The European Banking Authority shed light on its recommended three-step approach for covered bond harmonisation at a public hearing on Friday, but attendees warned of potentially costly and destabilising effects should some proposals be implemented in their present form.

The EBA’s recommendations are expected to be a key consideration for the European Commission when it next year decides what action may be appropriate to harmonise covered bonds – an element of its Capital Markets Union (CMU) project. The EBA is due to deliver finalised recommendations to the Commission and other European authorities in December.

Speaking at the EBA’s offices in London on Friday, executive director Adam Farkas (pictured speaking) described the regulator’s three-step approach recommendations as offering a “fully fledged” harmonisation framework.

“Our framework aims to ensure that only those financial instruments that comply with the harmonised structural, credit risk and prudential standards can be branded as covered bonds, and can have access to special preferential regulatory and capital treatment as offered in the current EU legislation,” he said.

“You will note that we not only propose to strengthen existing rules on covered bonds, but also suggest a number of new requirements which are currently not addressed in the EU regulation. These requirements include those best practices which we have developed from principles to more specified criteria, as well as some other new areas of possible regulation.”

Lars Overby, head of unit – credit, market and operational risk policy, at the EBA, noted that many of the rules the regulator is proposing are already in place in some jurisdictions, but not in all or are not well defined. He said there is a good case to have definitions set so that there is a clear idea of what a covered bond is.

Ahead of the hearing Luca Bertalot, EMF-ECBC secretary general, said the industry body is set to back the EBA’s proposals, but noted that “the devil is in the detail”, and the challenges of drafting appropriate rules quickly became apparent when the EBA opened the floor to questions.

The workings and proposed treatment of soft bullets and conditional pass-throughs threw up most of the more contentious aspects of the hearing.

Overby said a key issue for these structures is who has the power to trigger the change of payment mode, and the EBA has proposed that the issuer cannot effect the change.

The first question from the floor centred on this topic, with a BNP Paribas representative noting that in France, with its specialist issuer model, the status of the “issuer” is different from in jurisdictions where covered bonds are issued by universal banks with an on-balance sheet model. The EBA acknowledged that the wording of rules regarding “issuers” would therefore need to reflect this.

Jac Besuijen, president of the Dutch Association of Covered Bond Issuers (DACB), said the Dutch welcome the proposals in setting a “benchmark” for CPTs – “for us that is crucial” – allowing CPTs to retain preferential regulatory treatment.

However, he questioned why the EBA has proposed that only CPT issuers have to publish loan-by-loan/stratified data.

“It’s either for all covered bonds, or it’s for none,” he said, noting that Dutch issuers would not be against such a requirement for all issuers and could easily fulfil the requirement.

EBA policy advisor Christian Moor said that “it’s more relevant” to CPTs since investors may be left with, say, a 30 year extension reliant on payments from the underlying assets under such structures, rather than only a year or so under soft bullets.

As well as saying that the change of payment mode may not be effected by the issuer, the EBA in its presentation said the change of payment mode may only be effected upon two triggers being hit (the covered bond issuer having defaulted and the covered bond not been repaid at its scheduled maturity date) and “at the discretion of the special administration”.

Jim Gibbons, senior capital markets manager at Nationwide Building Society, said that in UK covered bond programmes the change to soft bullets is automatic and that introducing discretion would “destabilise” this.

Further toing and froing between the EBA and market participants regarding aspects of soft bullets and CPTs – such as appropriate liquidity risk mitigation – led a Barclays representative to suggest that the regulator misunderstands the products.

Taking into account the cumulative impact of everything EBA is proposing, a representative of the Italian Banking Association (ABI) said he fears covered bonds will become “a little bit expensive”, citing requirements such as a higher, 5% minimum overcollateralisation (OC) level.

Overby said the EBA recognises the need to do an impact assessment on the OC requirement, but noted that a higher level has worked in some jurisdictions, is a requirement under other EU regulations, and is necessary to meet rating agency targets. He added that the ultimate decision should lie with the Commission since there is a “political” element to the issue.

Michael McCormick, head of covered bond origination at Credit Suisse, asked whether minimum OC levels will need to be stipulated in national legislations or can be contractual. Overby said that would be up to the Commission, but noted that if there is a Directive then the rules would have to be put into national law.

Overby added that a Directive would be “an appropriate solution” in respect of its proposals.

He said that some of the areas included in step 3 – “voluntary convergence” – and others outside the remit of the current proposals are nevertheless on the EBA’s radar and deserving of further attention. He said that being more ambitious and setting more requirements at the moment would involve attempting to fix too many things that would be difficult to be implement at a national level.