastructure loans would be. It says that this is primarily due to the fact that a cover pool consisting of SME loans could be created in a sufficiently granular way while infrastructure loans are frequently for complex project funding that could be of a very high volume. Therefore, it believes a structure with a dual recourse mechanism wouldn’t be suitable for a cover pool consisting of infrastructure loans. It also comments that certain eligibility criteria are to be established for SME loans so that these are suitable as a product similar to a covered bond. It also states that only long-term loans or leasing receivables should be selected that are not impaired and were issued based on clear credit underwriting standards. The entire cover pool should be sufficiently granular and include at least 500 individual credits of which not more than 2% should be attributed to the same borrower unit. Compared with the 5% that in future will be mandatory for all covered bonds, the degree of overcollateralisation should also be much higher. The EBA suggests that overcollateralisation should be at least 30%.

This assessment by the EBA tallies with the comment by rating agency Fitch, which said beforehand that the SME loans would be more suitable for ESNs than infrastructure loans. Furthermore, according to Fitch, we can expect that the degree of overcollateralisation will be much higher than for a classic covered bond because in the case of the European SME securitisations rated by Fitch, overcollateralisation of the senior tranches exceeds 30% on average.

Regarding the ESNs, the EU Commission would like to create another instrument to refinance banks on the capital market that is to sit somewhere between classic covered bonds and STS securitisations. It’s difficult to foresee whether it will actually achieve its aim of boosting the issue of SME and infrastructure loans. After all, SME loans can already be securitised and the high-quality STS securitisations already represent a new segment and should increase the level of security for investors. Furthermore, the opportunity, in addition to refinancing, of also receiving equity relief for the underlying asset pool, should be an advantage for the banks. Therefore, synthetic securitisations are often used for the securitisation of SME loans or project financing. This is also reflected in the exception especially created for SME loans in new art. 270 CRR . It specifies that if senior positions in SME securitisations comply with the conditions stated in this article they can qualify as STS securitisations although under the new securitisation regulation, passed in December, synthetic securitisations are ruled out as STS securitisations. In other words, apart from the exception in art. 270 CRR, synthetic securitisations can’t benefit from the more favourable risk weights for STS securitisations.

Should an appropriate policy be created for ESNs, it remains to be seen whether it would be accepted by the market. It will also definitely depend on the treatment of the ESNs with regard to the regulations on minimum capital requirements. The EBA hasn’t made any concrete suggestions about this yet. According to the EBA, if minimum structural requirements are complied with, preferential treatment of SME ESNs compared with unsecured exposure by banks is conceivable. In February this year, Commerzbank paid back in full the only covered bond it had issued under its SME Structured Covered Bond Programme in 2013. Perhaps it will revive the programme after the publication of a legislative proposal by the EU Commission on ESNs. Following the publication of the final EBA report, which is expected in mid-July, it will become clear whether and what future SME ESNs and infrastructure ESNs can expect.