An EU Covered Bonds Directive is among recommendations the European Banking Authority (EBA) put forward in a report today (Tuesday) that will be a key consideration for the European Commission when it decides on any harmonisation action under its Capital Markets Union project.

The EBA released its recommendations today after having presented them at a public hearing on 18 November. The final version confirms the “three step approach” outlined previously.

“The framework builds on the strengths of the existing national frameworks, while, at the same time, allowing better protection for the covered bond product by ensuring more consistency in terms of definition and regulatory treatment of covered bonds in the EU,” said the EBA. “This framework aims to ensure that only those financial instruments that comply with the harmonised structural, credit risk and prudential standards can be branded ‘covered bonds’ and have access to special regulatory treatment and preferential risk weights, as offered in the current EU financial regulation.

“Importantly, the proposal seeks to provide a balanced and pragmatic solution to harmonisation that meets harmonised prudential objectives while, at the same time, building on existing well-functioning national covered bond markets, keeping flexibility and specificities of national covered bond frameworks and leaving room for varying national implementations (where appropriate).”

The three step approach comprises:

developing a new covered bond directive to provide a definition of the covered bond and specify structural quality requirements for all regulated covered bonds in the EU.

amending the Capital Requirements Regulation (CRR) to strengthen conditions for those covered bonds that seek preferential capital treatment.

encouraging convergence of national frameworks on a voluntary basis in some specific cases by means of non-binding instruments.

Today’s report confirms comments by EBA officials at the hearing that step 1 should be done by means of a Directive. Covered bonds must meet the requirements of step 1 in order to qualify for preferential capital treatment as part of step 2, but not all will be able to – the EBA, for example, confirmed that its view is that SME covered bonds should not be eligible for preferential treatment under CRR.

The report runs to 159 pages, so The CBR could not review it in its entirety before going to press, but few significant differences to the draft presented at the hearing were immediately apparent.

Soft bullet and particularly conditional pass-through (CPT) covered bonds continue to be singled out for special treatment, with the EBA stating in its step 1 recommendation that “these qualify as covered bonds, as long as they comply with some additional requirements” and noting that they “essentially introduce changes to the core characteristics of the covered bond product”.

However, this comes alongside acknowledgement that different maturity structures will need to be treated differently when it comes to requirements to mitigate liquidity risk. The EBA also took a step back from a proposal to require loan-level disclosure on CPTs, saying instead that “a higher level of disclosure may be more appropriate”.

Luca Bertalot, EMF-ECBC secretary general, previously said the European Covered Bond Council supports the EBA’s general approach and today reiterated this as well as noting the challenges harmonisation efforts face given the diversity of structures in the market and differences at the national level.

“The three-step approach is a good attempt to capture this,” he told The CBR, “offering a degree of harmonisation while not jeopardising the national products.”

The Association of German Pfandbrief Banks (vdp) said the EBA’s approach overcomes fears that harmonisation might lead to a dilution of standards.

“Full harmonisation of covered bond markets in Europe based on low standards is therefore no longer under discussion,” said Wolfgang Kälberer, head of the vdp’s Brussels office. “The EBA’s regulatory proposal is very promising and points in the right direction.

“However, a number of the suggestions are very far-reaching, and as we know, the devil is in the detail.”

The Commission is expected to make a decision on any harmonisation measures towards the middle of 2017, after a study it commissioned is completed in the new year, while the European Parliament and other European institutions will also have their say on any new framework.

“It is now entering a very complex institutional process,” said one market participant.

The full EBA report is available here.