«They say things are happening at the border, but nobody knows which border» (Mark Strand)
by Patrizio Messina
Abstract: The article analyses the framework of Covered Bonds legislation, focusing on the European regulatory fragmentation with regards to this tool. Indeed, together with its utility within the structured finance environment and its challenging enhancement of potential interested investors entourage, the paper aims at highlighting how a lack of uniformity can lead to investments barriers within the European Union market.
Summary: 1. Introduction. – 2. Regulation. – 3. European Harmonization. – 4. The Report. – 5. STEP I: EU Covered Bonds Directive. – 6. STEP II: Amendments to the CRR. – 7. STEP III: Voluntary convergence. – 8. Developments harmonization. – 9. The Impact Study. – 10. EBA Opinion. – 11. Results of the Impact Study.
Covered Bonds issuance is thus based on a general scheme involving:
(1) the transfer by a bank – which does not need to be the same bank as the issuer of the bonds – to a special-purpose vehicle of assets of high credit quality;
(2) the granting to the special-purpose vehicle, by the transferor or another bank, of a subordinated loan aimed at providing the vehicle with the resources required to purchase the assets; and
(3) the provision by the vehicle of a guarantee to the bondholders, within the limits of the separate assets.
The main characteristics of Covered Bonds may be said to be the high quality of the assets transferred and the dual guarantee provided, i.e., on the one hand, the segregation of the loans transferred to the SPV and their designation for the satisfaction of the bondholders, and, on the other, the guarantee provided by the issuer pursuant to the civil regulation, in addition to the separate undertaking by the special-purpose vehicle in the event of a default by the issuer.
The first European regulation on Covered Bonds, even if poor, can be found in the Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS), which within Art. 52, provides a generic definition of Covered Bonds in order to identify the financial instruments in which UCITS may invest, and in Regulation No. 575/2013 (“CRR”), which, in Art. 129, on the other hand, identifies further conditions for obtaining preferential prudential treatment with reference to the capital requirements of credit institutions investing in Covered Bonds. These additional requirements, which set out the conditions under which investors in covered bonds can obtain such preferential treatment, while increasing the level of European harmonisation in the field of covered bonds, are not applicable outside of banking regulation. Therefore, in view of the fragmentation of covered bonds regulation between the different Member States on the one hand and the importance of covered bonds as a source of funding for national and European banks on the other hand, the need has arisen in the European context to regulate covered bonds as harmonised and comprehensive as possible.
1) a voluntary approach, with the use of non-binding tools in order to foster voluntary convergence by Member States on the regulation of Covered Bonds, such as the Commission’s recommendations to States on the implementation of best practices defined by the EBA within the national regulatory framework;
2) a European legislative framework on Covered Bonds (through a Directive or a Regulation of Community law that functions as the “29th Regime”).
The contributions sent by stakeholders in response to the consultation suggested that:
– the increased divergence in securities yields between Member States after 2007-2008 was not necessarily a consequence of legislative fragmentation or a disabling feature of the market, but probably a normal adaptation to the post-crisis environment;
– Covered bonds prices are directly related to the sovereign issuer risk, the credit risk of the issuer and the specific characteristics of each covered bond issuance programme (mainly in terms of structure and coverage);
– the rating of issuers and countries after 2007 led to the downgrading of many covered bonds issuance transactions, causing a loss of homogeneity of “AAA” ratings, from which almost all European covered bonds benefited and, as a result, a widening of the divergence between countries;
– demand on the investor side was not driven by the difference between the various legal frameworks, but rather by risk appetite, the search for an adequate return, investment strategies, regulatory regime, market liquidity;
– the prediction of the “29th regime” could lead to greater regulatory fragmentation in the short term. At the same time, the hypothesis of a European legislative framework on covered bonds, albeit with caution, has been more successful.
That said, on 20 December 2016, the European Banking Authority (“EBA“) published the final version of a report entitled “EBA Report on Covered Bonds – Recommendations on Harmonisation of Covered Bond Frameworks in the EU” (the “Report“). The Report builds on previous work and provides additional recommendations on how to further harmonise the national legislative frameworks on the covered bond instrument.
In response to Recommendations of the European Systemic Risk Board (ESRB) and following the publication by the EBA of their Report on EU Covered Bond Framework and Capital Treatment, EBA began an extensive analysis of the regulatory and legal framework for covered bonds in individual Member States, with a specific focus on alignment with EBA’s best practices.
1) summarise the activity of regulatory investigation which was carried out following publication of the Report on EU Covered Bond Framework and Capital Treatment (in July 2014);
2) develop four key recommendations (the “Recommendations“) to implement a common regulatory framework for covered bonds; and
3) set out three key steps for the implementation process of the Recommendations and define the necessary activities for each of them.
The Recommendations issued by the EBA are as follows:
Recommendation No. 1: Three-step approach to the harmonisation of the European regulatory framework for covered bonds.
Recommendation No. 2: Development of a covered bonds directive (the “CB Directive“).
Recommendation No. 3: Amendment of EU Regulation 575/2013 (the “CRR“).
Recommendation No. 4: Voluntary convergence of national rules governing covered bonds.
The Report suggests implementation of the above four Recommendations in three key steps which are summarised below.
– requirements on the dual recourse of a covered bond, segregation of cover assets and bankruptcy remoteness;
– requirements on the coverage principle, liquidity risk mitigation and cover pool derivatives;
– requirements on a system of special public supervision and administration related to covered bonds, including requirements for a cover pool monitor, supervision of the issuer on an ongoing basis, supervision in the event of the issuer’s insolvency/resolution, and administration of the covered bond programme following the issuer’s insolvency/resolution;
– transparency requirements — i.e. scope, format and frequency of disclosure of information;
– conditions for soft bullets and conditional “pass through covered bonds”.
EBA, also, recommends developing a new covered bonds framework, which primarily deals with providing a single and organic definition of the instrument. In particular, the definition, obtained in light of the experience of market players as well as the work of the competent authorities, should:
– define both minimum requirements and characteristics that covered bonds must have in all Member States;
– facilitate the achievement of a good level of harmonisation;
– differentiate covered bonds from other financial instruments with similar characteristics;
– replace and supercede all previous definitions, including for example those contained in the UCITS Directive.
The CB Directive would become the new European regulatory framework, ensuring a uniform development of the same legislation in all Member States, granting each Member State sufficient flexibility to safeguard its specific needs.
With reference to the risk weight treatment of covered bonds, the EBA recommends that the CRR is amended to be aligned with the provisions of the newly introduced CB Directive. In particular, with reference to Art. 129 of the CRR:
– eligible assets: EBA believes that the current level of eligible assets for Cover Bonds should not be extended. Funding for small and medium-sized enterprises (SMEs) and infrastructure financing should not be included among eligible assets; furthermore, they recommend further analysis on ship loans guarantees which are currently included in Art. 129 of the CRR as eligible assets) would be needed. In addition, the EBA recommends not extending the exemption for the inclusion of RMBS and CMBS beyond December 2017;
– limit on substitution assets: EBA recommends to amend the CRR in order to provide for the rules on composition of both replacement assets and limits within which replacement may be expected (this limit should be set at 15% of the minimum required coverage);
– LTV limits: EBA considers that the current LTV (loan to value) limits set out in the CRR are appropriate, however, the CRR should specify that they are “soft coverage” LTV limits and should be applied on an ongoing basis throughout the life of the programme;
– overcollateralisation: EBA suggests setting the minimum effective overcollateralisation at 5%; the percentage limits on exposures as currently set out in Art. 129 of the CRR should continue to be applied, but they should not be relevant to the voluntary overcollateralisation; and
– improving the disclosure policy for the issuer, so that the dissemination of transparent information can become a standard requirement for all regulated covered bonds, rather than a specific condition for obtaining a preferential prudential weighting factor.
More recently, on 17 May 2017, the European Commission published the study “Covered Bonds in the European Union: harmonisation of legal frameworks and market behaviours” (“Impact Study”). The report includes an overview of the European Covered Bonds market and, in particular, a cost/benefit analysis of the proposals submitted at the end of 2016 by the European Banking Autorithy on harmonisation.
1) an harmonised definition of Covered Bonds specifying its standard structural aspects (by amending Article 52(4) of the UCITS Directive);
2) the conditions for the specific prudential treatment of Covered Bonds (by introducing targeted amendments to Article 129 of the Capital Requirements Regulation).
Following EBA Recommendations published in December 2016, which set out the specific elements of a possible European legislative framework, the Impact Study focuses on: functioning and performance of European covered bond markets to identify improvements that can be achieved through EU intervention without damaging them, and the implications of possible EU actions and their potential added value also in view of autonomous market developments (such as the Covered Bond Label).
EBA’s proposals provide for the introduction of a liquidity buffer in Europe to cover all interest and repayment maturities over the next 180 days. In the case of covered bonds with the possibility of maturity extension (“soft bullet” or “Conditional Pass Trough” (“CPT”)), imminent redemption maturities should not be taken into account in the calculation of the liquidity buffer, as a kind of favouritism in favour of these solutions could be outlined.
On the basis of the EBA proposals, Covered Bonds of the soft bullet or CPT type should continue to be recognised as Covered Bonds and benefit from preferential regulatory treatment, provided that certain conditions that may be specified by the authority are met. In terms of Covered Bonds CPTs, the Impact Study proposes an initiative by private market participants to ensure the standardisation of the CPT mechanism and a new review by EBA within 2 years.
Despite the presence of valid arguments for the superfluity of a European legislative intervention, first of all the resilience shown by the covered bonds market following the economic crisis of 2007 – 2008 and, then, the fear about the change of the “one size fits all” approach, the Impact Study suggests some reasons to support the EU legislative action, namely:
– the existence of significant risks and vulnerabilities in the market, which could suggest that previous positive performance is not necessarily a guarantee of future soundness. Appropriate EU action could reduce future risks to the extent that it would improve covered bond frameworks, in particular following an issuer’s insolvency.
– the current lack of harmonisation between Member States and the relative weakness of certain aspects of covered bonds, while not necessarily considered serious by investors under current market conditions, could undermine the basis for the prudential treatment of the asset class of covered bonds. In this context, it has been noted that the debate on the best prudential treatment for covered bonds and securitisations, given the developments in both markets, may represent a step forward in terms of regulatory convergence. EU legislative action could better align the prudential treatment of covered bonds between Member States and provide for a better justification for the current specific treatment of covered bonds.
The success of the covered bonds instrument as a funding instrument for existing activities could contribute to broadening the macroeconomic financing needs of the Union and to achieving the objectives of the Capital Markets Union. This potential benefit could prove to be the solution to the risk of disruption in the traditional covered bonds market, a key argument in the justification of actions to be taken at EU level.
All in all, the above reasons lead of the Impact Study to conclude that the intervention of the European authorities is justified and the results that could result from it would raise the level of quality of the covered bonds market.
Market participants are waiting for the possible announcement of a Covered Bonds Directive by the Commission as part of the Mid-Term review of the Capital Markets Union by June 2017 and the publication of a first draft of the Directive in the first quarter of 2018.
Patrizio Messina is Lecturer at LUISS Business School in Legal aspects of International Business & Finance.
 European Commission (2015) Consultation Document: Covered bonds in the European Union. Available at: http://ec.europa.eu/finance/consultations/2015/covered-bonds/docs/consultation-document_en.pdf.
 The 29th Regime an alternative approach to EU integration allowing less law-making. Was provided for by the European Insurance and Occupational Pensions Authority (EIOPA) in a document entitled “Towards an EU-Single Market for Personal Pensions” which sets out a logic of harmonization of the sector by introducing a common regulatory framework for all existing private personal pensions (PPPs). Under this, individuals could adopt third pillar pension schemes throughout the EU, but national systems would continue to exist.The report follows on from the European Commission’s February 2012 White Paper on policy, which sought to find a solution to tackle the ageing population without adequate pensions. See please https://www.ipe.com/towards-a-29th-regime/10001409.article.
 This consultation also dealt with the issue related to the development of a harmonised European framework for covered bonds, admitting that legislative divergences between countries may pose a major obstacle in terms of liquidity and investment opportunities and highlighting the importance of several recommendations on best practices suggested by EBA.
EBA report on Covered Bonds: recommendations on harmonization of Covered Bond frameworks in the EU, available at https://www.eba.europa.eu/documents/10180/1699643/EBA%20Report%20on%20Covered%20Bonds%20(EBA-Op-2016-23).pdf.
 In accordance with paragraph 1, first subparagraph, Member States may raise the limit of 5% up to a maximum of 25% if the obligations are issued by credit institutions having their registered office in a Member State and subject to a special public supervision for protection of bonds’ holders. In particular, sums deriving from issue of such bonds are invested, conforming to the law, in assets able to cover receivables linked to the bonds for the entire duration and that, in case of insolvency of the issuer, would be used on a priority basis for both repayment of capital and payment of accrued interest. Where a UCITS invests more than 5% of its assets in bonds referred to in the first paragraph, issued by a single issuer, the value of such investments will not exceed 80% of the value of UCITS’ assets. Member States shall communicate to the Commission the list of bonds categories referred to in the first subparagraph, as well as the categories of issuers authorised under the law and supervisory arrangements to issue obligations complying with criteria set out in the Report. These lists shall be accompanied by a description of the offered guarantees. The Commission shall immediately submit this information to the other Member States, along with appropriate comments, and make it accessible to the public. Such information may be exchanged with the European Securities Committee referred to in Art. 112.
 The text of the Impact Study is available at http://publications.europa.eu/resource/cellar/8df6d9cd-8c65-11e7-b5c6-01aa75ed71a1.0001.01/DOC_1.
 The Covered Bonds Label was created by the European Mortgage Federation (“EMF”) and the European Covered Bond Council (ECBC) in 2012. Developed by the European issuing community, in close cooperation with investors and regulators and in consultation with all key stakeholders, the Label is a quality label that responds to a shared demand from market participants for high quality standards and increased transparency. For more information please see: https://coveredbondlabel.com/.
 The securitization transaction involves the sale without recourse of a portfolio of loans without recourse by a bank (“Originator”) to a special purpose vehicle (“SPV”), in which the latter buys the portfolio of impaired loans from the former at an agreed price and at the same time issues bonds in which the loans are incorporated, so-called “Asset-Backed-Securities” (“ABS”) to finance itself. The ABS are then placed with investors (so-called “Noteholders”) while the debt collection activity is entrusted to a Servicer, which is independent from the Originator.
Since its introduction, this structured finance technique represents an important leverage available to banks to meet their liquidity needs and, therefore, allow them to concentrate on their core business of financing businesses. In addition, financial practice has developed several securitisation models. On this subject, see Troiano, “Securitisation transactions”, p. 29; see also Granieri and Renda, “La securitization tra diritto e economia, tra normativa nazionale e modelli stranieri”, in aa.vv.. The securitization of loans in Italy, p. 8. For further information and literature on this form of securitization, please refer to the references identified by Troiano, “Le operazioni di cartolarizzazione”, p.35 ff.