The “winds are blowing” in the direction of legislative action to harmonise covered bond frameworks, according to Didier Millerot of the European Commission, who said a study is set to confirm the benefits of such a move, while stressing that balance will be key to any such initiative.

Speaking at a European Covered Bond Council (ECBC) plenary in Oslo on Thursday, Didier Millerot, head of unit, banks and financial conglomerates, DG FISMA, said that the Commission will communicate its decision on whether to propose a harmonisation of covered bond frameworks as part of the Capital Markets Union (CMU) mid-term review, which will be published in June, and may include an announcement that it will issue a proposal for a Directive on covered bonds.

“In my view,” he said, “it seems the winds are blowing in the right direction, at least from the point of view of those who believe there is actually added value in legislative action by the EU in this area.”

Millerot said he believes that central to the initiative will be the question of balance.

“Balance between the need to stimulate covered bond markets and jurisdictions that do not have them, and the need to ensure that long established, well-functioning ones continue to thrive,” he said. “Balance between what should be harmonised and what should be left, either to member states, market practice or self-regulation.

“Balance between what should be included in the general definition and what should be left to the prudential framework.”

Millerot highlighted two “fundamental elements” that will influence the Commission’s decision on what approach to take: the potential for developing new covered bond markets in member states where covered bond issuance has not yet taken place or where markets are underdeveloped; and the potential for making EU covered bonds even more attractive to investors.

He said this second point is particularly important in light of CMU and given that when the ECB’s covered bond purchase programme comes to an end “it would be good to have in place a framework that would ensure that investors are ready to take over in full confidence of the quality and safety of the product”.

He noted that another factor that could justify a new framework is the question of whether current rules are sufficiently robust and provide a clear enough definition of the covered bond product. He noted the European Banking Authority (EBA) considers that at least some improvements are required in that respect.

Millerot said a three-step approach to harmonisation recommended in a report from the EBA “makes sense indeed”, and is helpful for the Commission as it contains a fairly elaborate proposal for what a potential new EU framework could look like.

“Whatever approach we take in the future, we will need to look at the definition of a covered bond, which is currently located in the UCITS Directive – at least because it has a purpose going beyond UCITS and investment limits, and is referred to by the CRR and Solvency II frameworks,” he said.

“Secondly, it is logical to look at the additional conditions that are also suggested by the prudential framework, and whether these will need to be further detailed as well. Thirdly, the possibility to deal with remaining issues outside the EU legislative framework also needs to be looked at, as it is highly likely that any legislative action would aim at dealing with all issues pertaining to the proper regulation of covered bonds and the legal environment in which they operate.”

The Commission has also commissioned a study from ICF International to provide an assessment of the functioning and performance of covered bond markets, to identify potential improvements, and assess the costs and benefits of such interventions. Although the study is not yet finalised, Millerot said the preliminary findings allowed him to make a few comments.

“First, in terms of potential costs and benefits, the study is likely to confirm that there would be indeed benefits induced by EU action, in particular in terms of reducing fragmentation, and development of covered bond markets across the whole EU, but also in terms of investor confidence and robustness of the prudential framework,” he said.

Millerot said the study also helped to identify key features of a potential framework, and highlighted the question of eligible collateral would be of particular importance. He noted that there is a clear trend in the covered bond market towards mortgage-backed issuance, and acknowledged that issuers and investors place a lot of trust in this sector.

He added that there are other funding needs, in particular in the “very vast and vital” SME sector, but noted that stakeholders are cautious about admitting SME-backed issuance into the covered bond label.

One solution to this could be the creation of another framework, borrowing from the covered bond framework, for an alternative product that would not share the covered bond label, he said, acknowledging the ECBC’s proposals for a new product dubbed the European Secured Note (ESN). He said the Commission is very likely to address this question in the CMU mid-term review.

The issue of extendible maturities will also require special attention, Millerot said, as they are key to the safety of the covered bond product and label.

“I could further comment on other potential building blocks of an EU framework: for example, transparency, investor disclosure, public supervision, liquidity,” he added. “These are always important issues at EU level.”

The European Parliament’s Committee on Economic & Monetary Affairs (ECON) on 27 March published a draft of an “own-initiative” report into covered bond harmonisation, and Millerot noted that the first discussions of this will take place this week and that the ECON committee is due to vote on the report in June.

“Therefore it is too early to call which direction the EP will take,” he added, “but preliminary contacts imply that the EP could also see some merits in well-targeted EU action.”

Christoph Kimmerle, policy advisor, Economic & Monetary Affairs, European Parliament, told the plenary it is too early to talk about Parliament’s position, but – speaking in a personal capacity – said that there would be benefits to providing a more precise definition for covered bonds.

“As a starting point for European legislation, we have to see that the EU so far lacks a precise definition of covered bonds. So our agenda is clearly to address this problem and start with a principles-based approach, starting with the definition,” he said.

“I think this can open up a lot of opportunities. In the EU framework directive, providing a clear and concise definition of must-have features for covered bonds can be beneficial for stakeholders, establishing a unique, transparent, visible reference point and hence decrease the transaction costs. We believe this will also work against a watering down of the structural features.”

Millerot said any proposal for a Directive will likely not be put to Parliament or Council before year-end.

“And then, of course, starts the decision process,” he said, “which I hope could be not so difficult, provided we come up with a well-balanced proposal building on what the Parliament will have told us already and on what the EBA has given us as advice.”