EBA is advising against allowing infrastructure European Secured Notes in recommendations to the Commission, and is calling for a more restrictive SME ESN framework than for traditional covered bonds, such as 30% minimum OC, with different risk weight treatment to be considered.

The European Banking Authority (EBA) has released a presentation containing advice on European Secured Notes (ESNs) that it was in June 2017 mandated to produce, ahead of a deferred deadline of the end of this month.

In the European Commission’s call for advice on ESNs – defined as “dual recourse financial instruments on an issuer’s balance sheet applying the basic structural characteristics of covered bonds” – EBA was asked to consider, for SME bank loans and infrastructure bank loans, the appropriateness of 2016 EBA best practice guidelines, the appropriate risk treatment of any such ESNs, their impact on asset encumbrance, and any other relevant technical aspects.

In its advice, EBA comes out against the idea of infrastructure ESNs.

“A dual recourse structure would not be appropriate in the case of infrastructure exposures,” it says.

EBA cites the complex structure and lack of granularity characterising infrastructure loans, and their heterogeneity relative to real estate exposures, saying this would make it difficult to create an infrastructure ESN with a similar risk and underlying credit risk profile.

It adds that the dual recourse feature of infrastructure ESNs might be less suitable for institutions given the relatively high regulatory capital consumption of infrastructure exposures.

If the Commission does pursue the idea, it would be advised to restrict cover assets to project finance loans in the operational phase, rather than the construction phase, says EBA, given a clear difference in credit risk between the two and operational phase loans having a substantially lower credit risk.

It also says the Commission might instead consider exploring the possibility of creating an off-balance sheet infrastructure bond.

EBA says SME ESNs could be structured as dual recourse instruments.

“However, in contrast to covered bonds backed by real estate, the cover assets of SME ESNs would probably not be secured by a real estate underlying security,” it notes.

All the 2016 best practices would be appropriate to SME ESNs, according to EBA, but with adjustments to make them more restrictive in respect of the composition of cover pools, overcollateralisation (OC), liquidity buffers, and disclosure.

“Because of the high credit risk and refinancing risk that characterise SME exposures, the EBA recommends incorporating strict cover assets eligibility criteria at both loan and pool levels,” it says.

A 30% minimum OC requirement is proposed.

EBA says that based exclusively on the performance of underlying assets, no preferential risk weight treatment could be justified for SME ESNs, but that if its recommended enhancements are taken into account, a differentiated risk weight treatment compared with unsecured exposures to institutions could be considered.

Preferential treatment under UCITS, EMIR and BRRD – i.e. exemption from bail-in – could be considered for SME ESNs, it says, but not under LCRs until a liquidity assessment can be performed.

EBA more generally says that under current good funding conditions a new funding instrument is not needed. It argues priority should instead be given to making the new simple, transparent and standardised (STS) securitisation framework attractive in relation to SME loans, improving data on SME loans, and addressing the shortage of risk capital and equity finance to SMEs.

Finally – in line with many market participants – it highlights the risk of confusion if ESNs are not clearly separated from traditional covered bonds. It brings this out in its recommendations for regulatory treatment of SME ESNs, advising: “A clear distinction between the prudential framework for SME ESNs and covered bonds is maintained to avoid market confusion and potential negative reputational side effects on the covered bond market.”

EBA plays down the potential impact of ESNs on asset encumbrance, describing it as “moderate” and estimating it at 1.2 to 4.1 percentage points on the EU asset encumbrance ratio as at December 2016.

“The introduction of a new and well-functioning secured funding instrument for SME and infrastructure exposures could improve overall, rather than to worsen, the risk profile of issuers particularly if the ESN market is of high liquidity and of sufficient resilience in times of financial stress,” it says.

It notes that asset encumbrance has to be considered in the broad context of a bank’s overall funding, liquidity and business mode profile, and not only at a product level, and that should ENSs become highly successful, potential asset encumbrance limits could be considered at an aggregate and not instrument level.

The call for advice from EBA is part of the Commission’s work on exploring ESNs, which it is conducting in parallel with its higher priority harmonisation initiative.

You can find the EBA presentation here.