Article 6 of the proposed covered bond directive is proving a “major sticking point”, according to Commission and Parliament speakers at an ECBC plenary on Wednesday, with no satisfactory solution forthcoming, although the prospect of ESNs playing a role appears to be disappearing.

Progress in some contentious parts of the directive and regulation was highlighted by Didier Millerot, head of unit, banks and financial conglomerates, DG FISMA, who was speaking on a panel focusing on the legislative package at the European Covered Bond Council (ECBC) event in Munich.

However, Millerot said the definition of what a covered bond is was proving to be “the mother of all discussions”.

“What kind of general principles do you put in place to allow that, beyond the already CRR-eligible assets, you would give some margin of flexibility to member states to adopt some different types of assets, while still remaining within the boundaries of what should be a high level of quality covered bond?” he said.

The draft of Article 6 initially proposed by the Commission, which deals with this, has been widely criticised for being too loose in simply allowing for “other high quality assets” beyond those described in CRR Article 129. Meanwhile, noting that the Commission is keen to maintain a principles-based approach to the whole legislation, Millerot has previously excluded the option of drawing up a positive list of eligible assets as a way of defining what these other high quality assets may be.

Christophe Kimmerle, policy advisor, Economic & Monetary Affairs, European Parliament, agreed that Article 6 is “one of the major sticking points”. He noted a draft Committee on Economic & Monetary Affairs (ECON) report on the covered bond package led by Rapporteur Bernd Lucke had attempted to come up with an alternative description of what constitutes high quality assets.

“He tried to do this by alluding to the classical factors of a covered bond, namely having a solid collateral, a physical asset for instance, a correlation with the public sector, and if this correlation is decreasing then there should be something else compensating for that which is a higher demand for risk mitigation,” said Kimmerle.

At an ECON meeting last Monday (10 September) where the draft report was discussed, a variety of solutions to the issue were proposed, according to Kimmerle, with some people suggesting that the “other high quality assets” sentence simply be deleted, and others happy with the Commission wording.

“We shouldn’t forget that in the end we also have the objective of not disrupting the market, at least not too much, and if we were to go for this solution then we would end up in a world with CRR-only-compliant covered bonds, which I would see as a clear challenge for some jurisdictions,” he said.

Nykredit’s Morten Bækmand Nielsen, who is chairman of ECBC technical issues working group, highlighted the important role played by UCITS-compliant but CRR 129-ineligible covered bonds in contributing to financial stability in Denmark.

Noting that the covered bond package had been discussed at Ecofin and Eurogroup meetings the week beforehand, Jörg Kukies, secretary of state, German Ministry of Finance, stressed the importance of the quality of covered bonds being assured.

“From a German perspective, it is important that the framework will be fitted with a limitation against unsecure assets, and therefore defines general and abstract requirements for eligible cover assets which also cover the previous inventory of assets listed in Article 129 of the CRR,” he said in a keynote speech ahead of the panel discussion. “This also applies for the covered bond label. The label should only apply at the highest quality requirements, i.e. pertaining to Article 129 of the CRR.

“And therefore it is quite clear that a union-wide legislative covered bond framework could only serve as the intended cornerstone of long term finance in EU member states if the framework sets strict and clear requirements regarding the eligible cover assets.”

Sascha Kullig, head of capital markets at the Association of German Pfandbrief Banks, said that Lucke’s proposals – which envisage CRR 129-eligible instruments being called Premium Covered Bonds and others Ordinary Covered Bonds – had its merits.

“We will in any case end up with a directive allowing covered bonds being backed by other assets [other than those allowed under Article 129], and we all don’t know yet what type of assets this could be in future – maybe auto loans,” he said. “Our understanding is that in some countries you could issue them, if it’s allowed by national law, which we are not in favour of, but if this will be the result, we think that then we have to make this transparent, we have to make transparent the different quality of those Premium Covered Bonds and those other covered bonds.

“And for that reason we are in favour of Lucke’s proposal to distinguish between Premium Covered Bonds on the one hand and other covered bonds on the other – not because we want to see those other covered bonds, but we have to expect those other covered bonds. And also in the interest of investors we think it’s important to clearly identify the different covered bonds.”

However, the ECBC noted today that it considers the proposed name “Ordinary” inappropriate and potentially confusing.

Some market participants have suggested that legislating for European Secured Notes (ESNs) would be a way of setting a floor for the quality of covered bond-eligible assets, if lower credit quality and unsecured liabilities were included in their definition.

“From our understanding of the ‘Ordinary’ concept, it is not exactly clear who is in and who is out,” Luca Bertalot, secretary general of the EMF-ECBC, told The CBR. “We would like to have a clear demarcation line between when you have a real guarantee with the collateral and when you don’t.

“Where you don’t is an ESN, and where you have a pledge is a covered bond – that’s the demarcation.”

However, a lack of time to add ESNs to the package has been highlighted, with the Commission having said it would only act on them after the directive, although it has done some preparatory work.

BNP Paribas’ Boudewijn Dierick, who is ECBC deputy chair and moderator of the ECBC ESN task-force, advocated including in the directive a provision in respect of ESNs that would allow for their subsequent development, with details to be worked out later, possibly with the EBA mandated to assist in this – something Slavka Eley, head of unit, banking markets, innovation and products at the EBA, said the authority would be ready to help on. Dierick noted that while ESNs might not be a priority today, previous financial policy initiatives have not been embarked upon until it was too late, given the amount of time it can take to develop such projects.

Millerot had nevertheless already said: “One thing which is extremely clear in the minds of the member states is that this process is about regulating covered bonds; it’s not about putting in place something that would be an ESN. ESNs is something that, let’s say, merits to be reflected upon, but we are not in a process on the basis of our proposal to already try to regulate what this should like. It will be something that will take place later.”

Bertalot said this would represent a missed opportunity for the Commission.

“Growth and innovation have been leading concepts in the CMU debate,” he said. “The reference to the ESN concept – which surely has to be defined in the coming years – could also act as a cathartic element around the Article 6 discussion.

“Furthermore, this could offer the chance for a potential link to the sustainability agenda of the European Commission, which is currently still lacking from the directive.”

And, speaking to all stakeholders involved in the process, Bertalot said it is the time for realpolitik to solve dilemmas such as Article 6.

“We are ready to accept whatever the political decision will be,” he added, “as long as the quality is assured and there is clarity on what is in and what is out.”

Photo source: ECBC