Judith Hardt, secretary general, European Mortgage Federation explores the EU regulatory developments in covered bonds – past, present and future.

Not too long ago, industry insiders fondly referred to the covered bond as ‘a sleeping beauty’. But in recent years, covered bonds have emerged as an important segment of privately issued bonds on Europe’s capital markets. According to data from the European Mortgage Federation (EMF), the representative body of the European mortgage industry that represents the vast majority of covered bond issuers, there was more than E1500bn outstanding at the end of 2003. This account for about 16.5% of EU GDP and represents 17% of Europe’s bond market.
Today, there are active covered-bond markets in almost 20 different European jurisdictions and there is a strong expectation that the covered bond market will continue to grow, especially as national legislators across Europe have adopted modern covered-bond regulations or modernised existing ones. At the same time, the elimination of exchange-rate risk in the euro area and the initiatives undertaken by the European Commission (EC) to create deep and liquid European capital markets are encouraging many lenders to put greater emphasis on the covered bond as a funding instrument.
Building EU legislative framework
The EU legislative framework that has shaped today’s business environment for covered bonds and their issuers is the result of fundamental changes that have evolved over time. One of the important factors behind financial institutions’ demand for covered bonds has been the preferential treatment of such instruments in the directive on Undertakings for Collective Investment in Transferable Securities (UCITS) and other EU banking directives including those on insurance and investment, market abuse and the prospectus directive in light of the EC’s Financial Services Action Plan (FSAP). The FSAP was launched by the commission in May 1999 and contains the key elements for constructing an integrated European financial services market, and for the creation of a pan-European regulatory framework.
Efforts to further integrate the European securities markets culminated, at the end of 2002, in the resolution of the Market Abuse Directive. This strengthened the integrity of the securities markets in the EU and gives a boost to the fight against market manipulation and insider dealing, as it seeks, within a single regulatory framework, to “establish and implement common standards against market abuse throughout Europe and enhance investor confidence in those markets”. In this respect, practices usual in the market, such as price support for covered bonds and market-making, have been recognised as not constituting market abuse.
The new EU Market Abuse Directive is expected to recognise market-making in the jumbo covered bond (non-callable bullet bonds with a fixed coupon that are typically issued in sizes of E1bn-E5bn) market as accepted market practice.
The Directive on Prospectuses is another important piece of EU legislation which is intended to aid in the development of the European capital market. The directive is expected to make it easier and cheaper for companies to raise capital throughout the EU on the basis of approval from a supervisory authority (the “home competent authority”) in one member state. It will reinforce protection for investors by guaranteeing that all prospectuses, wherever they are issued in the EU, provide them with the clear and comprehensive information they need to make investment decisions.
Article 22(4) of the EU UCITS Directive is the central piece of legislation. It lists the eligibility criteria for the privileged treatment of covered bonds. Covered bonds that comply with these criteria benefit from a 10% risk-weighting. Over time, Article 22(4) has become the European definition of a covered bond. Although it provides a good framework, it is general in nature and gives no specification of the kinds of loans used as cover assets. The weakness was recognised in the new capital adequacy rules which now define more precisely which mortgage and public sector loans qualify as cover assets for covered bonds with a preferential weighting.
The new capital adequacy rules
The proposed new EU capital regime for covered bonds (CAD 3) further improves and clarifies the treatment of covered bonds. The draft, which was released in July this year, recognises the important role covered bonds play in EU financial markets and refines the rules that allow for a privileged treatment.
Under the new rules, which are still under discussion in Brussels, covered bonds are treated as fully secured loans to credit institutions. The basic criterion for any risk assessment of covered bonds is therefore the creditworthiness of the issuers. In addition to the criteria set out under Art. 22(4) of UCITS (see box), covered bonds will benefit from privileged treatment if they comply with the following requirements:
The asset pools that back covered bonds must only be constituted of assets of specifically defined types and credit quality.
The rules relating to mortgage property valuation (legal certainty, documentation, insurance, definition of market value, definition of maximum loan-to-value ratios, etc) and monitoring of mortgage loans.
The definition of covered bonds applies to both credit risk weighting approaches – ie, the standardised approach, and the internal ratings-based approach.
The commission’s proposal focuses in particular on the quality of the assets in the cover pools. Some experts argue that the current proposal is unnecessarily restrictive with regard to the eligibility of certain loans classes, possibly stifling further product innovation.
In addition, there are worries about the eligibility of central governments and central banks to guarantee covered bonds. Under the new rules, none of the new member states would be eligible for covered bonds because they are rated at A+ or below. This would be all the more unacceptable given that, on the other hand, some local authorities in member states would qualify. The industry is therefore arguing that, as a general rule, claims against EU member states should be eligible without any reference to credit quality steps.
And what will happen to the specificities in certain national laws that allow the inclusion of asset-backed securities? It is still uncertain how the national differences will be treated under the new common rules.
Risk weighting variety
Compared with the current uniform 10% weighting of covered bonds across Europe – with the notable exception of the UK’s structured covered bonds – the weightings of covered bonds under the new directive will vary much more between different issuers and national jurisdictions. There are different approaches to determine the risk weights: two standardised approaches as well as two internal ratings-based (IRB) approaches. And the weighting of covered bonds is linked to the underlying credit quality of the issuer.
Under the revised standardised approach, the risk-weighting of covered bonds is linked to the risk-weighting of the issuing credit institution. If the issuing bank is weighted at 20%, the covered bond will receive a 10% weighting.
To determine the risk weighting of the bank, national supervisors need to choose between two options. Under the first, they can link the weighting of exposures to credit institutions to the risk weight of the central government. For example, covered bond issues from a country with AAA to AA- ratings would maintain their current weighting. Option two enables supervisors to link the risk weight to an external rating so that covered bonds issued by a credit institution whose rating is below AA- would no longer be weighted at 10%.
The IRB approach provides a more sophisticated framework to determine credit risk-weights, and the calculation depends on two parameters: the probability of default (PD) of the covered bond issuer; and the loss-given default (LGD) of the covered bond exposure. LGD is the final economic loss stemming from all defaulted credits (real loss + cost + interest rate loss) divided by the gross amount of all defaulted credits.
The investing bank needs to assign a value to PD of the issuer in the foundation IRB approach and to both PD and the LGD in the advanced IRB approach. Again, as in option two of the revised standardised approach, the credit risk weight will be linked to the credit quality of the issuing institution. According to industry experts, there will be a much larger spreading of credit risk weights depending on the issuers’ rating.
In previous versions of the draft directive, the European Commission had proposed an LGD of 20% for covered bonds in the foundation internal rating based approach. The mortgage industry was dissatisfied with that proposal. It argued that it did not reflect the low LGD rates for loans secured on property and/or on claims against public sector entities.
According to a recent survey by the European Mortgage Federation, with historical data from six major covered bond issuing countries, the true LGD level for covered bonds is less than 10%. Based on this evidence, the commission conceded that under the foundation IRB approach the LGD for covered bonds should be set at 12.5% by CAD 3 (Annex VII, Part. 2, paragraph 8). This reduction in LGD level will save banks millions of euros in capital requirements, although the exact amount has not yet been calculated.
The European Covered Bond Council
Until the 1990s, Europe’s covered bond markets were mainly domestic. Today, covered bonds enjoy a prominent standing with investors around the world: the investor base has broadened significantly and with it investors’ expectations. The industry needs to sustain this momentum and rise to the challenges of becoming a truly international market. Europe’s covered bond issuers have responded to these challenges by launching the European Covered Bond Council (ECBC).
The council fundamentally widens the circle of interested market participants, which was hitherto limited to issuers, and will foster an open and constructive dialogue at the European level. Membership of the council is open to professionals in the covered bond market, including investment and commercial banks, rating agencies, trading platforms, stock exchanges, research analysts, law firms and mortgage insurers.
In addition to the legal issues, such as the weighting of covered bonds, asset segregation and bankruptcy remoteness, some of the issues for discussion will include risk management, the quality of the cover asset and the commitment by issuers in terms of market making.
The EMF will launch the ECBC during its annual conference on November 24-25. More than 30 institutions across Europe have already pledged their support. With the proposed new capital adequacy rules and talks about up-coming EU mortgage regulations, discussions in the council promise to be interesting. Sleeping Beauty has woken up.
For further information on the Covered Bond Council, please contact ECBCinfo@hypo.org
Article 22(4) of Directive 85/611/EEC (UCITS) requires:
The covered bond issuance must be governed by a special legal framework.
The covered bond issuer must be a credit institution.
Bondholders must have priority claim on the cover asset pool in case of issuer default.
The cover asset pool must provide sufficient collateral to cover bondholder claims throughout the whole term of the covered bond.
The set of eligible cover assets must be defined by law.
 The covered bond issuance must be subject to special prudential public supervision.


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