The capital treatment of ESNs has been highlighted as a key issue as EBA released its final report to the Commission yesterday (Tuesday), with the regulator recommending a holistic review of the framework for comparable instruments and investors seeing it key to relative value.

The final recommendations from the European Banking Authority (EBA) on the proposed European Secured Note (ESN) product do not include any substantial differences from preliminary recommendations published and presented at a public hearing last month, according to market participants.

As in its preliminary thinking, EBA recommends that SME-backed ESNs could be structured as a dual recourse instrument – albeit under a more restrictive framework than for traditional covered bonds – but advises against the creation of infrastructure ESNs.

The recommendations were requested in a call for advice from the European Commission, which defined ESNs as “dual recourse financial instruments on an issuer’s balance sheet applying the basic structural characteristics of covered bonds”. The Commission said it would consider creating the new asset class, which was put forward as a way of bridging a funding gap for SMEs and infrastructure projects.

“Based on the responses to the qualitative questionnaire circulated by the EBA to the banking associations and based on EBA’s own assessment, it appears that ESNs might be neither a priority nor crucially needed at the moment, given the current good funding conditions,” says EBA in the final report. “However, in a stressed economic environment, SME ESNs might provide a useful additional source of funding especially for small institutions with large SME exposures that do not have access to the securitisation market and/or can hardly issue unsecured long term debt.”

Assuming that 10%-30% of the funding of SME loans would be done through the product – a ratio the EBA said is comparable to mortgage financing – it calculated that the size of the SME-backed ESN market could in the near term range from EUR310bn to EUR930bn. If infrastructure-backed ESNs were also included, EBA calculates that the combined ESN market could be EUR390bn-EUR1,180bn.

“However, it should be noted that in the case where ESNs are not fully subject to the same framework and regulatory treatment as covered bonds, these figures could significantly overestimate the potential size of the market,” added EBA.

Agustín Martín, head of European credit research, public sector and covered bonds at BBVA, suggested banks in Spain and Italy are good candidates for ESN issuance as the Spanish and Italian banking systems currently make the most use of low-cost ECB funding, which they will need to refinance, he said, and also have a share of lending to SMEs that is above the median for European countries. Martín said SME-backed ESNs could be of interest to certain issuers once ECB QE ends and interest rates start to rise. In this scenario, spreads will widen particularly sharply for lower-rated and smaller banks, he said, making market access more difficult.

“We think that for ESNs to make sense from the funding cost perspective, the spread gap between traditional covered bonds and senior preferred needs to be over 60bp-80bp,” said Martín. “If corporate deposits are moved upwards in the insolvency hierarchy and the bail-inability treatment between the two types of senior unsecured debt is made equivalent in practical terms, this scenario would be supportive for ESNs to become a mainstream funding instrument for medium-sized banks.”

The depth of investor demand for the ESN product, and hence their viability, has been debated since the proposals were first put forward. For investors, the key drivers of interest in ESNs would be the instrument’s risk-return profile and regulatory treatment, said the EBA, citing treatment under the LCR and ECB collateral frameworks as being particularly significant in this regard.

In an investor survey, conducted by covered bond consultant Richard Kemmish in work for the Commission, some four out of five respondents said that if an ESN had the same issuer, credit rating, and regulatory treatment as a traditional covered bond they would still need to be paid a pick-up to see value in the ESN. A slight majority of those investors said they saw the differential being “a significant number of basis points (say, 20bp)”, while a slight minority said “a small number of basis points (up to 5bp)”.

The vast majority of respondents to the survey were investors already active in covered bonds.

The most important regulatory factor for investors appears to be preferential capital treatment for bank investors. Investors were asked what kind of spread pick-up they would require if ESNs lacked such preferential treatment, and were also asked the same question in respect of preferential treatment in Solvency 2, the ECB’s collateral framework and LCRs, and the lack of preferential capital treatment for bank investors elicited the highest number of responses requiring a pick-up, over 80%, and the highest number requiring a substantial pick-up, over 55%.

While saying that the performance of the underlying assets in SME ESNs could not justify preferential risk weight treatment for them, EBA said preferential treatment could be considered based on the enhancements it proposes for ESNs versus traditional covered bonds: it recommends a more restrictive framework, especially with respect to the coverage, liquidity and the disclosure requirements and strict eligibility criteria at both loan and pool level, with a minimum level of overcollateralisation of at least 30%.

EBA further suggests that “a holistic review of the existing CRR capital framework for comparable products should also be considered”, since covered bonds that would meet the requirements of the planned Directive but not be eligible for preferential treatment under CRR Article 129 could be unjustifiably be worse off given that they would be treated the same as unsecured debt.

Such a review could run counter to one of the reasons some market participants have welcomed the harmonisation initiative, namely that by ring-fencing the covered bond product it would bring an end to questions over the preferential treatment of the asset class – something EBA largely endorsed in 2014.

Michael Weigerding, research analyst at Commerzbank, said it also raises the risk of delays to the covered bond Directive.

“This could lead to the regulatory classification of covered bonds also being revised,” he said. “Such a step would probably be necessary in any case, in view of the possible preferential treatment of covered bonds from third countries in the coming years.

“However, discussing it at this stage, could markedly delay the covered bond initiative.”

The European Commission has insisted that it will deal with ESNs after introducing its proposed EU covered bond framework, which it is hoped will be finalised by the first quarter of next year. However, some market participants have called for ESNs to be added to the Directive, partly to mitigate other areas of concern in the Commission’s proposals.