The European Commission’s awaited legislative covered bond framework could miss an opportunity to strengthen EU countries’ divergent approaches to tackling FX risk, according to Fitch, should current proposals be adopted. Moody’s meanwhile cited eligibility of collateral types as key.

On Thursday of last week (8 June), the European Commission announced that it will present a legislative proposal for an EU covered bond framework in the first quarter of next year, as had been expected. The framework, which is due in the first quarter of 2018, is expected to follow proposals put forward EBA recommendations and take into account a report by the European Parliament’s Committee on Economic & Monetary Affairs (ECON).

In a report published on Wednesday, Fitch noted that current national covered bond frameworks across the EU take divergent approaches to dealing with foreign exchange (FX) risk. It said some legal frameworks, including those in Portugal and Ireland, rule that FX risk must be hedged, whereas in Germany and Slovenia, issuers must regularly stress test the impact of currency moves, although provisions vary. In some countries, such as Italy and the Czech Republic, guidelines are either broad or entirely absent, added Fitch.

It said the EBA and ECON reports, while acknowledging the risks posed to investors, do not include detailed recommendations to address them.

“Fitch understands that it is challenging to address FX risk completely via regulation or legislation due to its different sources and magnitudes in covered bond programmes,” it said. “But the move towards European harmonisation presents an opportunity to examine the risks posed to programmes exposed to large open foreign currency positions by currency fluctuation, which we believe are not addressed in all national frameworks.”

Fitch noted that exchange risk is most visible in covered bond programmes with open currency position between the assets and liabilities – citing Poland, Luxembourg and internationally diversified German programmes as examples – but also occurs when loans in a cover pool are backed by a security in a country with a different currency – a feature of some German and Polish programmes secured by commercial real estate loans.

On Monday, Moody’s said the introduction of a pan-European framework would be credit positive for EU covered bonds. It noted that the proposed framework is expected to build on proposals put forward by the EBA and ECON reports, which both focussed on credit standards.

“As a result, the proposal is likely to include improved credit standards, particularly in areas such as liquidity reserves for repayment of covered bonds, and, should an issuer fail, closer supervisory oversight and clearer operational procedures,” said Moody’s. “This would strengthen the credit protections offered by covered bond structures in a more standardised manner across the EU.”

It said that a key aspect of the framework will be whether and how certain assets may be used as covered bond collateral.

“The EC has not made a definitive statement on this topic,” added Moody’s, “but has indicated that non-covered-bond funding instruments are likely to be more appropriate for funding ‘non-traditional’ asset types.”

As part of the CMU mid-term review, the Commission said it will in parallel to its covered bond plans assess the case for developing European Secured Notes (ESNs) – a covered bond-style, SME-backed product proposed by the European Covered Bond Council (ECBC) – for the financing of SME and infrastructure loans.

Photo: Valdis Dombrovskis and Jyrki Katainen announcing the Commission plans; Copyright: EU