EU covered bond harmonisation measures will clarify uncertainties but gaps remain

The forthcoming EU Covered Bond Directive and corresponding changes to other regulations might facilitate cross-border capital flows but they won’t lead to uniform credit quality among covered bonds.

Once the European Commission’s deadline for comments on its covered bond harmonisation measures passes on 16 May 2018, the Directive goes in front of the European Parliament for a vote before the end of the election period in 2019. After that, covered bond investors can expect a wave of amendments to existing covered bond legislation across the bloc. The final directive will have to be transposed into national law within one year.

In a report published today, Scope says the proposed amendments will likely strengthen investor confidence in the credit quality of covered bonds, but they will not have a strong impact on the credit quality of existing covered bonds. However, the amendments will allow regulators to justify ongoing preferential treatment for covered bonds – to the benefit of issuers and investors.

Directive provides more clarity on cover-pool risks …

Generally, Scope views the Commission’s principles-based harmonisation proposal positively. “The proposed Directive and regulatory ‘labelling’ will clarify uncertainties for investors with regard to the treatment of covered bonds upon the insolvency of the issuer; will provide more clarity on eligibility of cover assets and the maintenance of an ‘evergreen’ cover pool – while also adding a stronger and more comparable supervisory framework across Europe,” said Karlo Fuchs, head of covered bonds at Scope Ratings.

On the basis that markets were expecting less fragmentation among covered bond legislations as well as clarity on the insolvency remoteness of covered bonds to result from the Directive, the Commission delivered.

… but remains broadly silent on maturity mismatches or other market risks

But there is a missed opportunity in the Directive, as the second most expected benefit – the reduction of asset-liability mismatch (ALM) risk and its impact on credit quality – has not been fully addressed.

“The mandatory short-term liquidity buffers for all covered bond programmes contained in the Directive are a positive step. The Directive will also standardise the use of structural elements such as the “trigger” for soft bullets or the use of pass-through structures,” said Fuchs. These measures will give the specific insolvency receiver of the covered bond more time to address the inherent structural mismatches and the risk of a bullet repayment.

If not regulated and actively managed during the going concern of the bank, structural ALM mismatches in cover pools can jeopardise the going concern of a covered bond programme and ultimately force it into insolvency

Other market risks, such as interest-rate and foreign currency risks are also only minimally addressed by the Directive. National translation of the Directive might introduce limits and adequate stresses but differences in risk will persist.

Further guidance on terms to facilitate and harmonise interpretation

Scope believes that even though it is a principles-based Directive, the Commission should provide more affirmative guidance on the interpretation of key terms, the implications of failing to meet certain conditions, and the transition between grandfathered and covered bonds issued under the new Directive. Limited details could undermine some of the potential harmonisation benefits.

The translation of the directive into national legislations might address some of the above. However, even when fully effective, credit differentiation between markets, banks and their covered bonds is here to stay.

The forthcoming EU Covered Bond Directive and corresponding changes to other regulations might facilitate cross-border capital flows but they won’t lead to uniform credit quality among covered bonds.

Once the European Commission’s deadline for comments on its covered bond harmonisation measures passes on 16 May 2018, the Directive goes in front of the European Parliament for a vote before the end of the election period in 2019. After that, covered bond investors can expect a wave of amendments to existing covered bond legislation across the bloc. The final directive will have to be transposed into national law within one year.

In a report published today, Scope says the proposed amendments will likely strengthen investor confidence in the credit quality of covered bonds, but they will not have a strong impact on the credit quality of existing covered bonds. However, the amendments will allow regulators to justify ongoing preferential treatment for covered bonds – to the benefit of issuers and investors.

Directive provides more clarity on cover-pool risks …

Generally, Scope views the Commission’s principles-based harmonisation proposal positively. “The proposed Directive and regulatory ‘labelling’ will clarify uncertainties for investors with regard to the treatment of covered bonds upon the insolvency of the issuer; will provide more clarity on eligibility of cover assets and the maintenance of an ‘evergreen’ cover pool – while also adding a stronger and more comparable supervisory framework across Europe,” said Karlo Fuchs, head of covered bonds at Scope Ratings.

On the basis that markets were expecting less fragmentation among covered bond legislations as well as clarity on the insolvency remoteness of covered bonds to result from the Directive, the Commission delivered.

… but remains broadly silent on maturity mismatches or other market risks

But there is a missed opportunity in the Directive, as the second most expected benefit – the reduction of asset-liability mismatch (ALM) risk and its impact on credit quality – has not been fully addressed.

“The mandatory short-term liquidity buffers for all covered bond programmes contained in the Directive are a positive step. The Directive will also standardise the use of structural elements such as the “trigger” for soft bullets or the use of pass-through structures,” said Fuchs. These measures will give the specific insolvency receiver of the covered bond more time to address the inherent structural mismatches and the risk of a bullet repayment.

If not regulated and actively managed during the going concern of the bank, structural ALM mismatches in cover pools can jeopardise the going concern of a covered bond programme and ultimately force it into insolvency

Other market risks, such as interest-rate and foreign currency risks are also only minimally addressed by the Directive. National translation of the Directive might introduce limits and adequate stresses but differences in risk will persist.

Further guidance on terms to facilitate and harmonise interpretation

Scope believes that even though it is a principles-based Directive, the Commission should provide more affirmative guidance on the interpretation of key terms, the implications of failing to meet certain conditions, and the transition between grandfathered and covered bonds issued under the new Directive. Limited details could undermine some of the potential harmonisation benefits.

The translation of the directive into national legislations might address some of the above. However, even when fully effective, credit differentiation between markets, banks and their covered bonds is here to stay.