Banks say time is right for covered bonds

Author: | Published: 24 May 2005
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Italian banks may soon be able to issue covered bonds. A new initiative could provide the necessary amendments to existing legislation to facilitate the development of a market that would allow banks to finance themselves on better terms.

If the proposed new legislation is passed, Italy will follow at least 12 other countries in Europe that have adopted new legislation or adapted existing legislation, including Germany where covered bonds (Pfandbriefe) were first issued at the end of the 18th century. Some countries, such as France, Ireland, Sweden and Luxembourg, have recently opted to pass specific enabling legislation. In contrast, in the UK the first issue of covered bonds, which took place in 2003, made use of existing legislation and combined securitization techniques with corporate guarantees to create a covered bond and no specific legislative changes were necessary.

Using securitization techniques, banks can transfer performing and non-performing receivables to an off-balance-sheet special purpose vehicle and thus remove these assets from their balance sheets and benefit from regulatory capital relief. Under a covered bonds structure, on the other hand, the assets used to secure the repayment of bonds must be performing and will usually remain on the bank's balance sheet (or at least on its consolidated balance sheet).

The market for the securitization of receivables in Europe has seen tremendous growth since the 1980s but it is likely that, partly as a result of the modifications that will come into force with IAS 39 and Basel II, the market for covered bonds will also expand throughout Europe.

In fact, if the new provisions introduced by Basel II reduce the risk weighting requirements for residential mortgages from the current 50% to perhaps 35% or even 20%, banks will have less of an incentive to remove performing mortgages to improve capital adequacy ratios.

Also, the introduction of IAS 39 will make it more complicated (and therefore more expensive) to obtain genuine off-balance-sheet treatment. Banks may well prefer to explore the covered bond route rather than the securitization route, especially if they think they are likely to get better pricing.

For investors, the risk weighting of covered bonds is often lower than for bonds issued under a mortgage securitization because, under the covered bond structure, the investor will have the benefit not just of the security over the mortgage portfolio but also the benefit of a bank covenant and/or guarantee which, although unsecured, entitles the investor to a claim against one or more companies in the originator's group.

As a result, both originators and investors have an interest in developing the covered bond market, and Italian banks are convinced that now is the time to introduce Italian legislation to permit the issue of covered bonds.

Moreover, banks operating in the European market will need to be able to compete on a level playing field and they will want to benefit from financing techniques that are available in other countries.

First attempt at an Italian law for covered bonds

In the second half of last year, the Association of Italian Banks (ABI) and the Bank of Italy put together the outline of a bill that essentially would have permitted Italian banks to issue asset-backed bonds provided that the assets involved fell within one of the following categories:

  1. medium- and long-term loans, secured by mortgages on real property in member states of the EU;
  2. receivables owed by member states of the EU or regional public bodies or receivables guaranteed by such public bodies; or
  3. asset-backed securities, provided that the relevant assets fall within categories 1 or 2 and those securities are not subordinated to any other securities issued as part of the same transaction.

Features of the proposed legislation included the following:

  1. the bonds to be issued could not exceed 80% of the value of the assets securing the bonds;
  2. details of the bonds issued and the assets securing them would need to be entered on a register and, from the date of registration, the security would be enforceable against third parties, with the holders of the bonds having priority over other creditors in respect of the assets;
  3. if the originator becomes insolvent, the bank insolvency commissioners would have the power to continue servicing the assets and the bonds or to transfer that function to another bank authorized by the Bank of Italy; and
  4. the periods during which the security could be overturned and the assets clawed back by a liquidator under relevant insolvency legislation would be reduced from two years (transactions at an undervalue) and one year (preference) to six months and three months respectively (as under Law 130/99 - the Italian securitization law).

For various reasons, the original proposals did not provide Italian banks with the flexibility they needed to implement a covered bond structure. In particular one of the concerns was that, because it would have involved the originator itself giving security over its assets, it would not have been available to banks with existing negative pledges because creating the security for such bonds would have caused a breach.

The Ministry of Economics and Finance initiative

The initiative to develop the covered bonds legislation has now been taken on by the Ministry of Economics and Finance (the MEF), which, it seems, intends to amend the existing Law 130/99 rather than create entirely new legislation.

It is good news that the MEF is aiming to tackle this issue by amending existing legislation. Professionals operating in the structured finance market know and understand the existing legislation and adapting that legislation should reduce the time and cost involved in understanding the changes. It would also appear to signify that the Italian government intends to adopt an approach of fixing only the main points in primary legislation and leaving the task of identifying and modifying other technical aspects and consequential changes to secondary legislation (such as decrees by the MEF and orders of the Bank of Italy).

It is understood that the MEF proposes to introduce new articles in Law 130/99 that will permit the incorporation of a vehicle company of the type contemplated by the current Article 3 (a Law 130 company). Unlike the current Law 130 company, which has to acquire assets and fund itself by an issue of notes, the new Law 130 company would be permitted to acquire the assets and give a guarantee for an issue of notes by the originating bank secured on the assets.

In effect it would permit a bank to issue bonds pursuant to Article 12 of Legislative Decree 385/1993 (the Consolidated Banking Act or CBA) and use the proceeds of the issue to advance a subordinated loan to a Law 130 company, which would then use that loan to acquire from the same bank the assets to secure the covered bonds. That loan would be subordinated to repayment of all amounts due under the bonds.

The benefit of adapting Law 130/99

By adapting Law 130/99, the covered bond structure would benefit from the following provisions:

  1. the assets transferred to the Law 130 company would be segregated assets for the purposes of Law 130/99 and therefore available only to satisfy the claims of the bondholders (paragraph 2 of Article 3);
  2. a legal transfer could be effected by publication of a notice of transfer in the Official Gazette and that transfer would be enforceable against debtors and third parties (paragraphs 1 and 2 of Article 4);
  3. payments made by debtors to the Law 130 company would not be subject to clawback (paragraph 3 of Article 4); and
  4. the transfer of the assets and the clause in the loan agreement between the issuing bank and the Law 130 company that concerns subordination should both benefit from the reduction of the periods for potential clawback action from two years and one year to six and three months respectively (paragraph 4 of Article 4).

Furthermore, there is no reason why a Law 130 company cannot be a subsidiary of the originating bank and therefore a covered bond structure would enable the originating bank to keep the assets on its consolidated balance sheet (and protect its stated market share).

One point that may need to be addressed is that, under paragraph 3 of Article 3 of Law 130/99, a Law 130 company can be incorporated in various forms including in the form of an SpA (a joint-stock company) or an Srl (a limited liability company). Article 2343 bis of the Italian Civil Code (in relation to an SpA) and Article 2465 (in relation to an Srl) provide that, where a company is proposing to acquire receivables from a shareholder in the two years after its incorporation for a price equal to or greater than 10% of its corporate capital, the selling shareholder must produce a formal report prepared by an independent expert (chosen by the court in the case of an SpA company). That report must contain a valuation of the assets to be sold and a confirmation that the value of the assets to be sold is not less than the price to be paid by the purchaser. If one is looking at doing an on-balance-sheet transaction involving a subsidiary of the originator, the need to produce this formal report will add to the cost involved and may affect timing. It will also overlap much of the work being done by the originator and its arranger with the rating agencies. It may be sensible to try to ensure that the proposed amendments provide for an express exemption from the need to produce such a report in these circumstances.

The eligibility criteria

It is likely that the MEF will want to introduce certain eligibility criteria to limit the availability of the covered bond structure. No details of any proposed limitations are yet available but possible candidates include:

  1. Type of assets: As in a number of other countries, it will probably be provided that the receivables to be transferred can only be mortgages over real property, receivables owed by member states of the EU or regional public bodies or receivables guaranteed by such bodies and bonds deriving from securitization transactions of the type above, provided that they are not subordinated to other securities issued as part of the same transaction. The list would be broadly the same list contemplated by the outline bill referred to above.
  2. Loan-to-value ratios (LTVs): Some countries have included limitations that mean that transactions can only benefit from the covered bond legislation if the LTVs for the loans to be included do not exceed specified levels. For example, Germany imposes limits of 60% for both residential and commercial property (while some other countries set the figure higher).
  3. Minimum over-collateralization: Germany has introduced a minimum over-collateralization requirement. It will be interesting to see if other countries follow suit.

Servicing and the insolvency of the originator

It is assumed that the requirements of paragraph 6 of article 2 of Law 130/99 would apply to the new Law 130 company so that the function of servicing the assets would have to be performed by a bank or financial intermediary entered on the register maintained by the Bank of Italy pursuant to article 107 of the CBA, but appropriate changes would need to be made to Law 130/99 to achieve this. In fact, as with existing securitizations, it will usually be the originating bank that continues to perform this function, so the registration requirement should not add any additional burden because the originating bank should already have its registration.

The insolvency of the originator would not automatically result in an insolvency of the Law 130 company and, ideally, if ever there were a default, the separation of the issuing and asset owning functions would mean that the underlying mortgage portfolio could be allowed to run its natural course and pay out the bondholders on a scheduled (that is, not accelerated) basis. Clearly, if the originating bank becomes insolvent, it would be necessary to turn to a back-up servicer, who would continue to manage the portfolio of receivables. That back-up servicer would itself also need to be registered with the Bank of Italy but there should be plenty of available candidates. It is possible, however, that the Italian government would want to reserve the right for the regulator to choose or at least to approve the appointment of the back-up servicer (as happens in Luxembourg).

The separation of the issuing and asset owning functions also has the advantage that an insolvency of the issuing bank would not necessarily cause any derivatives contracts entered into by the Law 130 company to protect itself against exchange rate risk and interest rate risk to be terminated early which would, of course, potentially crystallize an unanticipated additional liability to pay any close out or termination sums.

Benefits arising from the Ucits Directive

If the proposed changes are adopted in Italy, covered bonds issued by Italian banks (as with those issued in France, Spain, Ireland, Germany and other jurisdictions) should fall under the category of securities identified in Article 22(4) of the Undertakings for Collective Investment in Transferable Securities (Ucits) Directive (85/611/EC), that is, bonds that satisfy the following criteria:

  1. the bonds must be issued by a credit institution registered in the EU;
  2. the credit institution must be subject by law to special public supervision requirements designed to protect bondholders;
  3. sums from the issue of those bonds must be invested directly or indirectly in assets so that, for the whole maturity period, the bonds are fully covered by the assets;
  4. if the issuing bank defaults, the proceeds of the assets must be applied in priority towards payment of principal and accrued interest on the bonds.

If they do fall within that criteria, covered bonds issued by Italian banks should qualify as low risk investments and, under regulatory capital requirements, enjoy a risk weighting of 10% rather than the 20% risk weighting that applies to unsecured bonds issued by European banks. As a result, they are likely to be much more attractive to investors.


The flexibility introduced by Law 130/99 has meant that in recent years Italy has been one of the most active securitization markets for originating banks. If the MEF is able to obtain parliament approval of the amendments to Law 130/99 before, or immediately after, the summer break, the general expectation is that the market for covered bonds issued by Italian banks could develop quickly.