28 August 2024
Since July 2022, the regulatory treatment of covered bonds within the European Union (EU) is based on a harmonization framework which consists of a directive, that introduces a common definition of covered bonds,and a regulation, that amends the EU’s Capital Requirements Regulation. The directive also defines the pathway to achieve third-country equivalence – the alignment of the regulatory treatment of covered bonds issued by credit institutions inside and outside the European Economic Area (EEA). European covered bonds receive preferential regulatory treatment that extends beyond risk weightings to include:
While the Basel III reforms implementation has made preferential risk weights for covered bonds purchased by banks outside Europe possible, not all the countries that have already implemented the Basel III reforms
have decided to provide such favorable treatment. Importantly, covered bonds issued by credit institutions outside the EEA and purchased by European investors still receive a less favorable regulatory treatment than covered bonds issued by EEA-based credit institutions.
HOW EU EQUIVALENCE WORK
European authorities could, in the future, decide to grant equivalent treatment to covered bonds issued by non-EEA credit institutions. Alignment of third-country covered bond frameworks with the directive will be a
key factor. Article 31 of the directive stipulates that the European Commission (EC) will submit a report on third-country equivalence to the European Parliament and Council, which may be accompanied by a legislative proposal on whether or how an equivalence regime should be introduced. The EC’s assessments of equivalence are usually based on technical advice from European Supervisory Authorities, such as the European Banking Authority (EBA). In July 2023 the EC issued a call for advice (CfA) to the EBA on the performance and review of the EU Covered Bond Directive, including third-country equivalence. The EBA is required to provide its response before the end of June 2025, which includes input on the appropriate data and principles that should guide the determination of the equivalence exercis
EU financial services acts may contain “third-country provisions”, which empower the EC to decide on the equivalence of foreign rules and supervision for EU regulatory purposes. These legal acts define the conditions, criteria, and extent to which the EU may consider the regulatory and supervisory framework of a third country. Beyond the technical assessment of the equivalent legal framework, the EC will also consider other general financial policy criteria. These will include:
The EC will also consider the framework’s regulatory objectives and its outcomes, particularly on the impact of the third-country regime on EU markets. Finally, the EC will review wider external policy priorities and concerns, in particular, the promotion of international common values and shared regulatory objectives. From the outset, the entire process typically involves an intensive technical dialogue with the third country’s
authorities. These authorities are invited to contribute to fact-finding exercises relating to how their regulatory and supervisory frameworks deliver the outcomes set out in the corresponding EU framework.
The directive does not empower the EC to take the equivalence decision. Article 31 only requires the EC to submit a report on whether and how an equivalence regime could be introduced. This report can be combined with a legislative proposal, but the EC might consider that such a proposal is not (yet) appropriate. While submission of the report is mandatory, the legislative proposal is not. Three steps appear necessary to achieve third-country equivalence. First, a report justifying the introduction of an equivalence regime and defining the technical requirements. Second, a legislative proposal (directive or regulation) transposing these requirements into a legal act and empowering the EC to take an implementing decision. Third, EC recognition of the equivalence, after a thorough assessment of the third country’s covered
bond framework. Missing from the directive are also the technical requirements or criteria applicable to the equivalence assessment itself, meaning that almost all technical requirements guiding the equivalence assessment are at the EC’s full discretion. An understanding of both the fundamental principles to be considered and the level of technical detail required will be important. The EC’s legislative proposal could cover the following areas: 1) issuance by a credit institution; 2) existence of a legal framework; 3) dual recourse; 4) asset segregation (bankruptcy remoteness); 5) eligible cover pool assets (quality requirements for asset types, derivatives, LTV ratios, and valuation); 6) coverage requirements; 7) special public supervision; 8) liquidity rules; and 9) transparency (reporting and disclosures).
Striking the right balance between the safety features of product components and the necessary flexibility for third countries and their market traditions will be challenging. Technical specifications would therefore benefit from a principles-based approach. Local regulators will most probably prefer as a starting point the definition of covered bonds and the specific requirements set out in the Basel III framework.
Considering the timeline for the EBA response and that a potential legislative proposal must be adopted through an ordinary legislative procedure, the overall schedule might be stretched to 2026 or even beyond.
CURRENT ALIGNMENT WITH THE DIRECTIVE
Established in 2015, the European Covered Bond Council’s Global Issues Working Group (GIWG) aims to promote a better global understanding of covered bonds and foster convergence between countries towards
similar market solutions, infrastructure, and regulatory treatment.
Over the past few years, the GIWG has analyzed the alignment of global covered bond regimes with the covered bond harmonization directive. In February 2024 the GIWG published a Concept Note on third country equivalence, the result of a consultation with market participants such financial analysts, issuers’ representatives and investment bankers, and local authorities.
The analysis revealed full alignment with the dual-recourse requirements and an almost full alignment with the bankruptcy remoteness and asset segregation requirements. On the other hand, virtually none of the global regimes provide for intragroup or joint funding options. However, the lack of alignment with these requirements is not particularly relevant because, for example, the intragroup covered bond funding is only an option for national legislators. Hence there is no obligation to implement it globally.
The directive already allows for non-EU assets to be included in cover pools if they meet the directive’s eligibility criteria, and their realization is similarly legally enforceable to EU assets. Most global covered bond regimes have established asset eligibility criteria that already partially meet the directive’s requirements.
Asset coverage may require further clarification. This is because non-EEA regimes provide for nominal coverage but are not always as detailed as the directive about the type of cover pool assets that should contribute to the coverage requirement. The minimum required nominal overcollateralization level of 5% as specified in The amended Article 129 of the CRR is only included in one single third-country legal framework.
But issuers often meet this requirement on a contractual level, and if voluntary overcollateralization is considered too, all jurisdictions would meet this requirement.
Most global covered bond jurisdictions do not explicitly provide for a 180-day liquidity rule, but their frameworks often include other types of liquidity provisioning. While commonly allowed, the use of extendable maturity
structures is also not necessarily enshrined in law. And while non-EEA frameworks lack objective extension triggers, maturity extension triggers are, where applicable, mostly detailed in the contractual terms and conditions.
Global covered bond regimes are subject to covered bond public supervision, but the law does not explicitly require competent authorities to have the expertise, resources, operational capacity, powers, and independence necessary to conduct public covered bond supervision.
Global covered bond regimes require permission from the relevant authority to issue covered bonds, but some countries lack detailed requirements for permission. Supervision provisions in insolvency or resolution regimes are also often not as detailed as stipulated in the directive, while the global frameworks differ significantly in their reporting requirements to the authorities.
THE IMPORTANCE OF THIRD-COUNTRY EQUIVALENCE
As part of the CfA, the EBA must consider the impact of a hypothetical third-country regime on EU markets. To do that, the EBA will assess the holdings of third-country covered bonds by EU credit institutions and the
holdings of EU covered bonds by credit institutions in third countries.
Primary market distribution statistics show that, during the past decade, non-EEA investors (Asian and others) have bought on average 5% of the euro-denominated covered bond transactions of EEA credit institutions in the primary market and 8% of the non-EEA euro-denominated covered bonds. During the last two years third country investments in new EEA euro covered bonds have even slightly declined despite the reduced and ending allocations to the covered bond purchase programme (CBPP3) for eurozone covered bonds and the introduction of preferential risk weights for covered bonds in several non-European countries. The implementation of the Basel III reforms has therefore so far not unlocked a visible additional investor demand from third-country markets for European covered bonds.
While EEA investors are by far the most dominant primary buyers of the euro covered bonds of EEA credit institutions (at 89%), they are also the largest buyers of third-country euro covered bonds in the primary market (at 76%). For that reason, EEA investors will probably welcome a third-country equivalence regime for non-EEA legislative covered bonds. For third-country issuers, an equivalence regime will likely have the supportive side effects of broadening the interested European investor base for their covered bonds and reducing funding costs. Third-country covered bonds trade persistently wider than covered bonds issued by EEA banks. This reflects the less favorable risk weight and LCR treatment for these bonds within the EU. Unless the issuing bank is based in a G10 country (such as Canada or the U.K.), third-country covered bonds are also not accepted for ECB collateral purposes.
Figure 2 shows how average spread levels across different jurisdictions for euro covered bonds issued in the 2027 maturity segment differ. This is where the largest group of covered bond issuers has euro covered bonds outstanding. The legislative covered bonds of non-EEA banks from Australia, Canada, New Zealand, Singapore, and South Korea are quoted (at the time of writing) on average at about 15 basis points wider than the legislative covered bonds of Norwegian or Swedish banks.
By Antonio Farina, S&P Global Ratings, Colin Chen, Chairman of the ECBC Issues Workin,g Group and DBS Bank, Richard Kemmish, Consultant, and Maureen Schuller, ING Bank
Established in 1967, the European Mortgage Federation (EMF) is the voice of the European mortgage industry on the retail side of the business, representing the interests of mortgage lenders at European level.
