The European Commission is preparing to launch a tender for a study exploring the feasibility of developing European Secured Notes (ESNs) for SME and infrastructure loans, laying the groundwork for possible action in the second quarter of 2018.

The Commission analysed the possibility of SME (small and medium-sized enterprises) and infrastructure loan-backed covered bonds in considerations on possible action on harmonising EU covered bonds, ahead of its June announcement that it will present a legislative proposal for an EU framework in the first quarter of next year. The SME-related project has not only been under consideration as part of regulatory action on covered bonds, but also as a potential part of the Commission’s wider Capital Markets Union initiative.

The Commission ultimately decided to deal with any SME and infrastructure-backed covered bonds separately, announcing that it will assess the case for ESNs, targeting the second quarter of 2018.

To this end, the Commission has announced its intention to launch a negotiated call for tender to support the exploration of the feasibility of developing ESNs, which it defines as on-balance sheet dual recourse financial instruments that apply the basic structural characteristics of covered bonds to SME loans and infrastructure loans.

“The objective of the study is to obtain an assessment of the potential for establishment of European Secured Notes and of the regulatory and prudential treatment that could be granted to them under the existing EU legislation,” it said.

“The study should mainly consist of desk research, data collection and analysis, and investors’ outreach with the aim of estimating the size of the SME and infrastructure bank lending markets in the EU and each Member State, identifying the criteria to be used for defining the population of SME and infrastructure loans eligible for ESNs, identifying regulatory and prudential treatments applicable to ESNs and providing justification, and estimating issuers’ funding costs and investors’ required rates of return for ESNs in relation to the most relevant benchmarks.”

A previous study was conducted for the Commission during its harmonisation deliberations by consultancy ICF, involving Richard Kemmish.

This prior study considered whether eligible assets should be determined under EU covered bond legislation, and whether non-traditional, “alternative” assets such as loans to SMEs or infrastructure projects should be added. Feedback from stakeholders was largely in favour of bonds backed by alternative assets being clearly differentiated to protect the reputation of existing covered bonds.

“This is based on the widely held assumption that ‘alternative’ asset backed covered bonds will necessarily have a lower credit quality than ‘traditional’ asset backed covered bonds, all other things being equal,” it said.

However, there was disagreement among stakeholders as to whether or not alternative assets should be part of the covered bond framework or dealt with under a distinct “brand” such as ESNs.

“But further consideration is clearly needed on the merits of creating an alternative brand, which is beyond the scope of the present study,” it said.

The Commission is asking those interested in participating in the tender to respond by 4 September.

The European Covered Bond Council’s ESN taskforce has already been engaging with the Commission and submitted preliminary data to support its work at the end of July.

ESNs meanwhile featured prominently in a European Parliament report advocating action on covered bonds.