Following the conclusion of the trilogue negotiations between the EC, the European Council, and the European Parliament, the directive and regulation on the harmonization of covered bonds were approved on April 18, 2019, by the European Parliament.
The adoption of this legislative package caps several years of consultation with industry participants and efforts by EU institutions and regulators (see chart 1).
The legislative package provides a common definition of covered bonds, defines the product's structural features, and clarifies the responsibilities for supervision of the product. It also amends the CRR with the aim of tightening the conditions for granting preferential capital treatment.
Reasonable Transition Rules Should Ensure Smooth Implementation
The new rules will be effective toward the end of 2021
National authorities will have 18 months after the legislation is published in the Official Journal of the EU to transpose the directive into their national legislation and an additional 12 months to implement the new rules. Such an extended transition period will facilitate the implementation of the package, especially for countries such as Spain and Austria that may have to make more extensive changes to current legislation. Existing covered bonds complying with the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive and CRR will be grandfathered, and under certain conditions tapping them will be permitted for another two years.
Third-country equivalence assessments and European Secured Notes postponed
The European authorities decided to leave the equivalent treatment of covered bonds issued by non-European Economic Area credit institutions outside the scope of the directive and regulation. Instead, the EC will examine the issue and produce a report to the Council and Parliament within two years after the provisions of the directive have been applied.
Similarly, the Commission will assess the case for introducing European Secured Notes, a dual recourse instrument backed by riskier types of assets such as small and medium-sized enterprise (SME) loans, within two years after the transposition of the directive into national laws.
Final Text Is Mostly In Line With 2018 Draft Legislation
The final text is aligned with the EC's 2018 draft proposal (see "S&P Global Ratings Comments On The Proposed Directive For European Covered Bonds," published March 19, 2018).
|Key Changes Compared To The EC's 2018 Proposal|
|EC 2018 Proposal||Final legislative framework|
|Directive-compliant bonds called "European Covered Bond"||Directive-compliant bonds called "European Covered Bond"|
|CRR-compliant bonds called "European Covered Bond (Premium)"|
|Directive: Full coverage of covered bond liabilities||Directive: Full coverage of covered bond liabilities and minimum 10% OC if public undertakings as primary assets|
|CRR: Minimum 5% OC that can be reduced to 2% under certain conditions by national authorities||CRR: Minimum 5% OC that can be reduced to 2% under certain conditions by national authorities|
|CRR or high quality assets||CRR or high quality assets and exposure to public undertakings|
|Derivatives for hedging purposes||Derivatives for hedging purposes|
|MBS no longer CRR eligible||MBS no longer CRR eligible|
|Homogeneity of the pool|
|Only homogeneous assets||Mixed pools are allowed; member states to legislate further|
|180-day mandatory liquidity buffer||180-day mandatory liquidity buffer but in case of other liquidity requirements at issuer level member states can decide to suspend the obligation to maintain liquidity buffer at cover pool level|
|Legal and contractual extension permitted||Only legally established extensions permitted; no changes in ranking/sequencing of payments following an extension|
|EC--European Commission. OC--Overcollateralization. CRR--Capital Requirements Regulation. MBS--Mortgage-backed securities.|
Two labels for covered bonds
Covered bond programs that satisfy the provisions of the directive will be eligible for a "European Covered Bond" label. Those abiding by the rules set by both the directive and the regulation amending the CRR will be able to use the "European Covered Bond (Premium)" label.
Standard cover pool requirements ensure a level playing field
The CRR minimum overcollateralization is 5%, down to 2% in some situations.
At the directive level, the cover pool has to fully cover all liabilities including operational costs and interest. The final package introduces a 10% overcollateralization requirement if public undertakings are the primary cover assets.
However, in line with the 2018 draft regulation, the revised article 129 of the CRR specifies a 5% minimum overcollateralization level, with member states allowed to opt for a lower minimum level, floored at 2%, if the valuation of the assets is based on conservative mortgage lending values or on a model incorporating their assigned risk weights.
Residential and commercial mortgage-backed securities will no longer be eligible.
The regulation amends article 129(1) of the CRR to exclude residential and commercial mortgage-backed securities from cover pools, on the basis that they add unnecessary complexity to covered bond programs. Currently, a number of national frameworks allow such securities in cover pools, provided they do not exceed 10% of the nominal amount of the outstanding issue.
The use of loan-to-value thresholds in the CRR has been clarified.
The regulation clarifies that the current loan-to-value (LTV) ratio thresholds of 80% for residential loans and 60% for commercial loans mentioned in article 129(1) of the CRR do not determine the eligibility of assets. They correspond to the collateral level that may be included in the calculation of overcollateralization. These LTV ratio limits are applicable throughout the entire maturity of the loan.
Non-EU assets must offer an equivalent level of security.
Each member state may allow assets in the cover pool that are secured by collateral located outside the EU, provided these assets offer a similar level of security to collateral located within the EU, and are legally enforceable in an equivalent way to collateral within the EU.
Exposures to credit institutions including derivative contracts are limited.
Derivatives are only allowed for hedging purposes, and documentation must rule out termination in the event of insolvency or resolution of the issuer. Eligibility criteria for the hedging counterparties are left to individual member states.
The total exposure to credit institutions, including to swap counterparties, must not exceed 15% of outstanding covered bonds. However, if these exposures are held for overcollateralization purposes (such as in the case of Danish match-funded programs), they are excluded from the 15% cap.
Minimum disclosure requirements
The directive sets out that information should be provided to investors on a quarterly basis, with reports specifying the value of the cover pool and outstanding covered bonds (including an International Securities Identification Number list and an overview of the maturity extension triggers if applicable). The reports must also incorporate various stratification tables (geographical distribution, type of asset cover, loan size); details on market, interest rate, currency, credit, and liquidity risks; and levels of required and available coverage.
New eligible asset types are allowed
The directive states that, beyond assets listed in the current applicable regulation (residential and commercial loans, public sector loans, and ship loans), other assets types may be considered eligible, namely "high quality" cover assets (already contemplated in the draft directive) and loans to public undertakings, which are a new asset class for cover pools.
High quality cover assets are either secured by collateral with a 70% LTV ratio cap for physical assets; or by assets in the form of exposures, where the safety and soundness of the exposure counterparty is implied by tax-raising powers or by being subject to ongoing public supervision of the counterparty's operational soundness and financial solvability.
Loans to public undertakings are to entities that provide essential public services on the basis of a license, a concession contract, or other form of entrustment granted by a public authority. Borrowers must be subject to public supervision and have sufficient revenue-generating powers. Such loans are subject to mandatory 10% overcollateralization.
Despite the inclusion of "new" asset types in the definition of covered bonds, we do not believe this should result in the introduction of lower-quality assets in cover pools given the requirements introduced in the directive. Ultimately, it will be up to each member state as they transpose the directive into their national legislation to determine which assets will be allowed in cover pools in that jurisdiction.
More flexibility on homogeneity of cover pools
Compared to the 2018 draft directive, the final version relaxes the requirement for the homogeneity of cover assets, delegating to the national authorities to set out the rules on the pool composition, including the conditions for including assets with heterogeneous characteristics.
We do not expect any impact on existing programs, whether backed by a mix of residential and commercial loans, or by a combination of mostly residential and public sector loans, such as for the Compagnie de Financement Foncier SCF covered bond program.
Harmonization of liquidity requirements has been somewhat watered down
The directive specifies that the cover pool liquidity buffer must cover the net liquidity outflow for 180 calendar days, including both interest and principal. These requirements need not apply to match-funded programs, such as those issued in Denmark.
There was a debate during the trilogue process on whether liquidity requirements specific to a covered bond program might unduly penalize banks that already have to comply with broader requirements regarding their liquidity coverage ratio (LCR), which ensures that banks have sufficient liquidity to cover 30 days of net outflows in a stress scenario. The position of the European Parliament was that the covered bond liquidity requirements should apply in addition to the LCR requirements. However, the final text takes the opposite view--that is, that member states may decide that liquidity maintained under the LCR requirements at bank level can be taken into account in the calculation of liquidity buffer available at the covered bond program level.
We understand the effects of this provision to be temporary and expect the element of national discretion to be addressed at a later stage when adjustments to the LCR are made. Until then, however, this represents a watering down of the original intention of imposing a common framework for liquidity requirements. Given the flexibility in the wording of the directive, it remains to be seen whether national lawmakers will indeed choose to neutralize the double-counting of liquidity requirements, especially in countries where the 180-day liquidity provision for the cover pool already exists (including Belgium, France, and Germany).
Investor protection required, but a cover pool monitor and an administrator are optional
Member states are responsible for the protection of covered bond holders and may delegate this responsibility to the national regulator. The directive states that new covered programs must be authorized by the competent authority and sets out minimum operational and administrative requirements at the issuer level for this approval to be granted.
Competent authorities must cooperate with the resolution authority in the event of the resolution of an issuer, so that the rights and interests of the covered bond investors are preserved.
The directive does not make it compulsory for each jurisdiction to require the appointment of a covered bond monitor (for ongoing monitoring of the cover pool), nor a special administrator (where the issuer is insolvent). It also states that, where the cover pool monitor is not independent from the issuer, additional conditions must be met.
Conditions for extendable maturity structures
The directive is concerned with ensuring protection for covered bond holders of extendable maturity structures. To this end, it states that the maturity can only be extended subject to objective triggers established in national law, and not at the discretion of the credit institution issuing covered bonds. It clarifies that in the event of insolvency or resolution of the credit institution issuing covered bonds, maturity extensions do not affect the ranking of covered bond investors or invert the sequencing of the covered bonds program's original maturity schedule. Information about maturity extension triggers must be disclosed to allow investors to understand the consequences of insolvency or of resolution of the issuer for a maturity extension.
Given that national law will govern what constitutes an "objective trigger," we should expect a greater alignment of the conditions for extendable maturity programs within each jurisdiction, but not necessarily a convergence at the European level.
Certain Legislations Will Require More Adjustments
We expect that most countries will have to make amendments to their current legislation. Although we don't expect any major issues in implementing these new rules, we acknowledge that certain countries will have more work to do in order to align their existing framework with the directive. The chart below reports the results of a study conducted by the European Banking Authority (EBA), which shows the level of alignment of each country's existing framework with the EBA's covered bond best practices (which were used by the EC to formulate its proposal).
Framework Is Broadly Credit Positive
The new EU framework will not have a significant impact on covered bonds issued in established jurisdictions, with the exception of Spain, and we do not expect any immediate impact on our ratings. It does however establish a playing field that will enable greater comparability of covered bonds across jurisdictions, even if national idiosyncrasies will not disappear. By establishing a covered bond "brand," the framework endorses covered bonds as a crucial funding tool for financial institutions in the EU.
Going forward, we believe this legislation will lead to the establishment of national frameworks in member states that currently do not have any such framework. It will also stimulate the issuance of covered bonds in jurisdictions where banks do not usually rely on covered bonds for funding.
This report does not constitute a rating action.
|Primary Credit Analysts:||Tristan Gueranger, CFA, London + 44 20 7176 3628;|
|Antonio Farina, Madrid (34) 91-788-7226;|
No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw or suspend such acknowledgment at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.
Any Passwords/user IDs issued by S&P to users are single user-dedicated and may ONLY be used by the individual to whom they have been assigned. No sharing of passwords/user IDs and no simultaneous access via the same password/user ID is permitted. To reprint, translate, or use the data or information other than as provided herein, contact S&P Global Ratings, Client Services, 55 Water Street, New York, NY 10041; (1) 212-438-7280 or by e-mail to: firstname.lastname@example.org.