Covered Bonds

5 questions for Prof. Dr. Bernd Lucke, Member of the European Parliament

December 2018

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

How do you think covered bond harmonisation will deliver added value?

Prof. Dr. Bernd Lucke

Prof. Dr. Bernd Lucke

There are two interrelated issues. The first concerns financial market stability. The covered bond concept has found its way into various European regulations and, in particular, there is the implied assumption that a covered bond is a very safe, high-quality instrument. For this reason, EU financial market legislation grants it considerable regulatory privileges. But so far, there has been no precise definition of covered bonds in EU law. The UCITS directive does not even use the term, and the defining features are so general and vague that even risky and poorly collateralised financial instruments could qualify as covered bonds. This leaves an open door for risks within the financial system, which we are now closing and bolting shut. The new directive contains a suitably precise definition of a covered bond, so that in future only high quality, secure products can be referred to as ‘covered bonds.’
We now come to the second issue, that of added value: the directive obliges all EU member states to comply with its standards. So we are also doing the product itself a service because it cannot be watered down under the terms of the directive. We want those member states which do not yet have well-developed covered bond markets to promote the use of this successful financial instrument. But we do not want the good reputation of covered bonds in traditional issuer countries to be tarnished by a proliferation of riskier and lower value products which go by the same name. The terms of the directive allow us to achieve both aims.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

A list of eligible cover assets seems politically difficult to enforce. How, or by what means, will the specific quality of covered bonds be safeguarded? What concerns do you have about this?

Prof. Dr. Bernd Lucke

Prof. Dr. Bernd Lucke

Parliament followed my suggestion of a middle way. On the one hand, we provide a positive list of eligible cover assets, which corresponds exactly to the provisions of Article 129 (1) of the CRR. On the other hand, we also want to leave room for market innovations. It should be possible to have products with novel, unconventional cover assets, if these can ensure cover of similar quality to traditional collateral. That is why we have created a second class of covered bonds, in which the type of eligible cover asset is not defined. On the other hand, the cover assets must fulfil strict quality criteria which we do define. We allow lower regulatory benefits for this second class of covered bonds than for the premium class. This is not necessarily because they are less secure by design, but rather because there is less experience with this type of potentially innovative cover asset. This sub-prime segment is a class of security which has yet to demonstrate that it is both crisis-proof and reliable, just like the premium class. We want to be on the safe side when it comes to financial stability, and the two classes should also be labelled differently to ensure that investors are not misled.

That said, I am not completely happy with the definition of the premium class. Under pressure from the Italian delegates, up to 5% of premium class cover pools can now comprise receivables from financial institutions with credit quality as low as step 3. Unfortunately, the Christian Democrats in the European Parliament joined forces with the Social Democrats, who had campaigned heavily for this, so regrettably there was no majority for the harder line I advocated. I did manage to introduce some restrictions with regard to credit quality step 3, though. In general, only short-term deposits are eligible and the national supervisory authority has to grant approval for derivatives. But that does not alter the fact that credit quality step 3 can, in my view, jeopardise the reputation of premium covered bonds, because there are institutions at this level that could fail in a crisis. However, I must admit that I probably take a stricter view on this than even the German delegates from politics and industry. Shortly before the vote there was a chance that credit quality step 3 could be removed altogether from the bill before parliament, because the Christian Democrats were considering joining me on this issue, but unfortunately outside support was lacking.

Prof. Dr. Bernd Lucke

Prof. Dr. Bernd Lucke

That’s possible, but it will take some time. We have tasked the Commission with a study and if it shows that ESNs represent a sensible broadening of the range, the Commission will make an appropriate legislative proposal. I am not entirely convinced that we need ESNs, but neither am I decidedly against them. Ultimately it depends on whether there is a market for them. My main concern is that such a market could be artificially created for political reasons, by giving too much regulatory preference to ESNs. Such games are already being played with SBBSs.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

Why do you think structures with a maturity extension or pass-through could or should be subject to regulatory penalties?

Prof. Dr. Bernd Lucke

Prof. Dr. Bernd Lucke

Hold on! I did not want penalties. What I wanted was preferential treatment for bonds with maturity extensions. But I wanted less preferential treatment than for hard bullets. This is because investors’ liquidity risk generally increases when bond redemption can be postponed. If bonds with maturity extension options are riskier than classic products, then I think it imperative that the former gets a higher risk weighting than the latter.

Risk analysis and risk transfer between the issuer and the investor is very complex. Investors’ liquidity risk with CPTs is undoubtedly higher than with a hard bullet if the issuer is not insolvent but the maturity extension is triggered by an exogenous event. If the maturity extension is due to insolvency or resolution, the same applies provided the cover pool is so well collateralised, and possibly over-collateralised, that the payment obligations under the covered bond programme can be fully met, despite possible fire sales. If this is not the case, however, maturity extensions could reduce investors’ credit risk, and even a hard bullet would involve a liquidity risk.

Now, clearly, we want to structure the covered bond so that there is always enough cover in the pool. The case of insufficient coverage would be an unwanted exception, while adequate cover is the rule. Therefore, consistent with the design of our legislation is the assumption that bonds with maturity extensions generally present a higher liquidity risk for investors than hard bullets. And that is why they should have a higher risk weighting.

Christian Walburg

Christian Walburg

Association of German Pfandbrief Banks

Is covered bond harmonisation still at risk of failing? What is the risk that the trilogue will not be completed on time?

Prof. Dr. Bernd Lucke

Prof. Dr. Bernd Lucke

I think it is unlikely that we will not complete the trilogue in good time.

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