Changes to Slovakia’s covered bond law are being proposed to ease constraints on issuance, according to an official at one of the country’s biggest issuers, targeting LCR Level 2 eligibility and higher ratings, as Moody’s said covered bonds will become increasingly important for Slovak banks.

The Slovak covered bond market totals some Eu4.2bn and has been growing at around 10% per year, according to Moody’s, which published a comment on the country’s market on Thursday. The majority of it is privately placed and issued to institutional investors and some retail investors, according to the rating agency.

The two largest covered bond issuers are Slovenská sporiteľňa – a member of Erste Group – and VÚB banka – which is majority owned by Intesa Sanpaolo. As of 31 March, Slovenská sporiteľňa had Eu936m of covered bonds outstanding, and VÚB banka some Eu1.62bn. Moody’s added that the rest of the market is made up of five to six smaller issuers.

According to the rating agency, covered bonds finance only 6% of the banking system’s total balance sheet, and Moody’s cited Slovakia’s covered bond legislation as being among factors constraining the market, noting that the current framework differs from EU peers, and saying it expects these laws to change in the near future to converge to European Commission recommendations.

“Slovak laws governing covered bonds stem from 1990, and, unlike other European covered bond laws, force [a] liquidation of the cover pool upon [an] issuer’s bankruptcy and do not address a minimum level of overcollateralisation to protect covered bondholders against credit and market risks arising upon issuer’s bankruptcy,” Moody’s said.

Moody’s also noted that all mortgage loans in Slovakia are required to be 90% financed by covered bonds – although the National Bank of Slovakia may, upon request, lower this threshold to 70% – and that this has the effect of forcing Slovak banks to issue covered bonds regularly and in small amounts, rather than waiting to accumulate assets and then issue a larger amount.

The small size of Slovak banks’ issuance excludes their covered bonds from preferential treatment as even Level 2 assets, with the minimum size for Level 2A and 2B assets being Eu250m – the largest deals from Slovenská sporiteľňa and VÚB banka are Eu100m.

Vladimír Polhorský, head of balance sheet management at Slovenská sporiteľňa, told The Covered Bond Report that changes have been proposed to Slovakia’s covered bond law that include provisions that would give issuers greater flexibility.

He said the Slovak Banking Association (SBA) is collecting a second round of comments on the proposed changes to put to the Ministry of Finance shortly, with implementation targeted in spring 2017.

“We are currently in a process of updating local legislation regarding covered bond issuance and this will significantly help banks to become more flexible in their plans for covered bond issuance,” said Polhorský. “For instance, banks will have much better possibilities when our covered bonds become LCR-eligible.

“There are some special domestic regulatory limits currently that are pressing banks to issue covered bonds rather regularly in small issue amounts. It is practically not possible to issue covered bonds with an issue size over Eu250m – the limit to be LCR eligible – so our covered bonds are not so attractive for bank investors. This should be changed or cancelled so in the future banks can issue covered bonds when necessary for liquidity management and issue sizes could reach higher amounts.

“Other changes can help to improve the ratings of our covered bonds, and so can have a positive impact on funding costs.”

Moody’s also said that the use of covered bonds by Slovak issuers is constrained by a scarcity of eligible cover pool assets, as only mortgage loans are permitted to be used as collateral. Mortgage loans account for just 11% of gross banking loans in Slovakia, while remaining residential retail housing credits categorised as “housing loans” represent 30% of gross loans and are growing at twice the rate of mortgages, but these are currently not eligible as covered bond collateral.

“We consider that Slovakian authorities may alter the covered bond law in the future and align it better with EU peers, by including consumer housing loans as permissible collateral for covered bonds,” said Moody’s. “This would increase the amount of collateral available and ease the constraints on the market.”

The rating agency added, however, that the share of non-performing loans in the housing sector loan book stands at 2.7%, compared with 1.8% for mortgages, meaning that the underwriting of housing loans may need to tighten if they are to become suitable collateral.

Moody’s said that a prevailing low interest rate environment, economic growth, and deepening banking penetration are now fuelling rapid credit expansion in Slovakia, which is gradually outpacing the growth of deposits. Loan financing consumed 90% of deposits in December 2015, up from 85% at the end of 2010, Moody’s noted, while at the same time, banking penetration increased from 56% to 64% and a sharp decline in lending rates fuelled expansion in housing credits.

Moody’s said Slovak banks will gradually need to turn to capital markets as lending expands further and availability of deposits falls, and said it believes that the potential benefits of covered bonds – which currently fund only 6% of the banking system’s total balance sheet – relative to higher cost and higher risk alternatives are likely to drive growth in the asset class.

Polhorský said that the importance of issuing covered bonds is not growing due to the lack of other funding sources but rather due to upcoming regulation – including the NSFR and domestic regulation that will require banks to use more long term funding in order to finance loan growth.

Moody’s nevertheless noted that Slovak banks’ use of covered bonds could be constrained by upcoming regulation, with the NSFR requiring banks to hold more long term funding against encumbered (and hence cover pool) assets than for unencumbered assets.

“Further, future legislation on minimum own funds and eligible liabilities [MREL] will require banks additional bail-inable debt, which covered bonds are exempt from,” it added.

VÚB banka’s covered bonds are rated Aa2 by Moody’s, and those of Slovenská sporiteľňa are rated A by Fitch.