Dual recourse structures backed by SME loans proposed by the ECBC could appeal to new investors, but the so-called ESNs would not necessarily solve the problem of SME funding, according to speakers at a conference last week at which EBA and ECB officials shared their views.

In a position paper published on Wednesday of last week (6 March), the European Covered Bond Council proposed two types of instrument, dubbed European Secured Notes (ESNs). The first would feature an on-balance sheet dual recourse structure akin to a covered bond, while the second, off-balance sheet structure, using securitisation techniques, would retain a form of dual recourse and offer capital relief to the issuer.

Speaking on a panel at an ICMA Covered Bond Investor Council and The Covered Bond Report Conference in Frankfurt last Thursday (7 March), Luca Bertalot, secretary general of the EMF-ECBC, described the ESN as being something in between covered bonds and securitisations.

“Let’s call it a super high quality securitisation,” he said. “It is not a covered bond.”

Moderating the panel, Ted Packmohr, head of financials and covered bond research at Commerzbank, suggested that the proposed on-balance sheet ESN is “a covered bond in all but collateral”, but Bertalot said that the distinction is important in order to protect the covered bond product from being watered down.

“We strongly believe we have a successful story during the most important financial crisis of our century,” he said. “This is due to very specific characteristics – a legislative framework, very standardised collateral, and a very privileged regulatory treatment.

“Introducing ad hoc new categories of collateral, or having a very high fragmentation of the initiative at national level can be seen as a risk.”

Bertalot said the ESN would require a standardised definition of an SME, and must be able to be implemented across Europe with the same criteria. The ECBC’s paper said a common legal framework could be created for the instruments or existing laws could be amended, recommending that ESNs should benefit from pan-European standards and favourable regulatory treatment.

The ESN would differ from an SME loan-backed covered bond – such as one issued by Commerzbank in February 2013 outside Germany’s Pfandbrief Act – because it would be protected by legislation and therefore offer comfort to investors in difficult market conditions, according to Bertalot.

“This is not an ad hoc solution done by one issuer,” he said. “This wants to be a systemic solution on the plate of the European Commission.”

The instrument could also attract a new investor base, Bertalot added.

“It should bring new blood to the economy,” he said. “This is what Lord Hill would like to see.”

Jonathan Hill is the EU Commissioner in charge of moves towards a Capital Markets Union (CMU), the umbrella project for initiatives such as improved SME finance and securitisation.

In a comment on the ECBC’s proposals, Fitch said yesterday (Wednesday) that the industry body’s recommendations that ESNs should benefit from common pan-European standards, the potential involvement of supranational institutions as investors or guarantors, and favourable regulatory treatment would help channel positive market interest.

“By contrast, previous individual initiatives to provide secured bank funding backed by SME loans have remained isolated, although they have generated considerable debate in the media,” it said.

Agreeing that there is a need for such an anti-cyclical, dual-recourse instrument, Aaron Baker, global markets research at BBVA, said the ESN could appeal to investors while covered bond yields are low.

“If there is an alternative product such as this, instead of going down the credit curve to senior unsecured, for example, I think there would be some sort of interest,” he said.

However Baker said that for issuers the relative value of such a trade – when they could alternatively access TLTRO funding, issue covered bonds and cover the remainder of their balance with deposits – means interest would be limited while the European Central Bank’s QE programme is running.

“Having said that, there is a need and a recognition among issuers for an increase in investors coming to the market,” he added. “To an extent if there is that need then they will pay up.”

Sascha Kullig, head of capital markets at the vdp, agreed there may be a gap between senior unsecured funding and Pfandbrief issuance, although suggested other forms of collateral such as infrastructure loans or renewable energy should be considered, too.

“But we shouldn’t raise any expectations that we can’t fulfil,” he added. “I doubt that with an ESN bond, backed by SME loans, you will solve the problems we have in some countries. It is not the funding where the bottleneck is, it is more the equity.”

Meanwhile Massimiliano Rimarchi, policy expert, credit market and operational risk unit, regulation, EBA, said the EBA was open to looking at such instruments.

“In general terms, every avenue for financing the long term real economy should be explored, even from our perspective,” he said. “As soon as it comes to regulatory recognition, obviously we take a risk-based approach, we look at the safeguards.

“If these new instruments were to develop the same safeguards we expect from covered bonds, then probably we would take a risk-based approach and just acknowledge that.”

Earlier at the conference, Ulrich Bindseil, director general, market operations, at the ECB, said that the institution is open to innovations.

“Of course every innovation can have in principle positive and less positive elements,” he said. “So, looking at those structures that are mentioned here, SME structured covered bonds that were mentioned a while ago – the Commerzbank issuance – or more recently the conditional pass-through structures – in principle the ECB believes these structures have their merits, not that they are necessarily better and dominate other structures. But one can find merits in those which can benefit both the issuer and the investor side, and they can contribute to, let’s say, a more diverse asset class.

“So in principle dual recourse structures have potential to be innovated. Of course there is always at the same time a desirability of standardisation and homogeneity, so there is this tension. But overall the ECB would say that there are merits to explore those more diverse covered bond structures, and the ECB has also reflected that in treating those in its covered bond collateral framework and in CBPP3, in principle, favourably.”