Aspects of covered bonds’ regulatory framework have been up in the air this year, with a push towards harmonisation, new ECB repo rules and Brexit fall-out complicating the picture, but little negative impact is expected in 2017, even with TLAC/MREL an ongoing distraction.

The most eye-catching regulation-related headline affecting the covered bond market this year was the European Commission’s contemplation of a harmonisation of covered bond frameworks under its Capital Markets Union (CMU) initiative. The long-debated issue returned to the front pages again after the European Banking Authority (EBA) unveiled draft recommendations last month.

The EBA’s final report is due to be published and submitted to the European Systemic Risk Board, the Council and the European Commission before year-end, and an independent impact assessment study is due by end-2017. The European Commission’s final decision is expected in the first half of the year, and most market participants expect it to opt for a principles-based approach.

Analysts expect this to be positive in that it would result in no negative changes to covered bonds’ preferential regulatory treatment.

“However, individual countries might be forced to tighten their legislation in some details,” forecast analysts at Commerzbank. “In addition, secured bonds – currently not classified under the traditional covered bond model but advocated from a political perspective – may receive a regulatory boost

“We believe this flexible approach offers sufficient scope for the more conservative countries to preserve the strengths of their covered bond laws, i.e. we fear no quality dilution that could harm the spreads of core products.”

Whichever option the Commission chooses, however, it is expected that implementation will take substantially longer, and little to no impact is foreseen next year.

Other recently announced changes to covered bonds’ regulatory treatment have come from the ECB. The central bank on 3 November announced adjustments to increase its risk control measures for retained soft bullet and conditional pass-through (CPT) covered bonds, which will be implemented in the second half of 2017.

“At the bottom line, the incentive for issuers to use retained covered bonds for ECB repos will therefore be reduced further, which fits into recent years’ trend and should in principle not cause any deteriorations on the public markets,” said Commerzbank analysts.

Despite the move, analysts expect the widespread trend towards such extendible maturity issuance to continue next year. The Commerzbank analysts noted that in 2016, new euro benchmark issuance in extendible format exceeded hard bullet issuance for the first time.

“2017 should continue along these lines,” they said.

The ECB also lowered haircuts for credit quality step (CQS) 3 eligible covered bonds (i.e. covered bonds rated triple-B).

“The impact on the market should be relatively minor, as the huge majority of covered bonds have a rating better than CQS3,” said analysts at UniCredit. “Only Banca Carige (three bonds), Banco Mare Nostrum (three bonds), IM Cédulas, Cédulas TDA and HSH Nordbank (shipping) and VakıfBank (one bond each) have such bonds outstanding.

“However, the move from the ECB could drive issuers with retained issues in this rating category to sell those bonds into the market.”

Catching up to do

Overall, the preferential regulatory treatment that covered bonds have enjoyed is expected to be maintained – with treatment under BRRD and LCRs increasing the product’s attractiveness – and regulation is seen remaining in the backseat while drivers such as the ECB’s purchase programme steer the covered bond market next year.

Other recurring regulatory topics, such as Basel risk weights, or the EC’s NSFR, are not expected to take shape for some time.

However, TLAC (total loss-absorbing capacity) and MREL (minimum requirement for own funds and eligible liabilities) have clouded analysts’ forecasts for the covered bond market in recent years.

Issuers’ needs to build buffers of loss-absorbing capital in order to meet requirements has seen many focus on other markets at the expense of covered bonds over the last two years. This week, Crédit Agricole and Société Générale issued the first senior non-preferred transactions, and further such “Tier 3” issuance is expected next year after the European Commission proposed other EU countries follow the French example.

Banks’ continuing preparations for TLAC and MREL are therefore expected to remain a dampener on covered bond supply next year – although most analysts say the impact will be relatively modest.

“A majority of banks still have some catching up to do in order to meet these requirements – provided they are already known,” said Christoph Anders, senior covered bond analyst at DZ Bank. “This could occur at the expense of covered bonds, although we believe the impact on new issue volumes of covered bonds in 2017 will be limited.”

Analysts noted that banks still have time to fulfil such needs. TLAC and MREL will not enter force until 1 January 2019.

“Second, the number of covered bond issuers affected by TLAC is limited and many smaller covered bond issuers are likely to escape the more stringent requirements that MREL currently envisages for national systemically important institutions,” added Anders. “Third, some banks have already announced that they will increasingly issue TLAC-eligible instruments as a replacement for expiring senior unsecured bonds, and non-global systemically important European banks have also already signalled similar plans in order to meet the MREL requirements.

“There will undoubtedly be some degree of substitution of covered bonds by TLAC/MREL-eligible instruments, although for the reasons given above we do not expect this to be a significant dampener for new issues of covered bonds as long as the latter offer a sufficient refinancing advantage.”

UK: the new Canada?

Official Brexit negotiations will begin next year, and the UK’s surprise vote to leave the EU has prompted market participants to reconsider the place of UK covered bonds among Europe’s elite.

Analysts said the risk for UK covered bonds should be limited, however, at least in terms of regulatory treatment. They noted that if the UK leaves the EEA, as many expect, UK covered bonds could lose some privileges under the UCITS Directive, CRR and LCRs, but said their ECB repo-eligibility should be maintained.

“On balance this would be comparable to the regulatory status of Canadian covered bonds, which nevertheless typically benefit from healthy demand,” said analysts at Commerzbank. “In addition we could imagine that, by the time the Brexit negotiations have been concluded, new EU measures for improved mutual regulatory recognition with third countries may be initiated as part of the planned covered bond harmonisation.

“These should also benefit UK covered bonds.”