The implementation of a common EU legislative framework for covered bonds in 2019 marks a new milestone for the asset class, which has now for over a quarter of a millennium strategically supported economic growth, market innovation and financial stability in Europe. Moreover, the introduction of the EU legislative framework represents a clear legislative benchmark at a global level and crowns a series of significant achievements in developing the European Single Market and supporting the concrete implementation of a Banking Union and the Capital Markets Union (CMU).
1769-2019: 250 years of a successful European story without borders
Covered bonds are a finance mechanism linking financial capital markets and the real economy. Their macroprudential value is deeply rooted in the high-quality nature of the collateral and the legal infrastructure protecting investors with a dual recourse mechanism. Their focal point is the mortgage system and the lien to a real guarantee. The quality of the collateral is the basis to secure the macroprudential treatment of the instrument and it is this quality that was paramount for Fredrick II of Prussia in 1769 when he launched the first covered bond, and which remains the basis of the EU legislative framework today.
The mortgage finance mechanism has long been used to secure private capital inflows, by providing a solid legal framework to protect long-term investors with a legal-financial safe harbour to boost private and public investments in relation to strategic objectives. This was so in ancient Athens when the mechanism was used to collect private capital to build a new fleet of triremes, capable of challenging Persian supremacy of the Aegean sea and defending the independence of Athens and Greek culture. Without this mechanism, Athens would not have been able to defeat the Persians (Salamis battle, 480 BC). Had the Persians won, Greek democracy and its cultural heritage, the western world and Europe would almost certainly look very different from the way they do today.
The Covered Bond Label
Since its establishment in 2004, the European Covered Bond Council (ECBC) has provided a global discussion forum in which to share market intelligence and best practices. This has facilitated discussions on legal developments, securing market innovation and consensus. Furthermore, it acts as a learning platform for new jurisdictions keen to introduce this asset class or update their covered bond legislation.
To a certain extent, the success of the covered bond product, both as a crisis management tool and as a cost-efficient lending instrument, has been contingent on the fact that the industry recognises that continual adaptation to the regulatory environment and evolution in the light of new market conditions is a key ingredient in the product formula.
This was exemplified with the establishment of the Covered Bond Label in 2012 when the Industry came together in response to a market-wide need for common qualitative and quantitative standardised disclosure. Through its standardised disclosure templates, the Label has enhanced market transparency, product comparability and financial stability. Further market efforts were undertaken in 2016, when Labelled Issuers developed the Harmonised Transparency Template (HTT) to provide harmonised cover pool information, facilitating investors’ due diligence.
New EU Framework for Covered Bonds & Global Recognition
From a macroprudential viewpoint, the growth in the use of covered bonds has increased the need for appropriate regulatory and legislative treatment of the asset class, at EU and, increasingly, at global levels.
In the context of the European Commission’s CMU project, efforts have been undertaken to harmonise national covered bond frameworks in Member States, with market consultations, studies and recommendations having been put forward by the different European Institutions. These efforts culminated with the European Commission’s publication in March 2018 of a formal proposal for an EU Framework for Covered Bonds and final political approval of the new legislative package in April 2019.
The Framework, which consists of two elements - a Directive and a Regulation, is to be seen as a single package and reference point for covered bond legislation at EU level, which until now has been deployed across a series of regulatory texts.
The Framework is principle-based in nature and aims to specify the core elements of a covered bond whilst providing a common definition. Importantly, the Framework is not meant to result in a uniform model for the asset class. Rather, it aims to provide a coherent legislative reference point whilst enhancing transparency requirements and defining the key qualitative characteristics of the product in a single text. Importantly, it recognises the fundamental role played by the Covered Bond Label as a globally recognised benchmark in improving transparency, harmonisation and setting high qualitative standards. Moreover, the Framework opens the possibility of introducing a third-country regime for covered bonds in European Union law.
At the time of writing, the Framework has been approved by the European Parliament and the Council, with its formal adoption expected to take place in December 2019. The Framework will officially enter into force 30 months after publication in the Official Journal of the EU (18 months transposition period + 12 months application period).
Beyond Europe, the Basel Committee on Banking Supervision finalised the so-called Basel III Reform in December 2017, recognising for the first time the robustness of covered bonds at the global level and reflecting this in preferential risk weights for the asset class. Similarly, the fact that the Basel III recommendations capture the key qualitative features already intrinsic to the Covered Bond Label represents a major success for the Industry.
Market Developments & EMF-ECBC Market Initiatives
With c. €2.6 trillion outstanding at the end of 2018, covered bonds continue to prove their strategic importance for European capital markets, contributing to effective allocation of capital and, ultimately, to economic recovery, stability and development.
Increasing attention is also being given to green and sustainable covered bonds. Against this background and with a view to facilitating market standards, in 2017 the EMF-ECBC implemented a “Sustainable Covered Bond” market definition via the Covered Bond Label.
The EMF-ECBC has continued its market development efforts by coordinating two further significant market-led initiatives in close cooperation with stakeholders and political institutions.
The European Secured Note (ESN)
In the context of the CMU, and to help strengthen banks’ capacity to support the wider economy, the EMF-ECBC has analysed the potential for the creation of a new financial instrument, the European Secured Note (ESN), targeting clients such as small and medium-sized enterprises (SMEs) or infrastructure loans, providing them with long-term funding. The envisaged ESN proposal, which is currently being discussed at EU level, considers long-term financing solutions for loans to these clients replicating the best practices of covered bonds (for funding purposes) and securitisations (for funding and risk-sharing purposes).
The Energy Efficient Mortgages (EEM) Initiative
To encourage energy efficient mortgage financing, the EMF-ECBC has taken forward work on the development of a standardised, pan-European Energy Efficient Mortgage financing mechanism designed to incentivise EU citizens to improve the energy efficiency (EE) of their home or to acquire an already energy efficient property by way of preferential financial conditions linked to the mortgage.
This mechanism is intended to be supported by a data protocol and portal to collect and access large-scale empirical evidence relating to energy efficient mortgage assets. This will allow a comprehensive analysis of de-risking energy efficiency features, which, in turn, can stabilise the underlying business case that energy efficiency has a risk mitigation effect for banks. As a result, this should represent a lower risk on the balance sheet of banks and could, therefore, qualify for a better capital treatment.
It is anticipated that the EEM Initiative will deliver a new product, an “Energy Efficient Mortgage”, which could be used for the purposes of green/energy efficient covered bond issuance.
Looking ahead
The harmonisation of the covered bond asset class at both EU and global levels represents a new era for the Industry. While principle-based harmonisation represents an opportunity to further develop the market, it is also clear that the Industry is faced with new regulatory, policy and supervisory developments. In conjunction with these, market conditions, environmental concerns and new trends will also continue to shape the product going forward.
In this context, the ECBC remains committed to fulfil its role as the leading market think-tank, striving to secure the highest qualitative benchmark in the implementation of the covered bond concept within the EU and beyond, and to defend its justified preferential regulatory treatment going forward.
Through the continuous fine-tuning of covered bond legislation, facilitation of market best practices, and by fostering market initiatives, the Industry remains proactive and ready to support the nascent CMU in order to allow markets to realise synergies so as to positively impact the funding value chain.
