The European Commission’s covered bond proposals are deemed to have achieved the “balance” being sought, with no deal-breakers identified – regarding extendible maturities, for example – but ambiguity around cover asset eligibility means some uncertainty remains.

The package unveiled on Monday consists of a proposed Directive, aimed at providing a common definition of covered bonds and defining the features of and rules applying to covered bonds seeking to use the new “European Covered Bond” label, and a proposed Regulation, aimed at strengthening conditions for granting preferential capital treatment for covered bonds through the introduction of further requirements.

Market participants and analysts said that while most countries will have to adjust their national frameworks to meet the requirements proposed by the Commission, the Directive and associated Regulation include no major surprises.

“My initial thought when I read it was it looked quite good,” said an official at an established issuer. “It seems balanced, and pretty well thought through.

“The devil is always in the detail, and people from all countries will need to see if there are things that, on second thought, need to be tweaked. But as far as I can see, there is nothing in it that would be a deal-breaker for any one country.”

The Association of German Pfandbrief Banks (vdp) welcomed the general compatibility of the proposals with the existing standards of the Pfandbrief Act, albeit with some reservations.

“The proposal will further improve future prospects for covered bonds as a key product for bank refinancing in Europe and will create a stable basis for privileged regulatory treatment,” said Jens Tolckmitt, chief executive of the vdp. “What is crucial for us is that the rules leave the necessary scope for further development of the quality of national products such as Pfandbriefe.”

Ruben van Leeuwen, head of credit strategy and regulation at Rabobank, said that the Commission’s “one size fits all” approach means the market impact of the proposed changes should be muted.

“Even though virtually all national frameworks would require some form of change (arguably more in Southern European than in Northern European jurisdictions), the new shirt that the EC has woven seems to fit most national frameworks,” he said. “As such, it can easily be argued whether the shirt with the European Covered Bond label is not too wide and that real harmonisation is therefore not going to take place.

“On the other hand, the EC also faced the reality, as the European Parliament already pre-positioned itself by asking for not too detailed set of regulations.”

Asset eligibility: what counts?

The proposed package replaces the current definition of covered bonds provided by the UCITS Directive. As part of its rules on what can constitute a covered bond, the proposed Directive requires that covered bonds are at all times collateralised by high quality assets referred to in points (a) to (g) of Article 129(1) of Regulation (EU) No 575/2013 or by “other high quality assets” that meet certain requirements, including that the assets’ market value or mortgage lending value can be determined.

Some market participants questioned what “other high quality assets” could ultimately be permitted, and say the Directive can thus be interpreted as making a less clear distinction between traditional covered bonds, i.e. those backed by traditional collateral, and other types of covered bonds than is currently provided by the UCITS Directive.

The vdp said the wording of the Directive allows the interpretation of permitted cover assets to be taken beyond traditional covered bonds such as Pfandbriefe, suggesting the Commission’s aim is to enable new types of assets to be used as collateral, in order to finance additional growth in the real economy.

“As expected, the proposed Directive is principle-based and lists all the key quality characteristics of covered bonds,” said the vdp’s Tolckmitt. “It calls for a minimum level of harmonisation and leaves sufficient scope for specific national features, based on national laws.

“Only the requirements for assets’ eligibility as cover could have been more detailed in the opinion of Pfandbrief banks, to provide better protection for covered bonds as a quality product.”

The question of new asset types being permitted into cover pools has been raised throughout the harmonisation debate, with some market participants concerned the use of SME loans, for example, could lead to a weakening of the covered bond product.

However, the Commission is separately looking into the establishment of a European Secured Note (ESN) product backed by SME loans. It said in a Q&A released in conjunction with Monday’s package that “SMEs loans and infrastructure loans are unlikely to meet the requirements set in the Directive because they are riskier assets”.

Luca Bertalot, secretary general of the EMF-ECBC – which first proposed ESNs – said the Directive’s wording has to be interpreted and ECBC members will discuss this in an upcoming meeting in Vancouver.

“The spirit of the legislator is pretty clear,” he told The CBR. “One of the preconditions of the Directive was to not damage working covered bond markets, and I think the Commission has very carefully taken on board comments from all member states to made sure the status quo is reflected in the Directive.

“We see and we know this is also behind the proposed regulatory requirements vis-à-vis asset eligibility.”

Bertalot noted that some parts of the covered bond market had been calling for a stricter approach with regards to asset eligibility, but that some parts of the market had been calling for a more inclusive approach.

“The Commission went for an inclusive approach, with the purpose of not creating any shocks in any functioning markets,” he said.

Extendible maturities relatively unscathed

The treatment of soft bullet and conditional pass-through covered bonds had also been flagged by market participants as a potentially controversial aspect of harmonisation, in responses to the EBA’s recommendations.

As had been expected, the Directive rules that any maturity extension cannot be triggered at the issuer’s discretion and must be regulated by law or contract, among other conditions, including that bankruptcy remoteness and recourse to the issuer must not be affected by an extension.

“In our understanding, at least Portuguese, Norwegian and some French issuers need to adjust their extendable structures or provide a credible legal interpretation clarifying that current extendible structures are not discretionary,” said Bernd Volk, head of covered bond and SSA research at Deutsche Bank.

Analysts said soft bullet and CPT structures used in other countries, including Belgium and Greece, may also need to be amended to comply with the proposed rules on maturity extension triggers.

However, the result is deemed to not be overly punitive for soft bullets and CPTs and was seen as leaving sufficient leeway for national specificities.

“Whilst the ECB has increased the discrimination between covered bonds with non-extendible and extendible maturities recently, we do not observe the same move from the European Commission, except the stricter conditions for maturity extensions,” added Rabobank’s van Leeuwen.

However, Cristina Costa, senior covered bond analyst at SG, said it remains an open question what precisely the Commission means by “the issuer’s discretion”.

What next?

Analysts suggest the new regime will take effect in 2020 or 2021, with discussions between the European Commission, the European Parliament and the Council widely expected to conclude by the end of 2018. The Commission has called for the implementation of all legislation proposed as part of its wider Capital Markets Union package by 2019, before the next European elections.

“The deadline for the new rules to be implemented at national level is shorter than we had expected: It is a one-year period after the new Directive enters into force, which in turn will become effective 20 days after its publication in the EU Journal,” said Ted Packmohr, head of financials and covered bond research at Commerzbank. “The CRR changes come with an equivalent timeline.

“Given the additional time it will take for the EU authorities to finalize the legislative process, however, this should be a manageable timeframe.”

The proposals suggest that UCITs-compliant covered bonds issued up to one day after the Directive enters into force will not be subject to the Directive’s requirements but will continue to benefit from the same regulatory treatment until their maturity.