Harmonisation of covered bonds is a perennial topic, but has been given more urgency with the release of an EC green paper on long term finance. Jörg Homey, covered bond analyst at DZ Bank, argues that investor reporting is ripe for statutory standardisation, but that any harmonisation of frameworks should not stifle innovation.

The European Commission in March published a green paper on the subject of improving the long term financing of the real economy, governments and infrastructure projects of the European Union*. The ultimate aim is to organise the financial system so as to make the economy’s entire aggregate savings available to potential borrowers (credit seekers) in an effective and efficient manner. The issues raised in the green paper also touch on covered bonds, especially the question of what would be the benefits and disadvantages of harmonising the national legal regimes governing covered bonds.

The likely difficulty of harmonising or even just aligning the legal foundations governing the varied range of European covered bond products is evident from the challenges facing market participants when they try to agree a universally acceptable definition of the term “covered bond”. At present the criteria defined in article 52(4) of the European Directive on Undertakings for Collective Investment in Transferable Securities (UCITS directive) are the most basic and most frequently used definition for covered bonds.

Harmonisation leads to a more homogeneous market

The arguments in favor of harmonisation include that it can help to make the covered bond market more homogeneous and easier to understand. The EU could make a positive contribution to transparency, for example by issuing a directive to define issuers’ reporting duties with regard to their covered bond programmes and cover pools. This could link in with the ECBC Covered Bond Label, or even better could write the Covered Bond Investor Council’s wish list of proposals for regular issuer reporting into law. Harmonising covered bond issuers’ transparency duties would also be a positive development because statutory minimum standards offer advantages over voluntary publication practices from an investor point of view. This is because issuers cannot walk away from statutory minimum standards if they become inconvenient. A Europe-wide consistent reporting standard would also improve the comparability of cover pools and make it easier to identify individual covered bond programmes’ strengths and weaknesses.

It would also be helpful to cover pool transparency if the EU implemented a general ban on repackaging (external securitisations, or using covered bonds as cover for covered bonds), following the lead set by the European Central Bank when it updated its requirements for repo collateral. This would make cover pools less complex, which would ultimately help to improve the transparency of covered bond programmes.

Europe-wide standards to regulate issuers’ cover pool calculations would also make sense. Specific minimum standards for calculation could be prescribed for the required tests, for instance making it normal practice to calculate the present value cover as well as the usual nominal value cover.

Further clarifications concerning potential cover assets would be helpful if they demarcated a clear framework within which different issuers’ covered bond programmes could compete. It would be worth considering harmonising the requirements governing cover assets’ geographical location. Restricting this scope to the EEA countries plus Switzerland would be a good starting point to decide which are let in and which are ruled out.

Creative destruction through trial and error

On the other hand, a levelling of overcollateralisation requirements would not be especially constructive. European legal overcollateralisation requirements (by covered bond legislations) range from 0%, or close to 0%, to 43%. It would be a better idea to let issuers retain their different international practices in respect of this easily managed measure.

One can similarly argue for variety in the areas of LTV caps or ceilings on borrower concentration levels within cover pools. This would give financial institutions valuable space to position themselves according to their respective business strategies, lending standards or valuation methods.

Turning to the asset classes that covered bond issuers are permitted to assign to their cover pools, claims on the public sector and property loans are the most common types. One argument for a narrow definition of eligible cover pool assets is that this would tend to counter the risk of dilution of the standards governing the covered bond market (and the resulting risk of reputational damage). However, the closer the control, the greater the constraints on market participants’ inventiveness, to the eventual cost of market innovation. The innovative covered bonds that are secured by loans to small and medium sized enterprises (SME covered bonds) are one of the recent examples of how a proven bond product like the covered bond can be extended to other asset classes.

Certain standards have already emerged across covered bond jurisdictions. This is probably partly because a few covered bond regimes from countries such as Germany or the UK have served and continue to serve as models for others. Variety in covered bond laws and programmes can, however, also be seen as beneficial in that this competition of ideas generates innovations and permits increasingly creative sophistication in the covered bond market as a whole.

It is vital for competition to function effectively since this process has brought forth a constant stream of new ideas in recent years that have even occasionally resulted in incremental improvements to national covered bond laws. It follows that the universal framework should not be defined too narrowly and should avoid unnecessarily constraining the creativity and inventiveness of market participants as they strive to find solutions and answers to ever changing problems and challenges. Accordingly, general requirements for covered bond programmes should not create new barriers to market entry. Issuers also need some space for discretion – the ability to design and operate their covered bond programmes with maximum effectiveness and efficiency in line with the dictates of their individual business activities and strategies.

You would still have to do the credit work

Whether rule books are harmonised or not, it remains a fact that banks always have the option to go beyond universal statutory requirements by providing voluntary undertakings that gain them brownie points with investors (or rating agencies). If they make use of this option (and this is what we would expect), investors would probably have to continue to invest the effort to individually vet covered bond programmes even if Europe’s laws are harmonised.

*Green Paper: Long-Term Financing of the European Economy, 25 March 2013

We are keen to hear well-argued opinions addressing topical themes in either a positive or negative (or balanced, even) light. If you would like to discuss contributing an opinion piece to The CBR , please e-mail Neil Day, nday@coveredbondreport.com, or call on +44 20 7428 9575. Also, feel free to share any thoughts on the above using the comment function below.