Luxembourg’s finance minister introduced a draft amendment to the country’s covered bond legislation on Friday that foresees the introduction of a new type of lettre de gage, co-operative covered bonds, and changes to insolvency procedures inspired by the Pfandbrief Act. However, it does not envisage abolition of the specialist bank principle because of concerns about the subordination of unsecured creditors.

Luc Frieden

The draft bill was introduced in Luxembourg’s parliament by Luc Frieden, the finance minister, and, according to an introduction setting out the motivation for the amendment, can be separated into two parts.

The first part concerns the insolvency regime for lettres de gage, with the modifications being proposed “inspired” by changes made to Germany’s Pfandbrief Act in 2010, such as the introduction of a new legal status for the cover pool administrator following an issuer default – “Pfandbriefbank with limited business activities”.

HSBC Trinkaus analysts said that the most complex regulations put forward by the draft Luxembourg bill have to do with the insolvency regime, and that a cover pool status similar to the aforementioned “Pfandbriefbank with limited business activities” is being proposed.

The introduction to the draft bill, in French, refers to a new concept of “compartiment patrimonial d’une banque d’émission de lettres de gage en activite limitée”.

The second main part to the draft bill, according to the introduction, contains more “pinpointed but still important” modifications, notably the introduction of a new type of Luxembourg covered bonds – lettres de gage mutelles or, in German and English, Verbundpfandbriefe and co-operative covered bonds.

According to HSBC Trinkaus analysts, the new framework for lettres de gage mutuelles could attract banks from countries with a co-operative network, such as Austria, Finland, France, and Germany, to set up subsidiaries in Luxembourg.

They noted that the draft bill sets out 10 requirements in relation to the issuance of lettres de gage mutuelles. According to the commentary on the draft bill, this type of covered bond is deemed to represent an “acceptable quality because of the obligation to provide for strict protection mechanisms for this activity”, namely a system of institutional guarantees that has to respect certain legal requirements.

The introduction to the draft bill states that the bank issuing lettres de gage mutuelles does not itself have to be a member of the co-operative network. Instead, it seems that the credit institutions whose assets form part of the cover pool backing co-operative covered bonds would have to be members of such a network, or that the banks guaranteeing loans granted by a lettres de gage issuer have to be members of such an “institutional guarantee system”.

Another change envisaged by the draft bill is the expansion of jurisdictions from which eligible public sector assets can be drawn, with HSBC Trinkaus analysts noting that loans and guarantees from countries outside of the European Economic Area (EEA) and OECD membership will become cover pool eligible as long as the rating from Moody’s, Standard & Poor’s or Fitch is at least AA-.

The introduction to Frieden’s draft bill directly addresses the topic of the specialist bank principle, which bankers had previously told The Covered Bond Report was going to be dropped in Luxembourg (see here for previous coverage). It sets out the rationale for not abolishing it, despite this step having been taken in Germany.

The text says that granting all credit institutions the right to issue lettres de gage would engender considerable risks for unsecured creditors, such as depositors. The asset encumbrance problematic, it says, stands in the way of an extension of the right to issue lettres de gage to all banks because of the subordination of depositors and the deposit guarantee scheme that this implies, “with all the negative consequences that such a situation would entail in the event of a crisis”.

“In order to maintain the stability of the financial sector as a whole and to safeguard a high level of confidence in the banking system, the draft bill is keeping the specialist bank principle for lettres de gage issuers in the Luxembourg regulation,” says the introductory text.

The draft bill can be found here.