A draft covered bond framework has been published in Estonia, the first of three that will tee up a Baltic framework for cross-border issuance, with such joint funding now endorsed by the European Commission’s Directive. Key features recommended by the EBRD are expected to be added later.

The Estonian ministry of finance on Thursday published for public consultation the draft legislation aimed at developing an Estonian covered bond market. Covered bonds have not yet been issued in Estonia.

The legislation forms part of a project launched by Estonia, Latvia and Lithuania to establish a pan-Baltic covered bond framework, which would facilitate the cross-border pooling of assets from the countries for joint covered bond issuance. The ministers of finance of the three countries signed a Memorandum of Understanding on the matter in November (pictured).

Moody’s said on Thursday that the implementation of the Estonian framework would be credit positive for Estonian banks, because it would allow them to diversify their funding sources and better match their assets and liabilities.

“Covered bonds would diversify banks’ funding away from a reliance on parental funding and potentially volatile non-resident deposits, a weakness in Estonian banks’ funding profiles,” said Moody’s analysts. “Covered bonds, which typically have terms of five to 10 years, also would be a cost-efficient and longer-term alternative to banks’ shorter term parental funding and deposits they currently use to finance 20 and 30 year mortgage loans.”

Estonia is the first of the coalition of Baltic countries to publish a draft covered bond framework. Based on figures from the end of 2016, Moody’s calculated that a combined pan-Baltic mortgage market would in size fit between the covered bond markets of Hungary and Slovakia, which are currently the smallest in Europe, but said it would still be large enough to attract international investors.

“It is too early to assess whether the efforts will be successful, but a pan-Baltic market would allow banks to gain the critical mass that allows benchmark-size bond issuance (typically from EUR500m) to create a liquid market and attract foreign investors,” said Moody’s. “Because all three Baltic countries use the euro, they will not incur currency risk when accessing the European EUR1.5tr covered bond investor base.”

Baltic countries’ total outstanding residential mortgage loans at year-end 2016

The rating agency noted that Estonia’s proposals to create a pan-Baltic framework are currently limited in detail, but expects that it will offer Estonian banks legal and operational certainty about using mortgage loans from all three counties as covered bond collateral.

Moody’s expects the draft covered bond law to be further developed during the Estonian parliamentary process, following the recent publication of the European Commission’s legislative proposal to harmonise European covered bond frameworks and set minimum standards.

Although the Estonian banking association has been working on producing a new covered bond framework for some years, the draft law published by the ministry of finance lacks features recommended by the EBRD to align it with European Banking Authority best practices and the Commission’s proposed Directive as well as those necessary for the establishment of the pan-Baltic framework. The EBRD is currently working with the ministry of finance on the relevant changes and is submitting them as part of the public consultation. Once the first public consultation is completed, an updated draft law is expected to be published for a second round of public consultation.

Moody’s said that the proposed Estonian legislation provides key safeguards to investors but some provisions are weaker and more ambiguous than the European Commission’s proposed minimum credit standards for covered bonds.

“On the positive side, the Estonian draft requires banks to stress test their covered bond programme to assess interest rate and currency risks and credit risks arising, for example, from falling house prices,” it said. “The draft law also requires the segregation of cover pool assets from the bank’s insolvency estate to leave the cover pool assets available for the benefit of covered bond investors, but leaves some ambiguity about the events that would trigger such separation of the cover pool.”

Moody’s notes that the proposed law also features a minimum overcollateralisation (OC) requirement of only 2%, below the 5% minimum proposed by the European Commission.

The Estonian ministry of finance plans to enact the law on 1 January 2019.

Directive’ joint funding model supportive

The European Commission’s Directive includes a joint funding model for separate legal entities, which would allow the use of loans collateralised by residential or commercial property mortgages granted by a credit institution as assets in the cover pool for the issue of covered bonds by another credit institution.

While the proposed model has only limited detail, the Commission states in the Directive that permitting joint funding between several credit institutions would support the growth of covered bonds in member states where markets are not well developed, citing difficulties currently faced by small issuers in establishing covered bond programmes and issuing in volumes sufficient for their bonds to be liquid.

Jacek Kubas, principal, local currency and capital markets department at the EBRD, told The CBR that the proposal of the joint funding model should make the success of the pan-Baltic project more likely.

“It is really good for what we are trying to achieve in the Baltics,” he said. “It is very relevant to us that the Directive sees this as an option.

“The joint funding facilitates the cross border approach, because member states will have to acknowledge that there is a higher level statement that joint funding should be happening.”

Kubas added that the joint funding model could also be used by banks in the same country, noting that a similar approach is already adopted by Hungarian banks, in order to meet a national requirement that a certain percentage of all their mortgage loans be financed by covered bonds.

However, he noted the impact will be uneven across the CEE region, noting that it will not add value in Poland, for example, where three covered bond issuers are already established and more are expected to join the market in the coming years.

Kubas said the implementation of the Directive will also be supportive for developing covered bond markets in the CEE region because it enshrines EBA best practices into law and provides an opportunity for countries such as Hungary, which uses a covered bond law implemented in 1997, to modernise their frameworks.

However, some bankers have noted that joint funding models have rarely been implemented to date, usually only by banks that already cooperate under the same brand, and said that use of the proposed model could be limited due to difficulties negotiating such an agreement and other legal hurdles, for example in national insolvency laws.

Kubas acknowledged that such challenges could mean the use of the joint funding model by individual banks in the CEE region is limited in the near term – except in Hungary, where a joint funding model is already used.

He said the Baltic banks most likely to pool mortgages and issue jointly under the planned framework are therefore banks that operate within the same group.

Alongside the joint funding model, the Directive proposes an intragroup funding model. This model allows the use, by way of an intragroup transaction, of covered bonds issued by a credit institution belonging to a group as collateral for the external issue of covered bonds by another credit institution belonging to the same group.

However, it is understood that Baltic banks in the same group are more likely to use the joint funding model than the intragroup funding model as it is deemed that it would be less costly and complex to pool mortgages – as proposed under the joint funding model – than for a small bank in each country to establish their own programme and prospectus especially to issue covered bonds that can be used as collateral – as proposed under the intragroup model.

The ministry of finance of Lithuania is expected to publish a draft covered bond framework soon, while the Latvian framework is understood to be less advanced.