The Investment Management Association believes UK Regulated Covered Bonds lack “the very high degree of certainty” that should be expected of a regulated product and are opaque, and that the framework needs more significant changes than those being proposed in a review.

In its response to a consultation on proposals announced by HM Treasury and the Financial Services Authority in April, the IMA said that it was unfortunate that, as before the UK framework’s introduction in 2008, it was not pre-consulted on reform proposals.

Jane Lowe, IMA

“This is unfortunate since it would appear that an assumption has been made that the regime needs little change, whereas we would argue that it might benefit from more significant change,” said the IMA in a letter signed by Jane Lowe, its director of markets.

The letter was accompanied by an appendix containing answers to the questions posed in the consultation, which ended on Friday.

The association outlined several concerns relating to the transparency and structure of UK RCBs, and urged HM Treasury to tackle these, even if such reform was not envisaged in the timetable for the review of the framework.

“For investors, the RCB regime is lacking the very high degree of certainty that should be expected of a regulated product,” said the IMA. “For issuers, the regime runs the risk that over time it will fail to attract long term stable investors into the product.

“If the impact of bank resolution and bail-in extends also to the RCB regime, this is likely to lead to a gradual withdrawal of long term investors from bank funding, leaving banks with a different and probably less stable investor base.”

Some market participants had suggested that such bail-in concerns might have been sufficiently addressed when the review was announced. The consultation paper said:

“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.”

However, concerns over the treatment of covered bonds in a resolution regime and other fundamental issues were addressed by the IMA in its concerns over the structure of RCBs.

“The Regulated Covered Bond regime remains complex and opaque in relation to a key feature, namely how and when the pool of assets is ‘secured’,” it said. “We advocate a switch to a simple and transparent secured issuance regime rather than an opaque regime of senior unsecured issuance.

“The question of how and when the pool of assets is secured is made substantially more problematic following the introduction of resolution regimes for banks in the UK. If a RCB issuer were placed in resolution it is not clear how this would impact the bonds; for example, it may interfere with the expected ‘trigger’ mechanism for default.”

The IMA said that the introduction of bail-ins of senior debt might affect the RCB regime and that to maintain investor confidence the RCB should be clearly carved out of bail-in requirements.

“Greater clarity is required on what would occur upon the occurrence of the issuer being placed in resolution,” it said. “This is particularly important as in contrast to many EU RCB regimes, a UK RCB is a senior unsecured bond and only becomes ‘secured’ by way of a guarantee on ‘default’. In a special resolution situation, this means that the guarantee may not be triggered under the relevant contract because the issuer is not deemed to be in default.”

The IMA said that if the review cannot address such concerns within its timetable, one should be planned in a year’s time to address the issue.

Key information ‘buried’, OC and encumbrance addressed

The IMA said that covered bonds have been increasingly taken up by its members in the past year but that they have not found the documentation “user-friendly”.

“Key information is frequently buried deep within detailed prospectuses (400+ pages is not unusual),” said the IMA. “Whilst they are able to manage this, we question why it should be necessary for a regulated product.”

The association argues in favour of disclosure of loan level data in line with Bank of England requirements.

“This is a much needed measure to improve investor confidence and transparency for Regulated Covered Bonds,” it said.

The IMA also called for the FSA to reveal the levels of asset encumbrance it allows each bank, saying that it is key to confidence in the regime that the regulator “should consider this aspect of bank funding holistically”.

A proposal for the introduction of a fixed minimum overcollateralisation level for RCBs was supported by the IMA. The association said that the lack of this feature in RCBs made UK covered bonds look weak, but it argued that those in other jurisdictions are too low to be meaningful.

The IMA recommended a 5% or 7% minimum OC level, noting that most UK issuers require a 7% minimum and that rating agencies generally require overcollateralisation to be in the order of 15% or more to maintain a triple-A rating. The association returned to the bail-in issue with regards to OC, too.

“IMA members would also like clarification regarding the status of the overcollateralised amounts in the event of issuer default, in particular with respect to the operation of the bank resolution regime,” it said. “Can HMT/FSA indicate that it is the intention that these balances should remain within the SPV until all investors have been paid out in full?”

The IMA documents can be found here.