Covered bonds

What is this about?

On March 12, 2018 the European Commission proposed the draft new Directive on the issue of covered bonds and covered bond public supervision (the CB Directive), which seeks to create an overarching framework to enable a more integrated covered bond market in the EU. Covered bond issuance across the EU has historically been regulated primarily at national level and there is a concern that, as between Member States, the covered bond markets and rules have become quite segmented. The purpose of this new CB Directive is therefore to establish minimum common standards of harmonisation based on existing national frameworks and implemented by national regimes (as opposed to being a fully homogenised, prescriptive and centralised regime), covering key aspects such as regulatory supervision, disclosure/reporting requirements and cover pool composition. While significant elements of the CB Directive closely resemble existing covered bond rules and structures, national legislators and regulators will need to carefully review existing covered bond legislation against the CB Directive (and, if necessary, make amendments) to ensure continuing compliance.

It should also be noted that the CB Directive includes requirements for investor reporting which are more extensive than those typically required in existing covered bond laws. Issuers will need to consider how they comply with these on future issuances.

The CB Directive includes a definition of covered bonds, which is intended to replace the definition of covered bonds in Article 52(4) of the Undertakings for Collective Investments in Transferable Securities (UCITS) Directive, with all references to covered bonds being required to be construed accordingly. It also intends to establish a common set of characteristics and structural features that a debt instrument must satisfy in order to be recognised as a covered bond under EU law, and to apply a new “European Covered Bonds” label for qualifying instruments. In the name of increasing investor protection, the CB Directive also sets out specific tasks and supervisory responsibilities for national regulators to carry out, as well as sanctions for non-compliance with the CB Directive.

To make it a single point of reference, the CB Directive tidies up some references to covered bonds in other existing EU legislation and is accompanied by a proposed new regulation “on amending Regulation (EU) No 575/2013 as regards exposures in the form of covered bonds”, which aims to better align the prudential treatment of covered bonds under the Capital Requirements Regulation (the CRR) (in essence, by tightening up the list of characteristics set out in Article 129 of the CRR which are required to enable covered bond investors to benefit from preferential capital treatment on their investment – i.e. to ensure that covered bonds are uniformly of appropriate quality to merit their preferential capital treatment). Of particular note, a new minimum pool overcollateralization requirement is prescribed (2 per cent or 5 per cent, depending on the pool assets).


Why is the Commission proposing these changes?

The CB Directive is a key part of the Commission’s Capital Markets Union (CMU) project, and is the result of extensive consultation and research dating back to 2015. The covered bond market in the EU is large (multi-trillion euro), well-established (especially in Denmark and Germany, which dates back approximately 200 years) and highly developed. As an asset class, covered bonds are regarded relatively favourably by the Commission, and are seen as a key source of cost-effective long-term funding for EU credit institutions.

However, the Commission has identified inefficiencies in this market (principally, the covered bond market has developed unevenly across Member States). Subject to differing rules, it is fragmented and concentrated in the hands of a handful of Member States. The CB Directive aims to remedy this fragmentation. So the key objective of the CB Directive is to achieve a degree of harmonisation of the diverse existing rules applicable to covered bonds across Member States, and to create a level playing field for the less developed covered bond markets. The Commission also wants to ensure that the favourable capital treatment afforded to covered bond investments is applied fairly.


When will the changes happen?

The proposals will now be discussed by the European Parliament and Council, with a target of end-May 2019 for implementation at the EU level. As it will be necessary for each Member State to then transpose the requirements of the CB Directive into national law, it is likely that Member States will be given at least a further year to achieve this. However, regardless of when the new regime actually comes into force, this is likely to have an immediate impact for market participants to consider on upcoming covered bond issuance and on existing covered bond programmes due for update. Pre-existing covered bonds are expected to be grandfathered.


Is this good news?

Yes (probably). For Member States where there is a developed covered bond market, and for vanilla covered bonds, the option chosen (i.e. a principle-based directive based on minimum harmonisation based on national regimes) should more or less preserve the status quo as it ought to allow each such Member State to retain most of the idiosyncrasies if its own market, subject to implementing a regime that is consistent with the CB Directive and ironing out any inconsistencies. Of the various options being considered by the Commission, there were two considerably more radical options but these have now been dropped. Whether or not the new regime achieves any of the other stated objectives (in summary, by facilitating a spur in covered bond market development and activity generally, lowering funding costs for issuers, and creating a market in Member States where there is currently no real covered bond market), will take some time to assess. It also remains to be seen if the transition to the new regime creates any temporary market disruption.


Is there anything else to consider?

Inevitably there will be some important questions to clarify around the intended interpretation of certain provisions in the CB Directive. For example, Article 10 of the CB Directive requires a “sufficient level of homogeneity of the assets in the cover pool so that they shall be of a similar nature in terms of structural features, lifetime of assets or risk profile”, without giving more detail. This potentially will lead to a degree of uncertainty when establishing cover pools. Also, Article 17 lists the pre-conditions for permitting extendable maturity structures, with Article 17(b) requiring that “the maturity extension is not triggered at the discretion of the credit institution issuing covered bonds”. For pass-through structures (which have become popular in recent years), it is unclear whether this restriction might cause any concern as the terms on which such a covered bond may extend beyond the originally scheduled maturity date are arguably within the control of the issuer.

The “European Secured Note” (ESN) is also coming. This is a parallel CMU-related project (with considerable overlap with the covered bond initiative) which the Commission is currently assessing following consultations in 2017. The Commission is considering the market potential for the establishment of an ESN framework, as well as the regulatory and prudential treatment that should apply. The Commission defines ESNs as “a dual-recourse financial instrument on an issuer's balance sheet applying the basic structural characteristics of covered bonds to SME loans and infrastructure loans” (e.g. a “covered bond” for SME loans and infrastructure loans). The Commission has made it clear that the ESN will likely provide a better mechanism for credit institutions to issue securities backed by SME loans and infrastructure loans, and potentially other riskier assets that are unlikely to meet the CB Directive requirements for covered bonds.