The EBA laid out a roadmap for harmonisation in European covered bonds at a public hearing yesterday (Tuesday), identifying best practices toward which national frameworks should converge. No high level objections were raised, but several recommendations proved contentious.

The principles of best practice are the outcome of research going back to a December 2012 mandate from the European Systemic Risk Board (ESRB), which the European Banking Authority linked to another mandate, this time from the European Commission, to look into the preferential prudential treatment of covered bonds under CRR.

Analysts highlighted as “good news” that the EBA considers the preferential risk weights for covered bonds to be appropriate. However, as previously reported by The CBR (see separate article), the EBA is proposing that other qualifying criteria be added to CRR Article 129.

The EBA is bringing its findings together in a report “EU covered bond frameworks and capital treatment”, which is in draft stage and was discussed at a public hearing in London yesterday.

“Nothing is cast in stone yet but we are getting close to the final stages,” said Andrea Enria, chairman of the EBA, during the introduction to the hearing.

The EBA has some two weeks to finalise the report, which will involve it being put to the EBA board of directors, before it is submitted to the Commission at the end of the month. The final report will be published in July, according to the EBA.

EBA officials spoke of the need and scope for more convergence in the European covered bond market to safeguard and further promote what has established itself as a crucial funding tool for banks with a reputation as a high quality and safe instrument. A comparison of national legal/regulatory frameworks in the EU reveals a high degree of heterogeneity, they said, noting that although covered bonds benefit from preferential regulatory treatment there is no harmonised EU framework, with only the UCITS directive providing for some commonality.

And while the existence of some differences between national jurisdictions is not negative, there are “lessons to be learned from best practices” identified in existing frameworks, said Enria, who along with his colleagues made clear that the EBA expects these principles of best practice to be adopted in changes made to national legal/regulatory covered bond frameworks. No single framework presently fully meets all of the principles of best practices, according to the EBA.

Covered bond analysts noted that the report presented by the EBA is only a preliminary version, and also that the recommendations it makes are not legal requirements. Under the CRR, the Commission has to report to the European Parliament on the issue of risk weights by the end of 2014, and the EBA is due to follow up on its interim report on best practices with another report for the ESRB by the end of June 2016.

Jan King, senior covered bond analyst at RBS, said that it will be important to see what actions will be taken by lawmakers and regulators at EU and ultimately the national level, but that the EBA’s work “clearly shows a trend towards harmonisation amongst covered bond frameworks within the EU, which should increasingly find its way into regulatory provisions and thus ultimately affect those not keeping up with the pace”. The trend is visible in a Commission green paper on long term financing of the European economy and recent regulatory developments in relation to EMIR and Basel Committee proposals on large exposures, he said.

“The most immediate impact will likely be felt from the review of the criteria for preferential risk weights which is due after the EC report to be submitted by year-end 2014,” he added.

Mixed pool restrictions among contentious best practices

No high level objections were raised at the hearing to the EBA’s introductory comments about the need and scope for greater convergence, but several of the specific principles of best practice proved contentious.

Frank Will, global head of covered bond research at HSBC Trinkaus, highlighted as controversial recommendations that covered bonds not be allowed to be backed by mixed asset pools, with the exception of residential and commercial mortgages (subject to ex-ante regulatory limits), and that the value of properties securing each loan be re-evaluated on at least an annual basis and this should feed into LTV limits.

He said that the restriction on mixed asset pools would in particular be a problem for Compagnie de Financement Foncier, whose cover pool comprises mortgages and public sector loans.

For cover pools combining residential and commercial mortgages, the EBA floated regulatory limits as a means “to ensure a certain degree of consistency is maintained in the risk profile of the cover pool throughout the life of the covered bond”.

A fair degree of critical feedback was voiced in relation to this principle, and the EBA acknowledged that regulatory limits are a crude way of achieving the above goal, but said that disclosure is insufficient and that it is open to considering other ways of ensuring the desired stability and consistency in the pool’s risk profile.

Among the most important and “controversially discussed” recommendations, according to RBS’s King, are: those on derivatives, namely that they should only be permitted for hedging purposes and must be included in the cover pool; a distinction between and requirement for both hard and soft LTV limits; and a requirement for a liquid assets buffer.

The latter may have implications for soft bullet and conditional pass-through (CPT) structures, according to analysts, given that they are designed to mitigate liquidity risk and therefore eliminate the need to hold liquid assets in cover pools.

The issue was raised at the hearing by Florian Eichert, senior covered bond analyst at Crédit Agricole, who today (Wednesday) noted that although EBA said it will take these structures into account in its final report it nonetheless emphasised that it wants a more consistent approach to liquidity risk across markets and will require that liquid assets be held by issuers.

“So having extension features does not seem to eliminate the need to hold liquid assets,” said Eichert. “Depending on the amount required in the end, this could reduce the economic rationale for soft bullets and CPT as they are designed to specifically minimise the need to hold costly liquid assets in cover pools. The rating benefit would obviously remain, in any case.”