Investors and issuers have reacted positively to the launch of a review of the UK covered bond framework by the authorities yesterday (Wednesday), saying that it should strengthen the product. Reassurances on the segregation of cover pools under bail-in scenarios was also welcomed.

HM Treasury and the Financial Services Authority said yesterday that the joint review aims to ensure that the UK covered bond market is better aligned with those in other countries and allows UK issuers to compete on a more level playing field. It also seeks to make UK covered bonds more attractive to investors and will deal with how covered bonds are treated in bail-ins.

Mark Hoban, Financial Secretary to the Treasury

“Making sure banks and building societies lend to families and businesses is vital for sustaining the recovery,” said Mark Hoban, Financial Secretary to the Treasury. “Today’s review demonstrates the Government’s commitment to supporting the UK’s growing covered bond market. The review will bring out the strengths of the UK’s covered bond regime and help lenders raise the funds they need to lend.”

Moves proposed under the review are:

• Introducing consistent standards of investor reporting
• Requiring issuers to maintain a fixed minimum level of overcollateralisation
• Designating a regulated covered bond programme as backed by only a single asset type in the legislation
• Excluding securitisations as eligible assets for regulated covered bond asset pools
• Creating a form role of “asset pool monitor” in the legislation
• Changes to regulatory reporting

Market participants reacted positively to the initiative.

“We welcome the recognition of the importance of covered bonds as a funding tool and the statement of intent to build upon the strengths of the existing framework, as well as ensuring their attractiveness to investors.” Chris Fielding, Regulated Covered Bond Council executive director, told The Covered Bond Report. “We appreciate everything said by the Financial Secretary with regards to the flexibility covered bonds offer and how they can complement unsecured funding and securitisation.”

Buy-side market participants were also encouraged by the government’s move.

“We welcome the joint initiative by the FSA and HMT to review the UK covered bond regulation and are supporting the authorities in their effort to make the current framework even better,” said Georg Grodzki, head of credit research at Legal & General Investment Management. “LGIM believes that covered bonds could become an important asset class for long term institutional investors and play an increasingly significant role as funding instrument for UK banks.”

Claus Tofte Nielsen, chairman of the Covered Bond Investor Council and senior portfolio manager Norges Bank Investment Management, said that the plans to strengthen the UK’s framework look good.

“They don’t want to have ABS in covered bonds and that is the first time we have seen that from the UK,” he said. “You can argue whether having ABS in cover pools is right or wrong, but I agree with the argument used, namely that the two products should be kept apart.

“Including ABS in covered bond pools should only be considered if this can be done without diluting the key characteristic of covered bonds, including unwarranted regulatory arbitrage.”

He also said that the transparency improvements being sought are aligned with the CBIC’s transparency initiative.

As well as the framework governing covered bonds, the consultation document discusses how covered bonds should be treated in a bail-in scenario, with the authorities noting that bail-in powers are an important issue for many investors.

“If a bail-in power were introduced into the UK’s Special Resolution Regime (SRR) for failing banks, the power would be subject to the same creditor safeguards that apply more generally within the SRR, including the safeguard that protects covered bond holders,” says the consultation. “In addition, the UK believes that, in the exercise of any bail-in powers, secured creditors’ rights to collateral should not be over-ridden, and that the claims of covered bond holders in relation to the asset pool of a covered bond, including under a guarantee which forms part of the covered bond arrangement, should not be affected.

“This would mean that only a secured creditor’s residual unsecured claims after realisation of collateral or recoveries under a guarantee would be subject to bail-in. As international negotiations about bail-in powers progress, the authorities should consider carefully the mechanisms by which creditors could call upon any guarantee forming part of a covered bond arrangement in respect of the original unsecured claims.”

The RCBC’s Fielding welcomed this.

“There has been a misplaced worry that in the case of a bail-in the assets in the cover pool could in some way be reclaimed,” he said, “but the consultation makes it crystal clear that the segregation of assets in a bail-in, the secured creditor’s rights to collateral, is not in question.”

And Bernd Volk, head of covered bond research at Deutsche Bank, said that even though it leaves open the question of how a covered bond holder’s senior unsecured claim will be treated in a bail-in, this is not necessarily a bad thing.

“While this sounds negative at first glance, in our view, it increases creditability of the FSA and therefore also the creditability of the covered bond regulation,” he said. “Excluding the implicit senior claim in covered bonds from bail-in in a bank resolution regime would be some kind of blanket guarantee and a further privilege for covered bond investors which would probably hard to justify regarding any kind of justice in insolvency procedure.”

However, market participants said that it was unclear how the review might affect the levels at which UK covered bonds trade.

“The rules are really positive, but the spread impact is hard to quantify,” said Frank Will, senior analyst at RBS. “The UK has already performed well, but there’s probably a little bit of room to perform better and this is a step in the right direction.

“However, I don’t think it’s a game-changer. It will probably do more for widening the investor base and engendering more confidence in UK products.”