The EBA made important changes on the back of industry feedback between draft and final recommendations for the European Commission, according to EBA policy expert Massimiliano Rimarchi, with soft bullets and conditional pass-throughs having proven “very controversial” topics.

In a keynote speech at an AFME Spanish securitisation and covered bond event in Madrid last Thursday, Rimarchi said the EBA’s recommendations to the European Commission in relation to its harmonisation considerations were aimed at increasing the consistency of the definition of the financing tool across the EU and protecting the covered bond “brand”.

He said this is important because – among other reasons – despite being uniformly treated in an increasingly “friendly” way in European regulations such as LCRs, bail-in and EMIR, “we know as a fact that they are different instruments due to different regulatory approaches”, and at the same time covered bonds are evolving.

“There is from the side of the markets themselves structural innovation,” said Rimarchi, “so more and more jurisdictions are issuing covered bonds that are no longer the traditional hard bullet instrument, but a soft bullet instrument with maturity extension or a conditional pass-through, so an instrument that after extension becomes more like a securitisation, if I may say so.”

He noted that the EBA’s recommendations regarding new structures and maturity extension were the most-discussed aspects at a public hearing in November, having proven “very technical and very controversial”. The EBA in both its draft and final recommendations included soft bullets and CPTs among those covered bonds that will be able to achieve the most preferential treatment.

“However, there is a major concern we have for both of them,” said Rimarchi, “which is that this first step of extending the maturity should not be at the absolute discretion of the issuer. It should only happen following a negative event, which in our reading of the current market practice and our, let’s say, reasonable approach to this is that the covered bond issuer has defaulted and the covered bond programme has failed relevant tests, of coverage, of repayment.

“If these two broad conditions both occur, then we understand maturity extension is the characteristic of CPTs and other extendible bonds in order to basically substantially alleviate liquidity issues.”

Indeed, the EBA recognised this feature with specific treatment in its proposed liquidity requirements, he noted.

“We are saying that given that these bonds extend maturity,” said Rimarchi, “the liquidity requirement of 180 days for principal repayment can take into account the final maturity, so the postponed one, not the scheduled maturity.”

The EBA took into account other concerns raised at the public hearing, he noted, citing as an example of “important changes” made from the draft to the final recommendations how they ultimately accommodated the nature of the relationship between covered bonds, specialist covered bond issuers, and their parents in models like France’s. Feedback highlighting how a 180 day liquidity requirement could not be fulfilled post-issuer default was also reflected, he added.

In a review of the EBA’s recommendations published on Monday, Moody’s nevertheless said that the proposals relating to soft bullet and CPT structures would need to be carefully implemented to avoid creating new risks.

“The proposal will be credit negative if the conditions or processes it creates may be difficult to comply with and thus increase the risk of non-payment on a covered bond,” the rating agency said.

“The EBA proposals are based on potential rather than actual issues around extension triggers to date,” it added. “While we are not aware of any cases where an issuer has actually exercised its discretion to trigger a maturity extension, in many covered bonds this would be theoretically possible. However, we expect the market would react negatively to the use of such discretion except in case of clear need.”

Other areas of the recommendations Moody’s said could pose credit challenges were (in its words): some ambiguity around the treatment of covered bonds in resolution; the lack of any restrictions on the type or composition of assets that may be included in cover pools; and the lack of any provisions for non-European Economic Area (EEA) issuers.

However, Moody’s said the EBA’s recommendations are overall credit positive for European covered bonds.

“The minimum standards will support baseline credit standards for national covered bond legal frameworks and in some cases strengthen some aspects of existing legal frameworks, both of which are credit positive,” it said. “Minimum standards will reduce refinancing risk by supporting market liquidity for covered bonds.

“The EBA also confirmed that covered bonds could continue to benefit from favourable regulatory treatment provided they comply with minimum standards. Continued favourable regulatory treatment is credit positive as it supports the depth and liquidity of covered bond markets and so reduces refinancing costs for covered bonds after issuer default.”

The European Commission is expected to decide what action, if any, to take regarding covered bonds towards the end of the first half of the year, also taking into account a study commissioned from ICF International involving industry veteran Richard Kemmish that it should receive later this month.

The Commission has not always followed the EBA’s recommendations, for example having given covered bonds more favourable treatment in LCRs than the regulator had advised.