The European Covered Bond Council has proposed on-balance sheet and off-balance sheet dual recourse structures backed by collateral such as SME and infrastructure loans, dubbed European Secured Notes (ESNs), in a response to an EC Capital Markets Union (CMU) green paper.

In its response published today (Wednesday), the industry body is responding to a consultation launched by the European Commission on 18 February in which it has been seeking, among other things, proposals on how to aid long term finance, build high quality securitisation, and broaden the investor base for the financing of small and medium-sized enterprises.

An ECBC taskforce on long term financing has been reviewing initiatives already underway and considering how the success of covered bonds in providing finance through the crisis could help further these causes.

“The ECBC response to the Green Paper on Building a Capital Markets Union aims at providing clear building blocks for a market initiative on a pan-European dual recourse long term funding instrument, which would allow for the financing of asset classes beyond the traditional covered bond collaterals, i.e. mortgages and public sector assets,” said the industry body in its response.

“This initiative, designed outside of the traditional covered bond space, aims at establishing the pillars for the creation of a pan European long-term funding portfolio, combining existing techniques and market best practices learnt during the crisis, for the establishment of an anti-cyclical funding toolkit for lenders that is also accessible in a stress scenario.”

The ECBC proposes two types of instrument.

“The first ESN would be closer in design to covered bonds in the sense that the collateral would stay on the balance sheet and the investor would have dual recourse to both the pool and the issuer,” it said. “The second ESN would resemble more closely what is referred to as ‘high quality securitisation’ This could provide capital relief to the issuing institution (as the collateral would be transferred onto an SPV), but still retain a form of dual recourse.”

The first, covered bond-like “on-balance sheet ESN” should, like its antecedent, have a similar legal and supervisory framework, developed eligibility criteria and transparency requirements, said the ECBC.

It envisages the second type, “capital relief ESN” – which draws more from securitisation techniques – freeing up banks’ balance sheets. Originators would face “skin in the game” retention requirements – for example, retaining the junior tranche or 5% of each tranche – while public sector sponsors such as the EIB, ICO or KfW could invest in or guarantee riskier parts of the structures “in the spirit of promoting the development of the securitisation market and the financing of the real economy through SMEs”, according to the industry body. The dual recourse nature of covered bonds could, meanwhile, be echoed through the originator guaranteeing the senior tranche of the ESN, it added.

A common legal framework could be created for the instruments or existing laws could be amended, said the ECBC. Meanwhile, qualification for preferential regulatory treatment in LCRs or Solvency II, for example, would bolster the initiative, it added.

At the same time, the ECBC stressed that the new instruments should be distinct from traditional covered bonds, which it said must be protected.

“Traditional covered bonds have ensured financial stability and access to capital markets during the crisis thanks to very precise macro-prudential characteristics,” it said. “Any watering down of these qualitative characteristics, by enlarging the risk factors, could jeopardise the systemic importance of this asset class.

“In the light of the current discussion on both SME lending and infrastructure investment and high-quality securitisation techniques and standards, it is important to identify a demarcation line between the traditional covered bond space and the potential use of dual recourse techniques for other kinds of assets as collateral.”

Photo: Commissioner Jonathan Hill, responsible for CMU