European covered bonds are in line for favourable regulatory treatment, especially in the context of new bail-in rules, but challenges remain, such as the continued fragmentation of the market and a general negative bias for bank ratings, said S&P yesterday (Wednesday).

The rating agency said that the European Union’s bank bail-in framework, the Bank Resolution and Recovery Directive (BRRD), could be the most important regulatory development for covered bonds this year, and that it further reinforced their importance as a funding tool.

“Unlike for banks’ senior unsecured funding, under the BRRD, covered bonds will not be subject to a so-called bail-in, meaning that the directive is likely to generate further investor interest in the asset class,” said Standard & Poor’s. “Additionally, from a regulatory stance, covered bond liabilities will not be affected by write-downs.”

Courtyard of the European Parliament

The rating agency is awaiting clarity on the final version of the bail-in regulation before deciding on how it may affect its covered bond ratings, but said that linking the covered bond rating to issuer credit ratings remains “generally appropriate” in its view.

Other regulatory developments could also affect S&P’s covered bond ratings and contribute to reshaping the market, said the rating agency.

It cited the European Market Infrastructure Regulation (EMIR), which sets out requirements for the central clearing of derivatives, and noted that the proposed EMIR framework appears to require covered bond programmes to post collateral, which would be challenging, especially in the case of an issuer insolvency.

“This is because the share of assets that could be used for posting collateral is limited and the legal frameworks typically designate the liquid assets to support the redemption of upcoming covered bonds,” said S&P.

Another positive development for covered bonds besides the BRRD are transparency requirements under the latest version of the Capital Requirements Directive (CRD), in addition to industry initiatives in this vein, according to the rating agency.

“Issuers trying to ensure that investors will continue to benefit from lower risk weightings have to regularly publish covered bond performance data,” it said. “Industry efforts such as the European Covered Bond Council’s (ECBC) comparative database of covered bond frameworks, as well as the ECBC’s label initiative, have also contributed toward the market’s better understanding of the individual program and jurisdiction-level differences.”

However, the European covered bond market remains fragmented and a 2013 European Commission (EC) Green Paper on the long term financing of the European economy is likely “to become an important step toward harmonising the different regulation, as it proposes to standardise the various European covered bond legal frameworks”, said S&P.

The initiative will probably be a long term project given the country-specific nature of insolvency regimes and pronounced differences between individual mortgage markets, but appears desirable, noted the rating agency.

“[A]s the market evolves, we believe a fresh look at individual frameworks may bring more consistency, benefiting both investors and issuers,” it said. “While economic and regulatory conditions have changed significantly, some countries have not updated their covered bond frameworks for some time.

“In particular, we see notable differences between countries that continuously update their legislation and those that firmly maintain the status quo, making it difficult for investors to assess how a covered bond might perform if a bank were to become insolvent.”

S&P said that the number of covered bond rating downgrades has slowed compared with previous years and that the share of negative outlooks on its covered bond ratings, at 20%, is the lowest since 2011.

It said that it does not expect one of the key events in 2014, an Asset Quality Review (AQR) by the European Central Bank, to materially affect its covered bond ratings because these already incorporate capital and asset quality weaknesses.

“However, irrespective of the AQR, as a general negative bias for European bank ratings persists, we cannot rule out potential knock-on effects on our covered bond ratings,” it said.

This is also because, on average, the number of unused notches in S&P’s covered bond ratings is lower than in previous years, meaning that covered bond downgrades following cuts of the relevant issuer ratings are more likely.