Momentum grows for EU covered bond regime

Author: Danielle Myles | Published: 3 Dec 2013
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  • Market participants’ support for an EU-wide covered bonds framework, to sit alongside national regimes, has grown in the past 12 months;
  • It coincides with EU authorities’ scrutiny of the asset class’s regulatory treatment, including its treatment under the liquidity coverage ratio;
  • There are concerns that even partial harmonisation could dilute the product and supervisory standards in the leading German and Danish markets, and harm competition and diversification;
  • Given the slew of more urgent financial reforms on the Brussels agenda, any new framework could be a few years away.

Industry support for an EU-wide covered bonds framework has grown over the past 12 months, with investors and issuers agreeing that harmonisation would help safeguard the asset class’s preferential regulatory treatment.

But the instrument’s reliance on national mortgage and insolvency laws, plus fears over diluting the purity of Germany’s pfandbrief market, mean any new regime would sit alongside – rather than replace – national rules.

The topic coincides with EU authorities’ scrutiny of the asset class; namely, the European Banking Authority’s (EBA’s) study regarding the instrument’s ranking under the liquidity coverage ratio (LCR), and the European Commission’s fragmentation concerns in its latest funding consultation paper.

"To many, the EBA survey and European Commission green paper for long-term financing clearly put harmonisation of covered bonds on Brussels’s political agenda," said Louis Hagen of Münchener Hypothekenbank, speaking at the Association for Financial Markets in Europe’s covered bonds conference in Berlin on Friday.

Recent speculation that the EBA will advise against the asset class being counted as level 1 in the LCR has renewed interest in the long-running harmonisation debate.

The European Commission’s ability to change regulatory privileges and force the industry to share high quality standards has forced many in the industry to reconsider their views on harmonisation.

"I must say that a couple of years ago I could not imagine what I am saying now, but from our perspective, to safeguard continued preferential regulatory treatment, a partial harmonisation of the covered bonds frameworks would seem beneficial," Hagen said.

Benefits of a single framework

As one of the few areas of finance to not be harmonised across the EU, the industry and regulators agree there are clear benefits to a single framework.

A more integrated market would be larger, more liquid, and improve ease of access for issuers. It would also create more issuances in the region’s less advanced markets, potentially helping financing in those countries.

EBA policy advisor Christian Moor also stressed the importance of a level playing field and transparency, so that bondholders don’t have to look to national laws to determine their recovery in the event of a bank’s insolvency.

Buyside panellists also saw the potential benefits. "We of course have some interest in harmonisation since, as you can imagine, it is a fairly complex [task] to analyse all the different regulatory regimes in Europe," said Tim Ockenga, head of investments at the German Insurance Association.

This would be particularly helpful in today’s low interest rate environment, which has prompted German investors to increasingly invest in French and Scandinavian covered bonds.

Ockenga added that greater consistency could greatly benefit small and medium-sized insurers, as they would need to devote less time and resources to comparing different markets.

Partial harmonisation

Jens Tolckmitt, chief executive of the Association of German Pfandbrief Banks (or Vdp) which co-hosted the event, said he was pretty convinced that there is potential for harmonisation.

"But this is limited by the fact that a lot of the legislation underlying covered bonds in different countries is classic national laws," he added.

For example, the asset class is inextricably tied to including insolvency and mortgage laws, which fall within the remit of member states’ jurisdiction.

Panellists throughout the day agreed that, as a result of this, full harmonisation is unlikely.

"We should probably move in the direction of having a European model that sits next to the national model, with certain components being harmonised to reap some of the benefits of integration, liquidity and market access," said keynote Philipp Hartmann, head of the European Central Bank (ECB) directorate general’s financial research division, speaking in his own capacity.

One-size-fits-all is not the right way to approach mortgage markets, he said, and so some national rules regarding market particularities and conditions must remain.

The question then, is which aspects of the market can be harmonised. According to Hagen, this is achievable in areas such as asset quality, transparency, a dedicated supervisory framework, and asset segregation.

Other panelists suggested that over-collateralisation could be another area to address.


Pfandbrief market

There are concerns that an EU regime could threaten the purity of the Danish covered bond and German pfandbrief markets, which created the asset class over 200 years ago.

"We are very pleased with the current pfandbrief regime," said Ockenger. "We think the quality is excellent, the transparency is strong, and so to that end we would not welcome harmonisation that would lead to a dilution of the high standards we have achieved in Germany."

Tolckmitt noted that for 20 years, Vdp had been thinking of ways to make the asset class more important at a European level, but that harmonisation was always decided against because the significant risk of dilution.

"If we welcome it, then it must be on the basis of high quality," he said. "This doesn’t mean German quality, but we have a certain view of what that means regarding special supervision and the good experience [we have had] in Germany."

Indeed, compromising the role played by today’s pfandbrief supervisors is a major concern.

"We like BaFin and Budesbank and how they treat the product," said Tolckmitt. "We are in good hands with the German regulators with regard to the product and they know the specifics of the law."

The question, he said, is how that would level out between a national and European level, if European supervision is enacted.

Such supervisory questions are already being asked with regards to the single supervisory mechanism and bank recovery and resolution directive under the incoming European Banking Union.

Less competition

An EU framework could also harm the product’s diversification and future development.

"A risk is that if you overshoot in harmonising, you may remove a source of competition which leads to innovation," said the ECB’s Hartmann.

Nordea Investment Management’s Henrik Stille said this might be the case, but that the limited harmonisation being discussed would ensure there would be still be plenty of opportunities to find underpriced opportunities in the market.

Hagen said there would still be room for competition and individual products. But he placed the onus of instrument quality and competition on investors.

"If they give credit to high quality, then it pays to produce high quality," he said. "If that is not the case, then we will end up at minimum levels and products will not be different anymore…it is very much up to the investors to pay for high quality that they get."

In any event, given the number of more urgent financial reforms being considered by EU authorities, any pan-European covered bonds regime could be a few years away.

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