As the covered bond market has grown in size and diversity, regulators have become increasingly vocal about their desire for more uniformity. In response, the industry launched the Covered Bond Label, but could the focus be shifting toward a regulatory approach to harmonisation? Susanna Rust reports.

Just as the European Coal & Steel Community was founded in the wake of the Second World War to prevent further conflict in Europe, so, too, are European policymakers decades later forging ahead with plans for another union in an attempt to avoid further calamity: this time, another financial crisis.

The goal is financial stability; the means, greater financial integration, in the form of banking union. Via common rules on capital requirements for banks, harmonised deposit protection schemes, a single recovery and resolution framework, and a single banking supervisor, the financial system is intended to be, if not crisis-proof, then at least more crisis-resistant.

Amidst this regulatory overhaul, covered bonds are also coming into European policymakers’ focus as a market where greater harmonisation could be beneficial.

Let us be clear: the idea of a common European covered bond framework has hardly even been floated in public, let alone any concrete proposals for legislation been put forward.

Covered bond veterans could also be forgiven for rolling their eyes when the subject is raised, given the number of times the topic has drifted in and out of the market’s consciousness over the past 15 years.

And yet by now there exists a collection of high level European Union regulatory statements and workstreams related to harmonising covered bond frameworks that lends the debate a more tangible edge.

Initiatives by the European Systemic Risk Board (ESRB) and the European Commission (EC) and work being undertaken by the European Banking Authority (EBA) are frequently cited by market participants as comprising the current context of discussions about harmonisation of covered bonds.

“During the last year, several requests and suggestions have been raised by different policymakers alluding to a harmonised covered bond legislation, or at least harmonised best practice,” says Pontus Åberg, senior economist at the European Central Bank.

He cites the ESRB, an EC Green Paper on long term financing, and also the Capital Requirements Regulation (CRR).

“Market initiatives like the Covered Bond Label initiative are also aiming to standardise the key features of covered bonds across legislations,” he adds. “This implies that the whole discussion has its roots in the said policy suggestions to harmonise issuance rules, thus addressing financial integration and meeting the demands for the single market.”

The ESRB and the Commission have each addressed harmonisation of covered bonds head-on.

In February 2013 the ESRB released recommendations on bank funding, suggesting that best practices in covered bonds — highlighted as an instrument generating asset encumbrance — be identified.

Speaking at a February hearing before the Economic & Monetary Affairs Committee of the European Parliament, Mario Draghi, chair of the ESRB as well as ECB president, said that the ESRB had identified the need “to extend best practices for covered bond regimes throughout the EU”.

“Covered bonds have been used increasingly to finance credit institutions, and they should be preserved as a high quality financial instrument,” he said. “While harmonisation is made difficult by underlying national legal regimes, the ESRB recommends that authorities foster convergence to the highest standards.”

The EBA was charged with co-ordinating the work to fulfil the task of a best practice inventory, with input from national supervisory authorities, with a view to it eventually deciding whether or not guidelines or recommendations, or even a legislative proposal, should be issued to endorse certain practices.

It was due to report to the ESRB by the end of December on the principles of best practice that it identified, and has an end-2015 deadline for delivering a final report that would include the EBA’s view on whether further action is desirable.

There are further instructions: “If the EBA identifies the need for a legislative proposal in this regard, it should report to the European Commission and inform the ESRB.”

The EC, meanwhile, broached the subject of harmonisation in covered bonds in a March 2013 Green Paper on the long term financing of the European economy.

It said that covered bond markets are “fragmented along national lines and further analysis is required to explore whether and to what extent greater harmonisation could spur the use of covered bonds”.

In a consultation launched by the paper, the EC asked: “What are the pros and cons of developing a more harmonised framework for covered bonds?” And: “What elements could compose this framework?”

Going the distance ‘unworkable’

There is no shortage of scepticism about the feasibility of further harmonisation in covered bonds among members of the industry, at least to the extent that this is equated with a move toward a single, common European covered bond framework.

The challenges are practical and political, and intertwined at that. Formidable challenges to a common framework, according to market participants, include the diversity of national mortgage markets and insolvency law across European countries.

“Even though a lot of issuers and investors would like to see more harmonisation, harmonising laws will take time,” says Boudewijn Dierick, head of flow ABS and covered bond structuring at BNP Paribas and chair of the ECBC rating agency approaches working group.

“You would have to convince national regulators that it is useful, but they will be protective of their own law, and then the legal systems are also different in different countries.”

In France and in Norway, for example, adopting an on-balance sheet issuance structure would require changing the country’s insolvency law in addition to the covered bond legislation, he notes, which would affect large volumes of outstanding covered bonds.

In a submission to the EC Green Paper consultation, the Association of German Pfandbrief Banks (vdp) said that full harmonisation of national covered bond legal frameworks would prove to be “unworkable”.

Also in a response to the EC consultation, the Federation of Dutch Pension Funds (Pensioenfederatie) said that “in order for the harmonised framework to be a success it is necessary to overcome many differences in national law between the various EU member states which we expect to be a challenging political hurdle”.

Speaking from the audience at a conference hosted by the vdp and the Association of Danish Mortgage Banks (Realkreditrådet) in Copenhagen at the end of October, an official at a Danish mortgage bank said that harmonisation would entail a loss of quality by stifling innovation and “kill the race to the top”.

In its submission to the EC consultation, the Association of Danish Mortgage Banks said that the pros and cons of developing a more harmonised framework for covered bonds “depend on the details”, and that the cons would outweigh the pros if significant changes are made to the foundation of the Danish mortgage model.

“From a Danish point of view, it is important to be able to keep the Danish mortgage system,” it said.

In its submission, the vdp meanwhile expressed concerns about a broadening of cover pool eligibility criteria and said that “full harmonisation of covered bonds on the basis of the lowest common denominator must be prevented in order to avoid the dilution of the products’ strengths”.

We’re on the case

But regulatory calls for greater uniformity have not fallen on deaf ears in the covered bond industry, and market participants are quick to defend its track record in this regard.

“Harmonisation has always been a key issue for us,” says Luca Bertalot, head of the European Covered Bond Council (ECBC). “You could say it was even one of the reasons for creating the ECBC.

“In the covered bond world we always had an exchange of best practices, a process of best practices spreading by way of osmosis. The fact that covered bond laws are being updated and amended is a sign of the willingness in the industry to improve and harmonise.”

Dierick echoes this sentiment.

“You have to see where we are coming from,” he says. “Five years ago there were some countries with covered bond laws, some had structured programmes, some didn’t have anything.

“There has been a lot of progress already and there is a trend toward harmonising where we can, for example in terms of the provision of six months liquidity in cover pools and minimum OC.”

The centrepiece of the industry’s efforts to harmonise is the ECBC Covered Bond Label initiative, whose value as a tool for protecting the asset class’s regulatory standing is seen as having been boosted by a recent decision to align the Label with the Capital Requirements Regulation/Directive (CRR/CRD).

Following a mid-October vote by the Covered Bond Label Committee, CRD-compliance rather than UCITS-compliance will be a criterion for qualifying for the Label. The change is effective January 2014, with a phase-in period of up to one year possible to allow for national implementation of the CRR.

The move to incorporate CRD-compliance means there will be a tighter perimeter around Labelled covered bonds than before. This could even exclude some covered bonds from the Label status — and yet therein lies the value of the development, according to market participants.

“It’s a very significant step,” says Dierick. “It shows the willingness of the market to go in this direction without even needing to do so given that the ECB or EBA have not publicly confirmed they will give any tangible benefit to the Label.”

The ECB is an observer on the Advisory Council to the Covered Bond Label, and Åberg said that it was in favour of the move to CRD-compliance.

“The compliance with CRD/CRR rather than the UCITS directive would make the label criteria slightly stricter,” he says. “It is a logical step, following the regulatory and central bank (Eurosystem) approaches.”

The ECB in November 2012 itself moved to CRD compliance in the eligibility requirements for own-use covered bonds in its collateral framework.

Bertalot at the ECBC says the decision to align the Label with the CRD is an important statement.

“It confirms the Label’s role as a convergence tool,” he says. “The added value is that it is dynamic, and will help bring about massive convergence of the European system around the key pillars of quality and transparency.”

Give harmonisation a chance

But in some quarters there appears to be growing openness to exploring the possibility of convergence going beyond that coaxed out by the Label.

The risk, according to Jens Valdemar Krenchel, head of Brussels office at the Association of Danish Mortgage Banks, is that the Covered Bond Label initiative is not taken seriously enough by regulators.

“What worries me is that the market is so fragmented and that there is no unified view on how to regulate covered bonds, which is why we come under pressure, time and time again,” he says. “For our members the dilemma is whether the Label is better or if a regulatory approach to harmonisation is better.”

Speaking at the vdp and Realkreditrådet conference in Copenhagen in October, Wolfgang Kälberer, head of the vdp’s Brussels office, and other panellists argued that the time had come for the covered bond industry to take a more positive stance on principles-based harmonisation, for the longer term benefit of the asset class.

He cited pressure stemming from the EC Green Paper to expand the type of assets backing covered bonds, and said that there is a risk of losing preferential treatment if the asset class is not ring-fenced somehow.

Elaborating on his comments, Kälberer later told The CBR that although full harmonisation is not desirable, and not even on the agenda at the moment, there is scope and a case to be made for some “high level, principles-based harmonisation”.

“The Label is good enough for now, but it won’t be in the future,” he says. “It doesn’t address public supervision or other areas like asset segregation or bankruptcy remoteness.

“There needs to be a discussion about harmonisation within the industry so that we have a unified view should the issue become more serious in a couple of years.”

The vdp has identified four areas where it would be willing to explore “the value added of a regulatory approach towards a more harmonised framework for covered bonds”: asset class eligibility, special public supervision, transparency, and bankruptcy remoteness.

“Any harmonisation has to be at a high level,” says Kälberer. “Member States must retain discretion to decide on and maintain the technical details.”

He and the ECB’s Åberg, also a panellist at the Copenhagen conference, acknowledged industry concerns and scepticism about full harmonisation, but said that there are many potential benefits and that the covered bond industry should give harmonisation a chance.

“These questions shouldn’t stop us from starting with the exercise,” said Åberg at the time.

He expanded on his views to The CBR, saying that the harmonisation issue can be approached from two angles.

“One is a top down approach, i.e. to consider starting an analytical exercise with the aim to develop directly one covered bond legislation in the EU; a big bang exercise,” he says.

The other approach would be bottom-up, which would start by looking into key features that are important for covered bonds and are set in the respective national legislations. The idea would be to try to harmonise them, but still within domestic-based legislation, according to Åberg.

“When this has been done, the potential move to one single EU legislation would be easier and potentially not even necessary since the key parameters would have already been harmonised and standardised,” he says.