European Commission report on capital requirements for covered bonds
As per Article 503 of Capital Requirement Regulation (CRR), the European Commission (EC) was required to submit a report, based on a report on European Union (EU) covered bond frameworks and capital treatment submitted by European Banking Authority (EBA), to the European Parliament (EP) and the council of the EU on the following four points:
· Are preferential risk weights (rws) appropriate for covered bonds?
· Are preferential rws appropriate for aircraft loans?
· Are preferential rws appropriate for guaranteed residential loans?
· Review of the article 496 derogation?
The report was published by the EC on October 20, 2015 containing the observations /considerations/ recommendations of EC on the above mentioned issue. Moreover, EC seeks stakeholders’ feedback on most of the issue through a dedicated Consultation Paper on covered bonds ("CP"), as was announced in the CMU Green Paper on 18 February. Following are the observations /considerations/ recommendations of EC:
1. Are preferential risk weights (rws) appropriate for covered bonds?
The EC is of the view that the preferential risk weights currently laid down in Article 129 and the own fund requirements for specific risk in Article 336(3) of the CRR remain an adequate prudential treatment for qualifying covered bonds. The view is based on the following observations:
· The overall credit performance of the European covered bond has been ‘robust’,
· The support of government of various member states to the issuer of covered bonds in their respective country, instances of default has been extremely low.
Covered bond laws of Member States are in line with the requirements prescribed under Article 52(4) of Directive 2009/65/EC and also follow standards set out under Article 129 of CRR. The harmonization of these laws help in improving financial strength of the global market and creating a standard of quality that investors seek to rely on.
However, there are differences between the laws of the various Member States mainly in term of safety and transparency. Convergence of the laws are recommended. In order to achieve this the EU requires stakeholder feedbacks on the convenience and shape of an integrated EU covered bond framework.
2. Are preferential rws appropriate for aircraft loans?
Based on recommendation in the EBA’s report the EC is of the view that at present covered bonds secured by aircraft loans (aircraft liens) should not be considered as eligible asset under Article 129 of the CRR. The view was backed by the fact that various factors are to be considered while valuing an aircraft which makes the valuation highly complex. Also there is not much historical data available on the performance of aircraft loans. Moreover there are very few lenders as well as issuers of covered bonds backed by aircraft liens. Most importantly there is a lack of legal requirement under most covered bonds framework wherein no proper provision is dedicated towards handling the complexities involved in a covered bond structure backed by aircraft liens.
However, the EC is keen on seeking stakeholder’s feedback on this particular issue as it is of the view benefits in terms of economic growth may be achieved by ‘encouraging sound lending to the real economy on the back of covered bond-like technology using these assets as collateral’.
3. Are preferential rws appropriate for guaranteed residential loans?
At present covered bonds guaranteed by residential loans, subject to certain eligibility conditions, are considered as eligible assets in accordance with Article 129 of the CRR.
Based on the recommendation in the EBA’s report the EC is of the view that the these assets shall continue to be a part of eligible assets, however an additional condition shall be added to its eligibility condition, i.e. in case the covered bond issuer has defaulted then the legal framework governing covered bond should in no manner hinder the administrator of the covered bond programme to ‘place mortgage liens on the loans included in the cover pool’.
The EC also seeks stakeholder’s feedback on this additional condition.
4. Review of the article 496 derogation?
Article 496 states:
“Until 31 December 2017 competent authorities may waive in full or in part the 10 % limit for senior units issued by French Fonds Communs de Créances or by securitisation entities which are equivalent to French Fonds Communs de Créances laid down in points (d) and (e) of Article 129(1), provided that both of the following conditions are fulfilled:
(a) the securitised residential or commercial immovable property exposures were originated by a member of the same consolidated group of which the issuer of the covered bonds is a member, or by an entity affiliated to the same central body to which the issuer of the covered bonds is affiliated, where that common group membership or affiliation shall be determined at the time the senior units are made collateral for covered bonds;
(b) a member of the same consolidated group of which the issuer of the covered bonds is a member, or an entity affiliated to the same central body to which the issuer of the covered bonds is affiliated, retains the whole first loss tranche supporting those senior units.”
Pursuant to Article 503 of the CRR, the EC was required to review the derogation under Article 496 of the CRR in order to opine whether the said derogation is appropriate and should be extended to other types of covered bonds. As is clear from the above pretext that the said Article sets out a derogation for senior units issued by French Fonds Communs de Creances or equivalent securitization instruments. As per EBA, the derogation to the 10% limit should be removed after 31 December 2017. There are various reasons for this decision of which the most important being the intricacies of a double-layer structure resulting from the inclusion of RMBSs or CMBSs in the first layer, as cover assets, into a covered bond programme giving rise to complex features involving various hedging contracts, service contracts, rating triggers etc than in a single layer structure. Also a double layer structure involving securitisation instruments shall be relatively less transparent and more complex to manage than one layer structures.
In this regard the EC seeks stakeholder’s feedback before forming its view on ‘whether it would be suitable to let the derogation lapse or to make it permanent or replace it with a covered bond framework that may include provisions on covered bond structures backed by securitisation instruments.’
Basis the above observations /considerations/ recommendations of EC it is quite clear that it is not willing to incorporate any amendments to the regulations without understanding the concerns of the stakeholders. Therefore we will have to wait to receive the feedback of various stakeholder to see whether any amendments will at all be made to the regulations.