The Association of German Pfandbrief Banks (vdp) and Moody’s have commented favourably on aspects of a European Commission consultation paper on covered bonds released on Wednesday, but warned that a full harmonisation approach could have negative consequences.

The paper, published last Wednesday as part of the Capital Markets Union (CMU) project, outlined the Commission’s intention to “promote a more integrated EU framework for covered bonds based on high quality standards and best market practices” to establish a more integrated European covered bond market. It said this could be achieved either by allowing voluntary convergence of national covered bond laws around recommended European Banking Authority best practices, or through direct EU product legislation that would harmonise existing laws or provide a new framework.

Welcoming in principle the Commission’s thoughts, the Association of German Pfandbrief Banks (vdp) said it is in favour of a flexible approach based on high market standards or on a binding minimum harmonisation, rather than the establishment of a new unified product with a separate legal framework.

“In the Pfandbrief banks’ view, the only feasible route is to set minimum standards at a high level,” said Jens Tolckmitt, chief executive of the vdp. “This is because, by gradually leading the national rules towards a common standard of quality at the European level, clear qualitative improvements to the general conditions for covered bond markets in the EU could be achieved.

“At the same time, this could prevent systemically incompatible interference in existing national regimes, some of which are in fact functioning very well. By contrast, full harmonisation at the European level could cause the market more harm than good.”

Moody’s said today (Monday) that if the EU were to adopt the proposed framework’s features this would, on balance, be credit positive for covered bonds in some EU jurisdictions as it would require credit positive features that are not yet standard across the market. However, it highlighted some proposals as being credit negative for some jurisdictions, for example a ban on intra-group hedges.

“The Commission’s proposals also do not offer a recommendation to limit exposure to commercial real estate in a pool that also contains residential mortgages,” it said. “This would be negative for certain countries if it overruled existing limits such as the 10% limits in Sweden and Finland.”

The Commission suggested that resolution authorities could be given powers to set a maximum level of overcollateralisation either in the ongoing life of covered bonds or at the time of resolution or insolvency of the issuer, and the rating agency identified this as potentially problematic.

“It is difficult to know how an objective maximum would be set,” Moody’s said. “Adding overcollateralisation is often the most straightforward method of managing – where possible – the credit risk associated with a covered bond.”

The rating agency identified the most credit positive features as being:

- Detailed operational procedures for cover pools upon issuer insolvency.

- Special administrators appointed to cover pools upon an issuer default to protect the interests of covered bondholders.

- Nonperforming loans not permitted in cover pools.

- A quantifiable buffer of liquid assets for the benefit of the covered bonds.

- An independent cover pool monitor.

The vdp argued that a “29th Regime” – a unified framework distinct from Europe’s existing 28 national covered bond frameworks – would also not be feasible in pure form, above all because key legal areas such as insolvency law have not been harmonised at the European level. It added that should a 29th Regime be introduced, it should not enjoy regulatory treatment more favourable than national products.

The Association of Danish Mortgage Banks (Realkreditrådet) also welcomed the initiative.

“If European legislation on covered bonds is enacted, the Association of Danish Mortgage Banks will make dedicated efforts to ensure that fundamental principles underlying sound mortgage credit models – such as the Danish mortgage model – will provide the building blocks of such legislation,” said Ane Arnth Jensen, managing director at Realkreditrådet. “This is an ambitious goal.

“That is why it is essential to ensure that covered bonds should remain extremely secure and stable instruments – no matter which format and content such EU initiative comes in. In this context it is important that covered bonds are treated according to their high qualities compared to other types of funding, namely securitisation.”