The European Commission’s proposed covered bond package should be updated to address “problematic” or “irrational” provisions or ambiguities on issues such as pool homogeneity that could undermine its aims, according to industry concerns articulated in new detail.

The Commission’s legislative proposal to harmonise EU covered bond laws was published for public consultation in March. The consultation period closed on Wednesday, and the Commission has published the feedback it received from 15 respondents comprising industry bodies, institutions and rating agencies from across Europe.

This includes a position paper from the European Covered Bond Council (ECBC) – which it published on Thursday – that collates feedback gathered from 14 covered bond jurisdictions representing 95.7% of the covered bond market outstanding in the EEA and over 86% of the global covered bond market. Some organisations, such as the Association of German Pfandbrief Banks (vdp) and Finance Denmark, submitted feedback both directly to the Commission and via the ECBC.

The ECBC received 55 concerns, and notes that most of the comments it received were in relation to five articles: Article 10, on the composition of the cover pool; Article 6, on eligible assets; Article 11, on derivative contracts in the cover pool; Article 16, on the requirement for a cover pool liquidity buffer; and Article 15, on requirements for coverage.

Respondents were asked to rank concerns in order of seriousness, and Articles 10, 6, and 16 were most prominent in this respect.

Summarising feedback on Article 10, the ECBC highlighted concerns over a lack of clarity regarding a requirement that member states ensure a “sufficient level of homogeneity” of cover pool assets, so they shall have “a similar nature in terms of structural features, lifetime of assets or risk profile”.

A number of respondents say it is unclear whether it will be possible to pool residential real estate loans with assets such as public sector loans, derivatives and commercial real estate loans, while there is also concern whether assets with different maturities would be considered as sufficiently homogeneous. Furthermore, some respondents are concerned that as there is no such homogeneity requirement in Art. 129 of the CRR, there could be discrepancy particularly with regard to current cover pools.

Such concerns are elaborated upon in feedback from Finance Norway, which states it has interpreted the wording “lifetime of assets” as an approximate measure on the average duration of the underlying assets in the cover pool, but highlights that other interpretations are possible and called for a clarification.

“It would be highly problematic if the term is meant to reflect the time until maturity, for example, of the individual mortgages included in the cover pool,” it said. “These loans are by nature granted with different maturities.

“As the individual mortgages in a cover pool typically have different time until maturity, a requirement on common maturity standards would imply a large decline in eligible mortgages and have a detrimental impact on covered bond markets.”

French covered bond issuers CFF and Caffil said the requirement seems to be “a strong amendment of the mixed covered pool as they exist in several European countries”, and propose the wording of the requirement is updated to be less specific about the level of homogeneity required.

“This amendment is in contradiction with the EBA and European Commission’s objective which is reminded on page 4 of the Directive: ‘A fundamental aim of the approach in this package is to avoid disrupting well-functioning and mature national markets’,” they added.

Many other respondents called for Article 10 to be entirely removed from the Directive. The vdp, in a position paper submitted directly to the Commission, says there is no evidence that a lack of cover pool homogeneity is causing concern in the market.

“What is not dysfunctional should not be regulated,” it said.

On Article 6, respondents suggest that the wording of the provision – which requires that covered bonds be collateralised by high quality assets referred to in CRR Article 129 or by “other high quality assets” – leaves potential for a watering down of covered bonds’ quality.

“We conceive the missing specification of the ‘high quality’ requirement as a qualitative uncertainty of the proposal,” said the vdp. “We therefore advise to replace or complement the ‘high quality’ criteria by a precise list of tangible assets suitable to cover a longer life-cycle matching the long term maturities of the outstanding covered bonds.”

The Association of Swedish Covered Bond issuers (ASCB) said that under the proposed provisions, alternative assets such as aircraft loans and software licenses could be included as collateral.

“This possibility, within the draft Directive, to include other assets in the pool may risk diluting the cover bond brand which is undesirable and not in line with the intention of the directive,” it said. “To avoid this risk, it is important that the wording of the directive only allows for the traditional high-quality assets used for covered bond issuance.”

The industry’s concerns regarding Articles 6 and 10 have been acknowledged by a European Commission official. Didier Millerot, head of unit, banks and financial conglomerates, DG FISMA, said at an ECBC plenary on 18 April that the Commission could implement changes to the proposed Directive, for example, introducing a detailed list of eligible cover pool assets.

Article 16 proposes the requirement of a 180 day liquidity buffer covering interest and principal payments, setting rules on what type of assets can be used. The introduction of a mandatory liquidity buffer has been cited as one of the main positives of the Directive by rating agencies.

However, respondents say the article – the third highest prioritised concern in the ECBC’s feedback – is not in line with Article 129 of the CRR regarding the credit quality steps of exposures, and say it adds an additional liquidity buffer to the one already in place for the LCR.

“It is not rational to impose requirements that force issuers to have an additional liquidity buffer outside the cover pool, only to fulfil the LCR requirement,” said Finance Norway. “The purpose with the liquidity in the pool is to cover outgoing cashflows, and this liquidity is not in any way encumbered for being used to redeem maturing covered bonds.

“The two liquidity buffers will serve the same purpose of ensuring liquidity for the covered bond investors. Hence, the covered bonds Directive/LCR delegated act should be amended so that the assets in a segregated liquidity buffer in the cover pool are deemed unencumbered when calculating the fulfilment of liquidity requirements.”

Article 11 of the proposed Directive states that member states should define rules on the use of derivative contracts in cover pools in order to ensure investor protection, including at least the introduction of the limits on the amount of derivative contracts in the cover pool. Some respondents are concerned that the insertion of such a limit may harm hedging strategies.

“It is positive with the possibility to use derivatives to mitigate risk between loans and issued covered bonds,” said Finance Denmark. “But the use of derivatives should not be limited as this would mean that it will not always be possible to mitigate all risk on the covered bonds.

“This will affect the prices on the issued covered bonds and hence the interest rates of borrowers.”

Finance Denmark also elaborated concerns regarding Article 15, shared by respondents from other jurisdictions, which it said is “difficult to understand”.

The article proposes a set of minimum requirements for the coverage of all covered bond liabilities by cover pool assets. These include – under rule 1(a) – that all liabilities, including the obligations for the payment of principal and any accrued interest of outstanding covered bonds and maintenance and administration costs, are covered by the assets in the cover pool, and – under rule 1(b) – that the calculation of the level of coverage required ensures that the total nominal amount of all cover assets are at least of the same value as the total nominal amount of outstanding covered bonds, referring to this as the “nominal principle”.

The Danish industry body says the current wording of the coverage requirement leaves it unclear what the nominal principle means.

“For instance, on derivative contracts, where market values can be positive, zero or negative, and differ substantially from the nominal principal,” it said. “A positive market value of derivative contracts should be included in the coverage.

“In general, the coverage requirements in both 1(a) and 1(b) need to be more precise. At the same time, it should still be principle-based, leaving room for the necessary national flexibility and still keeping the high quality of covered bonds.”

Overall, many respondents said the Commission had succeeded in producing a balanced proposal containing few surprises.

“It addresses all important aspects which are necessary to create a sound legal European covered bond framework, while leaving enough room to specificities and traditions of national covered bond regimes,” said the vdp. “Covered bond public supervision is strengthened, allocating supervision and licensing to the competent national authorities.

“This represents an added value of the proposal.”

The ECBC said it appreciated the constructive dialogue held between the covered bond industry and EU institutions and reiterated that the industry stands ready to offer further support.

“The safeguarding of the macroprudential and qualitative characteristics of this asset class, which is deeply rooted in the financial tradition of the Old Continent, is essential to guarantee the crisis management nature of the tool,” said Luca Bertalot, secretary general of the EMF-ECBC. “Moreover, we believe that the adoption of a robust legislative framework for covered bonds will represent a clear qualitative benchmark for investors, issuers, legislators at European and global level.”