An ECON draft report proposes accommodating ESN-type instruments in the forthcoming covered bond directive, in line with a recent industry push, but market participants have queried its wording and a lack of a clear perimeter for the overall product. Harsher treatment of CPTs is also put forward.

Dated Friday (17 August) and led by Rapporteur Bernd Lucke, the Committee on Economic & Monetary Affairs (ECON) draft report builds on the European Parliament’s position as outlined in July 2017, when it recommended including European Secured Notes (ESNs) as a third tier alongside “premium covered bonds” (PCBs) – those which meet CRR Article 129 eligibility criteria for preferential treatment – and “ordinary covered bonds” (OCBs) – those which do not meet such criteria but otherwise comply with the directive.

The Commission is considering ESNs separately to and a step behind its planned covered bond directive and regulation, but some key market participants have recently been calling for ESNs to be included in the same legislation, both to accelerate work on the proposed instrument and to help deal with flaws in the Commission’s draft directive. Article 6 of the proposed directive has been criticised as being too weak in merely stating that cover assets need to be “high quality”, thereby potentially not providing a strict enough perimeter for the asset class – something deemed essential to protect the preferential treatment of covered bonds in the long term.

ECON criticises the Commission proposals for not sufficiently distinguishing between what it calls PCBs and OCBs, and suggests that PCBs are designated “European Covered Bonds (Premium)”.

The ECON draft report then says there should be no list of possible asset types for OCBs (or exclusionary list).

“Rather, all types of assets (even those which Parliament had in mind for ESNs) may, in principle, be eligible for OCB cover pools,” it says, noting that this is in line with UCITS and that a list may be hard to reconcile with a principles-based approach – something the Commission has stressed the need for consistency on.

However, ECON then proposes eligibility criteria for cover assets that it says are necessary to ensure that OCBs are liquid and almost risk-free. These effectively limit cover assets to public sector loans, lending collateralised by physical assets, and loans to entities that are rated investment grade by an ECAI.

According to Luca Bertalot, secretary general of the EMF-ECBC, the draft criteria would not accommodate the envisaged ESNs backed by SME or infrastructure loans, even if ECON may want to allow such issuance.

“Moreover, the use of the OCB bucket for a future broader scope – ensuring innovation and growth – would not secure the protection of the covered bond tradition and name from a potential contagion risk, which was the ultimate scope of the ESN proposal,” he told The CBR. “Furthermore, the lack of the ESN concept could represent a missed opportunity of linking the covered bond directive to the sustainability agenda.”

Bertalot and other industry representatives argue that including ESNs as a third tier in the directive based on eligibility criteria to be determined by the European Banking Authority (EBA) would both allow for the creation of the new instrument and set a quality floor for covered bonds. The EBA has already produced a report for the Commission with its recommendations for ESNs.

ECON meanwhile recommends that – contrary to the status quo – OCBs be granted some preferential risk weight treatment, equivalent to 70% of the risk weight they would face if unsecured – particularly given that simple, transparent and standardized (STS) securitisations have been granted preferential treatment.

The committee’s draft report also seeks to address issues that have been raised regarding the homogeneity of cover pools and liquidity buffers, and makes new proposals on joint funding structures.

A new threat to conditional pass-through (CPT) structures is included in ECON’s draft report: the committee proposes that, for covered bonds whose maturity can be extended by more than one year, risk weights increase according to the longer a maturity can be extended.

“Parliament emphasized that regulatory preference should be granted corresponding to the safety of assets,” it says. “In terms of risk there are pros and cons of extendable maturities, but clearly the longer the possible maturity extension, the more risk is shifted to the investor.”

ECON recommends including this in amendments to CRR Article 129, noting that soft bullet and CPT structures were not yet developed when it was devised.

The committee’s proposals come after the European Central Bank in February similarly announced moves to treat extendible maturity covered bonds more harshly.

Bertalot said the ECBC’s taskforce is collecting industry feedback by the end of August to be discussed in September. The deadline for proposed amendments to the draft report are due by 25 September, after which the report will be considered and in late November voted on by ECON. The final report would then be voted on in the Parliament plenary in the first quarter.

The ECON draft report can be found here.

Photo: Rapporteur Bernd Lucke