The European Commission and Council are rethinking Articles 6 and 10 of the proposed Directive, a Commission official told the ICMA CBIC and The CBR conference yesterday (Wednesday), but key industry players want to add ESNs to the Directive to address such issues and to gain political support.

Speaking on a panel discussing the covered bond package and European Secured Note (ESN) developments, Valeria Miceli, policy officer, European Commission, told delegates at the conference in Frankfurt that the Council has already held several meetings on the covered bond package, comprising a Directive and Regulation, with member states adopting a “positive and constructive” approach and negotiations progressing “smoothly”.

She highlighted that two key areas of concern for the industry are being addressed: Article 6, which has been criticised for being too weak in allowing covered bonds to be backed by assets that are “high quality”, without defining this further; and Article 10, which is deemed too restrictive in a similarly loosely defined requirement that cover pool assets have a “sufficient level of homogeneity”.

Miceli said Article 6 will not stay as it is but is being redrafted in Council to be “a little bit more precise”. She said there is no appetite by Member States for a more detailed list of assets and that the only other way is to “better define and specify those principles”.

Article 10 is being totally redrafted, added Miceli. She said it will still provide a principle prohibiting the mixing of assets of a “really different nature”, but that it will not hamper the ability to mix assets that are already being mixed in well-functioning markets.

Mira Lamriben, policy expert, European Banking Authority, said that EBA very much welcomes the overall covered bond package, and most of the ideas it included in a 2016 report being included, but has some concerns about several aspects.

“Generally speaking, we would have appreciated the Directive being a little less flexible,” she said.

She noted that there are no Level 2 mandates, for example, which could have been appropriate for providing more clarity on Articles 6 and 10. And while welcoming the introduction of a minimum overcollateralisation requirement, she said the possibility of this being 2% OC and the complexity of related calculations adds confusion.

Andreas Denger, senior portfolio manager, covered bond analyst, at MEAG and chairman of the ICMA Covered Bond Investor Council (CBIC), agreed that more clarification on “high quality assets” is needed.

“What investors do not want is that there is any chance to water down the product, that we get some assets we do not want through the backdoor,” he said. “So this should be made clear, what can be high quality assets, or even more importantly what cannot be high quality assets.”

Miceli for the Commission acknowledged that the proposals are more flexible than EBA had recommended and that more detail in some areas would have been welcome, but said that if a principles-based approach is adopted – in line with the feedback the Commission received – then the proposals need to be principles-based in all areas, and also that Level 2 mandates would contradict this approach and hamper member states from accommodating their national products.

She nevertheless agreed that EBA guidelines in respect of Article 6 could be useful and would not go against the principles-based approach, and would also not affect the schedule for finalising the package.

However, Sascha Kullig, head of capital markets at the Association of German Pfandbrief Banks (vdp), said that even EBA guidance would be inappropriate as it could end up being relied upon in future in matters that have rightly been left up to national authorities because of differences between jurisdictions.

He said that an alternative way of dealing with the Article 6 problem would be to include ESNs in the covered bond Directive, rather than potentially dealing with them with distinct action afterwards, as is the Commission’s current plan.

“That sounds very strange at the beginning, but in our view the most important thing is to distinguish clearly between covered bonds and ESNs, and this can be achieved no matter whether you have two Directives or legal frameworks, or just one,” noted Kullig, who pointed out that having one framework rather than two could also be easier, for example should any amendments to both need to be made in future.

“So what’s the benefit of having ESNs in the Directive?” he added. “If you have ESNs in the Directive, you could say everything that’s eligible for ESNs can’t be eligible for covered bonds, so in our view this could be a very good approach.”

He told The CBR that if SME loans were defined in the Directive as an asset class being included in the ESN tier of the Directive rather than the covered bond part, it would then be clear that credit cards, for example, would not be sufficiently high quality to back covered bonds.

Luca Bertalot, secretary general of the European Mortgage Federation-European Covered Bond Council (EMF-ECBC), also noted that inclusion of ESNs in the current covered bond package could help politically in the European Parliament, which has pushed the ESN idea and might otherwise be disappointed to see it not taken up in the current Parliamentary and Commission terms, which end next year. All the panellists agreed that the timeline of finalising the covered bond package by the first quarter of next year is challenging.

“Not having an SME element in the European Parliament is not ideal for negotiation,” said Bertalot. “And we cannot afford a bottleneck, we cannot afford a problem, because if we lose two weeks, our train of February will leave the station without us on board. To be very practical, we need to respond to the requests – which are very legitimate – of the people of Europe to have space for something important for Capital Markets Union (CMU). So not having this in the package is a problem.”

He said that including ESNs in the current package would achieve this as well as addressing the Article 6 problems.

Bertalot noted that the first draft report of the Parliament’s ECON committee, led by recently-appointed rapporteur Bernd Lucke, is to be prepared by 17 August, and that the deadline for amendments in Parliament will be 25 September. He and Kullig also noted that the full details of ESNs could be set at a later date since – unlike traditional covered bonds – no principles have yet been set for the new instrument and hence this would not contradict the principles-based approach being taken elsewhere.

Miceli said that the idea of including ESNs in the main covered bond package had been discarded at the beginning of the process for two reasons: because it would not have the necessary elements in place in time to make a decision on whether this would be appropriate; and because of strong feedback from most stakeholders to keep the two separate in order to avoid any mixing and thereby protect the covered bond’s reputation from any negative spill-over effects that could come from a more risky type of product. She said that this latter consensus persists among member states.

And she said that in light of the targeted timeline for the covered bond Directive, although assessment of ESNs – including possibly a public consultation on ESNs in the autumn – will continue, a decision on any further action will then be left to the next Commission.

Away from the panel, Sweden was cited as a key obstacle to agreement on adding ESNs to the Directive. Representatives of the country and its banking industry have been against almost any of the actions proposed under the covered bond harmonisation initiative.

Denger meanwhile played down the extent to which ESNs might find an investor base.

Photo: Valeria Miceli, European Commission (left), and Mira Lamriben, European Banking Authority, speaking at the event yesterday.