The potential harmonisation of European covered bond frameworks will have a more significant impact on Spain’s idiosyncratic covered bonds than other national markets, bringing both positive and negative consequences, according to Moody’s.

The European Commission is widely expected to propose harmonisation of national covered bond laws of EU member states, via a Directive, as part of its Capital Markets Union mid-term review next month. The European Banking Authority (EBA) provided a template for harmonisation in a recommended three-step approach in December, and separate reports from the European Parliament and consultancy ICF have since found merits in legislative action.

In a report published today (Thursday), Moody’s said that if harmonisation is implemented according to the EBA’s proposals, Spanish covered bonds will be more affected than those of other European countries, because Spain’s covered bond framework differs more significantly from what would become the new pan-European standard.

“On the positive side for Spanish covered bonds, the European Banking Authority’s proposals include a number of requirements that are more stringent than is currently the case under the Spanish legal framework for covered bonds,” said Jose de Leon, manager, covered bond team, Moody’s. “If these standards were implemented in Spain, it would be credit positive for Spanish covered bonds.”

These requirements include: a minimum standard on liquidity for principal and interest payments; higher standards in relation to cover pool derivatives; new transparency requirements; the appointment of independent cover pool monitors and administrators; and a requirement to carry out regular stress tests.

The proposed minimum standards would also give Spanish issuers greater flexibility to incorporate structural features, such as pass-through repayment mechanisms, to better mitigate credit risks, which Moody’s deems a credit positive.

Another positive for Spain could arise from the invention of a new product, dubbed the European Secured Note (ESN), Moody’s said. The ESN, which would be backed by SME loans and would share features with covered bonds, while being distinct from them, was proposed by the ECBC to avoid a dilution of the covered bond product.

A DG FISMA official said recently that the Commission is likely to take up the issue of SME-backed issuance in its mid-term review.

Moody’s said ESNs would improve the funding options of Spanish banks.

However, the rating agency said harmonisation could harbour risks for Spanish issuers. In particular, Moody’s expects the level of overcollateralisation (OC) benefiting Spanish covered bonds to decline if the EBA’s proposals are implemented in Spain.

Under the current framework, Spanish covered bonds are backed by the issuer’s entire mortgage or public sector loan book, in contrast to most European countries. This idiosyncratic feature means that Spanish covered bonds have by far the highest OC in Europe, compensating for other weaknesses in Spanish covered bond structures, according to Moody’s. As of the end of 2016, Moody’s-rated mortgage-backed programmes from Spain had an average OC of 157% and public sector programmes 66%.

The EBA’s three-step approach includes a proposed minimum OC level of 5%, well below the 25% minimum under the current Spanish law for mortgage covered bonds and 43% for public sector covered bonds.

The rating agency also highlighted that the EBA proposals include less stringent LTV limits for cover assets than are currently enforced under Spanish law. If laws such a “soft” LTV limit were implemented in Spain, Moody’s said the pool of eligible assets would increase and banks would be able to issue more covered bonds backed by loans of lower quality.

Furthermore, Moody’s said that a lack of clear communication about how any harmonisation process would be implemented could increase execution risk for Spanish covered bond issuers and hinder their ability to access the market – adding that Spanish banks are more reliant on covered bond funding than those in other countries.

“In addition,” it said, “a long implementation process with no visibility on the outcome, similar to what occurred when the Spanish treasury issued a consultation paper on potential changes to the legal framework for covered bonds in 2014 but did not reach a conclusion, could affect the market for a prolonged time.

“Spanish banks will also face some liquidity challenges in 2020, with the repayment of the majority of funds borrowed via Targeted Long Term Refinancing Operations (TLTROs) and the amortization of around Eu32bn of covered bonds scheduled to occur in that year. If the implementation process for harmonisation is still ongoing by 2020, it would have an adverse effect on banks’ ability to raise funds through covered bonds.”