Covered bonds have long benefited from preferential regulatory treatment, and the most recent source of this has been Article 129 of the Capital Requirements Directive (CRD IV), which defines what exactly a covered bond is. Any change to this threatens to rock the market.
So the European Banking Authority's overview of the covered bond market, published on July 1 this year, could have real consequences.
The EBA was asked by the European Commission to explore whether Article 129 of the Capital Requirement Directive (CRD) needed updating - a project made all the more urgent by the exemption of covered bonds from bail-in. If covered bonds are to be a bombproof instrument, the only wholesale bank funding channel outside resolution, the definition of covered bonds needs to be watertight.
The EBA’s study outlined best practices in covered bonds, and though it found broad similarities between all regimes, it also discovered differences such as the way the dual recourse mechanism works, or the way information is provided.
If a covered bond issuer defaults, the market takes it for granted that covered bond investor have a claim on the collateral. But the EBA thinks the other recourse, to the issuer's insolvency estate, might not apply in some circumstances.
The EBA also believes it is important to have a common definition of what issuers are expected to report to investors.
The European Covered Bond Council’s Label initiative has set the groundwork and the Covered Bond Investor Council has developed the ideal disclosure template. Their efforts are likely to be the starting point, but the EBA may include other factors.
For example, the definition of a non-performing loan is critical, not just for covered bonds, but the whole credit risk framework. There are also big differences in the way collateral is valued. And though many regimes specify maximum loan to value (LTV) limits, there is no single definition of the way it should be calculated.
Valuations and LTVs feed directly into the concept of overcollateralisation (OC) suggesting there should also be a common definition of the way OC is calculated. Investors should have a right to use OC to make sure they get paid in case of an issuer’s insolvency, so there is no reason why that should not be legally reinforced across Europe.
The EBA has made its recommendations to the European Commission (EC) which will report to the European Parliament and European Council in December.
The EC may decide that if the asset class is to continue getting preferential risk treatment it deserves, the CRD definition will need to be tightened up and reflected within all of Europe’s legal frameworks.
In December 2015 there will be a follow up check as the EBA sends a progress report to the European Systemic Risk Board on how far its recommendations for the covered bond market have been implemented. No progress on harmonisation by then could mean tougher risk weights for the asset class.
The market needs to knuckle down and deal with the technicalities of harmonisation. It sounds complicated, but none of it is impossible, and failure could cause real pain.