Covered bonds regulation

Another component of the capital markets union, initiated in 2015, concerns the harmonisation of the regulations on covered bonds throughout the EU. On 12 March 2018, the EU Commission presented a proposal aimed at supporting and boosting the development of the markets for covered bonds throughout the EU.

In the past, covered bonds have proved to be efficient and robust sources of loan funding for banks in the EU, even during the financial crisis. However, covered bonds are more important in some member states than others, which explains the variations between the applicable national regulations in each case. Due to the different national legal frameworks and supervisory practices, the EU market for covered bonds is currently considered to be very unevenly developed. With this in mind, a critical eye needs to be cast on preferential treatment of covered bonds at the EU level due to their low risk where capital requirements under the CRR is concerned.

The purpose of an enabling framework in the EU is to ensure that covered bonds are safe, robust and subject to the same regulations throughout the EU. The proposed regulations tap into a cost-efficient and sustainable source of funding to make it easier for banks to lend to industry. In addition to the cross-border increase in flows of capital and investments, a broader and safer range of investment opportunities can be offered to investors. The goal of the regulation proposals is to help stabilise the financial system and fund the real economy.

The proposals include a principle-driven directive on the issue of covered bonds and associated amendments to the CRR regarding exposures from covered bonds.

Supervision of covered bonds

The proposed directive on the issue of covered bonds, public supervision of covered bonds and on amending the UCITS directive and the BRRD (2018/0043) stipulates minimum harmonisation based on national regulations as follows:

• a joint and cross-sector definition of covered bonds that is coherent when supervisory regulations are adopted;
• the structural features of the dual recourse mechanism, the quality of collateral in the cover pool, liquidity and transparency requirements etc.;
• responsibilities and duties on the part of public covered bond supervision and
• the use of the label ‘European Covered Bonds’.

Only high-quality assets are to be eligible and therefore included in the cover pool. As a result, it must be possible either to determine the market value or the mortgage lending value of the assets.

The EU Commission’s press release indicates that loans for SMEs or infrastructure are more risky assets and therefore probably don’t meet the directive’s requirements. The EU Commission is currently looking at the advantages of another instrument for SME and infrastructure loans: the European Secured Note (ESN). This would have the same structural characteristics as covered bonds.

Due to the covered bonds directive proposed, amendments to the UCITS directive and the BRRD are required. The definition of covered bonds in art. 52, section 4 of the UCITS directive will be replaced by references to the new directive. UCITS may raise the 5% limit to a maximum of 25% for covered bonds as long as the requirements – based on this directive in the future – are met. In order to define covered bonds, the BRRD refers to the existing definition in the UCITS directive for outstanding bonds as well to the new directive for future issues.

Accompanying amendments to the CRR regarding exposure of covered bonds

The purpose of the draft regulation to amend the CRR regarding exposure in the form of covered bonds is, above all, to change the current CRR art. 129. The goal is to add further requirements (regarding overcollateralisation and the substitution assets) in order to tighten up conditions for granting preferential regulatory treatment. Previous stipulations on transparency will be moved to the above-mentioned directive in the section on structural characteristics of covered bonds. The other conditions will be retained.

Regardless of the assets in the cover pool, the value of the overcollateralisation (securities that exceed the requirements for coverage) is set at 2% in exceptional cases but otherwise at 5%. The suggested level of overcollateralisation harmonises with the EBA recommendation but is lower than the Basel standard. In the majority of member states, the minimum overcollateralisation stipulated is currently lower than 5% so that the issue of covered bonds could entail more regulations for many banks once the current proposal comes into force.

The quality of covered bonds is to be guaranteed at a high level across the EU and justify preferential treatment from a supervisory standpoint. For investors it’s particularly interesting to note that the authorities concerned will in future have to show on their websites which covered bonds comply with the new requirements and are permitted to feature the European Covered Bond label. Names for ’Pfandbriefe’ established in Germany will still be protected. The Association of German Covered Bonds Banks (Verband deutscher Pfandbriefbanken, vdp) believes that the proposal to reform the European covered bond market allows for enough leeway to factor in specific national features because minimum key quality criteria standards for covered bonds are stipulated. Following adoption of the proposals, a 12-month transition phase is planned before the new regulations apply.