The ECBC says in a response to an EC [corrected from ECB] green paper that there is a tension between the desire to boost the long term lending capacity of the banking sector with the help of new covered bond instruments, such as SME backed deals, and the value that would come from greater harmonisation of the asset class.

The European Covered Bond Council made its comments in a response released yesterday (Monday) afternoon to a green paper on the long term financing of the European economy published by the European Commission in March.

The ECBC notes how covered bonds have played a central role in banks’ funding strategies even amid the volatility of the crisis, and how this has attracted the attention of regulators and market participants worldwide. Given the need to provide lenders with long term financing tools, this could result in greater use of covered bonds in sectors “that are not traditionally addressed under the current ‘covered bond’ concept”, says the ECBC.

“However, enlarging the use and the scope of the covered bond structures to different asset, maturity and risk profiles could increase the degree of heterogeneity in the covered bond arena,” it warns. “This could lead to a significant fragmentation of the covered bond market and could jeopardise the quality features and regulatory recognitions that currently characterise this asset class.”

This tension is brought to the fore in the ECBC’s discussion of covered bonds backed by SMEs – an area of the real economy highlighted in the EC’s green paper.

The ECBC says it backs SME covered bonds – which made a breakthrough with the launch of a Commerzbank deal in February – but also advises caution.

“The ECBC believes that covered bond techniques – in particularly the dual recourse character of the instrument – could be used by banks for the refinancing of SME loans, as we have already seen in Germany and in Turkey (where SME backed bank bond is due to be issued),” it says. “The ECBC, as the think-tank of the industry, supports the development of this market segment as long as the fundamental differences between the two products – particularly in terms of recovery values – between mortgage or public sector backed covered bonds on the one hand and dual recourse instruments backed by SME loans on the other hand – lead to a clear differentiation between the classical product and these new types of secured bonds.”

It adds that while some of the long term funding techniques characterising the product could potentially be adapted and integrated in other funding tools, transforming the covered bond asset class into “a new all-purpose form of collateralised funding” is not the best way forward.

Addressing the more general questions posed by the green paper, the ECBC says that harmonisation is already being enhanced and the asset class ring-fenced through the Covered Bond Label initiative, while the industry is continuously fine tuning best practices resulting in a process of convergence.

However, the industry body notes that minimum standards also take into consideration different market conditions and practices that are not linked to the covered bond product per se, such as insolvency laws or structural differences in mortgage markets.

It nevertheless cites three key areas that offer scope for further harmonisation: special public supervision, transparency, and bankruptcy remoteness.

Implementation of special public supervision varies across jurisdictions, so a decent level of harmonisation could be conceived at a European level, says the ECBC. Regarding transparency, it points to progress made under National Transparency Templates within the Label initiative, and says that this is ongoing.

The ECBC says that given that the diversity of national covered bond regimes makes harmonisation of technical aspects of asset segregation mechanisms and the preferential treatment of bondholders in insolvency proceedings unworkable, a debate about some common principles underlying the security concept of covered bonds appears more sensible.

“These principles could relate to the relationship between the general insolvency estate of the bank and the cover pool, as well as their respective administrators,” it says. “A common European approach could also address the criteria triggering the over-indebtedness and liquidity of cover pools and the proceedings to be applied post-insolvency.”

Other areas the ECBC mentions as possibly offering scope for further harmonisation are: asset and liability management; minimum legal requirements for overcollateralisation levels; licence systems; cover pool disclosures; and asset monitors.

The ECBC paper can be found on its website.