Covered Bonds: Mapping a New World

1 September 2016

By Waleed El-Amir, Head of Group Finance, UniCredit & Chairman of the European Covered Bond Council (ECBC)

On the 23rd of June 2016, a new and significant page in the history of Europe was written. The political and market dynamics triggered by the decision of the United Kingdom to  leave the European Union (EU) are giving rise to completely new and unpredictable perspectives on the Old Continent.

Once again, mortgage lenders and covered bond issuers are exposed to an unprecedented macroeconomic landscape with an extremely fragile and vulnerable political, institutional and social framework. In our view, however, one thing is sure: covered bonds will continue to serve as an effective crisis management tool providing an essential long-term financing instrument.

During the financial crisis of 2008 and subsequent years, the covered bond community made immense efforts to bring about convergence in market best practices and to offer a common set of market initiatives to the EU institutions, presenting a robust and consistent asset class amongst what were very fragmented national legal and macroeconomic landscapes.

Looking back over the last year, it is clear that  the covered bond space has been fundamentally  impacted upon by major waves of monetary policy,  supervisory review and regulatory change. These  developments and the new perspectives that they  bring with them are reshaping market dynamics  as well as the environment in which the asset  class operate.

In September 2014, the European Central Bank (ECB) announced the launch of the third covered bond purchase programme (CBPP3) alongside a first asset backed security purchase programme (ABSPP). This was closely followed in Q1 2015 by the public sector purchase programme (PSPP), complementing the existing private sector assets operation with one focused on government debt. The expansion, in both size and scope, of the ECB’s monetary stimuli aims at propelling the Eurozone out of its current deflationary path. Moreover, for the first time, lenders and investors in some parts of the EU were faced with the unprecedented challenge of a negative interest rate environment.

In  November  2014,  the  new  European Commission started its five-year term and the EU began a new chapter in the process of European integration. The Juncker Commission set itself the ambitious political task of fostering growth whilst maintaining financial stability in 28 EU Member States, and has focused its attention and actions on galvanising Europe against the risk of further recession and deflation by coordinating structural reforms, investment, and budgetary, fiscal and monetary policies. These initiatives will affect the lives of more than 500 million citizens. The Commission’s subsequent call for the creation of a Capital Markets Union in 2015 has put the spotlight on the role of the banking sector in supporting the growth agenda and on the contents of the long-term financing toolkit at the disposal of stakeholders.

Looking at the process of European integration in more detail, an additional fundamental building block was put in place in November 2014 when the ECB fully assumed the supervisory tasks and responsibilities given to it in the framework of the Single Supervisory Mechanism (SSM), thereby taking charge of the euro area’s 129 biggest credit institutions. This represents the biggest expansion of the ECB’s powers since the introduction of the euro. The SSM, which is based in Frankfurt, represents the first established pillar of the Banking Union and is harmonising 19 sets of national supervisory practices aiming at a single pan-European framework, and obliging banks to take more precautions against crises.

The second pillar of the Banking Union, the Single Resolution Mechanism (SRM), was agreed upon in 2014 and implemented through the end of 2015. The main objective of the SRM is to ensure that potential future bank failures in the Banking Union are managed efficiently, with minimal costs to taxpayers and the real economy. The SRM is managed by the Single Resolution Board in charge of the decision to initiate the resolution of a bank, and in some cases can it step up funding the resolution procedure using the Single Resolution Fund (SRF) war chest. Now the debate has shifted to the completion of the Banking Union by the introduction of its third pillar, the European Deposit Insurance Scheme (EDIS). EDIS introduction will be accompanied by risk reduction measures.

The changes of recent months to the regulatory and policy environment in Europe are having a significant impact on the long-term financing and housing finance sectors.

When considering how best to shape the future European banking landscape and build the Capital Markets Union that will ensure the capability of the Industry to support the growth agenda and provide long-term financing to the real economy, several areas of reflection can be identified:

  • Striking the right balance, in terms of a level playing field, between international banks operating in the European Union and European actors operating both internationally and domestically.
  • Carefully examining the market impact of several key regulatory developments and trying to secure the European banking pillars in the Basel Committee debates: i.e. Net Stable Funding Ratio (NSFR), risk weighting, capital floors framework, leverage ratio.
  • The role of European lenders in the framework of housing and small and medium sized enterprise (SME) financing, and lending to the real economy is becoming increasingly multi-faceted with the introduction of the Capital Markets Union.
  • The role of covered bonds and the Industry’s firm commitment to achieve a higher level of harmonisation, in line with EU objectives and market preferences.

Political Perspective & the role of the ECBC

The path to the achievement of a common market offering free movement of goods, services, people and capital has been a long and gradual one. Starting in  the 1950s with the signing of the Treaties of Paris and Rome, the process really started to take shape in 1985 with the initiative of the Delors Commission to design the Single European Act (SEA), and was developed further in the 1990s and 2000s. Very much in line with the spirit of Delors, the Juncker Commission is revamping and extending what has gone before through its growth agenda and its plans to create deeper and more integrated capital markets in the EU Member States by way  of the CMU.

At present, after several years of financial crisis, the three dimensions of the European project – financial, political and economic – are converging in a “unicum”, which is rapidly accelerating the process of European integration. However, this acceleration is also dramatically highlighting the frictions, lack of convergence and institutional gaps of the current European mechanisms. The outcome of the UK referendum can arguably be listed as an unintended consequence of this process.

The financial services industry, which is a fundamental element of the European political and social landscape, can potentially play a crucial role in facilitating convergence and integration by enhancing transparency and market best practices.

Understanding the transmission channels that exist between the financial and other sectors of the economy is critical when assessing growth and financial stability. The latter is crucial as robust financial systems are viewed as those that do not adversely affect the system itself, and those that are capable of withstanding shocks and limiting disruption in the allocation of savings to profitable investment opportunities.

Thus far, politically, the financial services sector has acted as a scapegoat for the financial crisis, for market fragmentation and for political uncertainty. In this challenging political atmosphere, the EU institutions have initiated an overarching reform of the financial sector. In doing so, regulators have walked – and continue to walk – a difficult and dangerous path, in their quest to find a balance between harmonisation on the one hand and respect for national market traditions on the other, whilst at the same time limiting adverse collateral effects and ensuring social cohesion.

This new transition period is giving rise to challenges and expectations which have a much broader and deeper impact generally in EU society than ever before. The Industry is faced with the challenge of harnessing these new dynamics and contributing to the integration process by playing a proactive role in building the CMU so as to ensure financial stability and lending capacity, and to support economic growth, which remains at the heart of the European project.

In this context, the ECBC is now playing, more than ever, the role of market catalyst and think-tank, which is, in turn, allowing the market to converge and coordinate by speaking with one voice. Moreover, the role played by the ECBC in this new context ensures the smooth functioning of the market itself by identifying and implementing common qualitative standards and quantitative parameters. Looking ahead, the ECBC is determined to continue to act as the Industry discussion forum and market “lighthouse”, developing a clear vision of the challenges and opportunities on the horizon amongst market participants and, subsequently, guiding the Industry through these uncharted waters.

Regulatory Recognition

In light of the current debate on Basel IV, more than ever the covered bond community is determined to ensure that the qualitative characteristics of the covered bond asset class will be appropriately captured in the future regulatory landscape. Since the beginning of the financial crisis, a diverse set of financial regulations has been approved by the European institutions, all aimed at strengthening the financial sector and rendering it more resilient to shocks. Amongst the most notable legislative proposals are: the Basel III framework for capital requirements; the Banking Union, which encompasses the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) including the framework for resolving banks (Bank Recovery and Resolution Directive – BRRD) and the newly proposed rules for a European Deposit Insurance Scheme (EDIS); together with the revamping of the European capital market structure.

In particular, the implementation of the Capital Requirements Regulation (CRR) / Capital Requirements Directive (CRD) IV package in the EU is the backbone of the EU’s Single Rulebook for banks, which aims at providing a single set of harmonised prudential rules that all financial institutions throughout the EU (approximately 8,300 banks) must comply with, thus helping complete the single market in financial services. SME and mortgage lending, key drivers of recovery in the real economy, are predominately based on bank lending principles that are rooted in the banking supervisory tradition, which thereby facilitates due diligence for investors and proper risk assessment.

Looking at the numbers, roughly 85% of financing in the EU is provided by banks. The overall financial strength of the European economy is strongly correlated to banks’ ability to lend to both the private and public sectors.

This capacity has been impinged as a result of new global rules that require banks to increase their capital ratios.

The implementation of the Basel rules, together with the proper treatment of covered bonds and High Quality Securitisation, raises questions about how a level playing field can be ensured at the global level, especially for economies strongly reliant upon these funding instruments, such as in Europe. More importantly, as has been clearly indicated by their recognition in the ECB’s CBPP3 and ABSPP, these instruments play a pivotal role in the creation and development of a Capital Markets Union as key long-term financing tools and as a means for a common monetary policy to be effectively transmitted to the real economy.

This strong macro-prudential recognition was further confirmed by the publication of the Liquidity Coverage Ratio (LCR) delegated act by the European Commission the 10th of October 2014, in which covered bonds have been categorised as Extremely High Liquid Assets (Level 1). The ECBC welcomes the Commission’s recognition of the macro prudential value of covered bonds. Indeed, the inclusion of covered bonds in Level 1 will facilitate the aim of delinking the sovereign from the banking sector.

A Real Economy Long-term Funding Tool

Covered bonds represent a key funding tool for the future European banking industry. They are an effective way of channelling long-term financing for high quality assets at a reasonable cost.

“Covered bonds improve banks’ ability to borrow and lend over long-term horizons and, therefore, represent a stable source of funding for key banking functions such as housing loans and public infrastructure.”

For instance, long-term financing is crucial for housing finance. Building or purchasing a home is the most significant investment for the majority of European citizens, representing typically four to five times their annual income. In the absence of pre-existing wealth, they would have to wait for 40 or 50 years if they had to rely solely on their individual savings. Borrowing resources is therefore necessary to acquire a home and more generally to support the European economy.

Given the size of the investment, their repayment must be spread out over a long period to be compatible with their annual savings capacity. Long-term funding tools for banks are therefore required to avoid asset and liabilities mismatches. Covered bonds are typically designed for mortgage lending, and it is important to recall that a mortgage-focused bank tends to have more asset encumbrance than a bank with a non-mortgage focus. Cutting back lending capacities of those more specialised mortgage-focused banks would limit the credit supply to housing finance.

The efficient availability of mortgage finance is also based on the ready availability of financing at the longest tenors possible and the lowest price feasible. Without this, the mortgage market would be a function of market sentiment and the refinancing rates available to borrowers would be subject to much more price volatility, making planning for private households more challenging. In this context and in particular in times of low risk appetite from investors, covered bonds play an essential role in ensuring the flow of capital in financing long-term growth and the real economy. They offer key safety features such as a strict legal and supervisory framework, asset segregation, and a cover pool actively managed in order to maintain the quality of the collateral. During the recent financial turmoil, the existence of a well-functioning covered bond market has allowed governments in Europe to constantly channel private sector funds to housing markets and maintain a relatively efficient lending activity without increasing  the burden for taxpayers and public debt.

The growth agenda debate has also dominated economic and political discussions beyond the EU, raising the key questions of how to finance economic growth and how to create an efficient and robust long-term financing toolkit. This debate has a very high political profile as it engages key stakeholders at both an international and a national level. Furthermore this raises fundamental questions regarding the fine-tuning of the Basel III parameters and the right calibration between enhanced risk assessments, reduction of systemic risks and continued lending capabilities of the banking sector. Such discussions belong, traditionally, to an emerging market landscape, where the World Bank has always played a pivotal role in assisting the development of capital market infrastructures which aim at ensuring economic growth and social development.

Looking at the numbers produced by the World Bank,  8.3  billion  people  are  expected  to  be  alive by 2030, with 60% of them living in cities. Consequently, the global demand for new dwellings is foreseen to rise by 565 million over the same period. Furthermore, the World Bank considers that in emerging markets, five permanent jobs are created for every new housing unit built, with the figure being even higher in the developed world, thus making housing a key driver for economic growth and social stability.

Market Developments

Covered bonds are at the heart of the European financial tradition, having played a central role in funding strategies for the last two centuries. The strategic importance of covered bonds as a long-term funding tool is now recognised at a global level. Outside Europe, Australia, Canada, New Zealand and South Korea have already implemented covered bond legislation in recent years. Major jurisdictions including Brazil, Chile, India, Japan, Mexico, Morocco, Panama, Peru, South Africa and the United States, are either in the process of adopting covered bond legislation or are investigating the introduction of covered bonds.

“The strategic importance of covered bonds as a long-term funding tool is now recognised at a global level.”

In recognition of the global spread of covered bonds and with a view to ensuring that the key quality characteristics of the asset class remain its foundation around the world, in late 2015 the ECBC established a Global Issues Working Group (GIWG), which held its first meeting in Singapore in March 2016. This year’s ECBC Fact Book provides comprehensive coverage of related new legislative frameworks and developments, and shows how the ECBC, through the GIWG amongst other channels, is further strengthening its role as the principal voice of covered bonds, not just in Europe but globally.

During the recent years of market turmoil, covered bonds demonstrated a strong degree of resilience. Throughout the crisis, they played a pivotal role in bank wholesale funding, providing lenders with a cost-effective and reliable long-term funding instrument for mortgage and public-sector loans. The Industry continues to build on the lessons learnt from the financial crisis while maintaining a focus on the essential features and qualities that have made the asset class such a success story. The ECBC firmly believes that the quality of the asset class will continue to be the basis of our strength in the future.

The  success  of  covered  bonds  also  lies  in  the  Industry’s capacity to respond to the challenges of the current crisis and its ability to share market best practices. This allows a continuous fine-tuning of European covered bond legislation and facilitates a strong level of transparency for the asset class. As  indicated  above,  the  instrument  has  enabled  European Member States to continue to channel private sector funds to housing markets and maintain efficient lending activity without an additional increase of burden for taxpayers or public debt. Furthermore, the on-balance sheet nature of covered bonds is an efficient and simple alternative to complex originate-to-distribute products ensuring financial stability.

The commitment to contribute to European efforts to enhance financial stability and transparency has led the covered bond industry to launch a quality Label. The Covered Bond Label was developed by the European issuer community working in close cooperation with investors and regulators, and in consultation with all major stakeholders such as the European Commission and the European Central Bank. The Label is based on the Covered Bond Label Convention, which defines the core characteristics required for a covered bond programme to qualify for the Label.

The  Covered  Bond  Label  and  its  transparency  platform ( have been operational since January 2013, providing detailed market data, comparable cover pool information and legislative details on the various national legal frameworks designed to protect bondholders. As of August 2016, 91 labels have been granted to 77 issuers from 14 countries, covering over EUR 1.4 trillion of covered bonds outstanding. In this context, covered bond issuers have come together to develop a Harmonised Transparency Template. From 2016 onwards (with a one year phase-in period), this provides cover pool information in a harmonised format, which allows for both the recognition of national specificities, with the National Transparency Tabs, and the comparability of information required to facilitate investors’ due diligence.

The critical mass achieved by this initiative (c. 60% of covered bonds outstanding globally hold the Label) is a clear sign that the Industry sees the need to respond to the requirements of new classes of investors by providing higher levels of transparency  to aid investment decisions. Equally, it is important to highlight the progress that has been made in recent years in terms of collating and distributing relevant macro-level information on the covered bond sector:

  • The ECBC website continues to be the primary site for aggregate covered bond market data and comparative framework analysis; and
  • The ECBC Fact Book, now in its eleventh edition, remains the most widely read source of covered bond market intelligence.

Looking Ahead

In conclusion, the ECBC believes that the quality of the covered bond asset class will be the basis of our strength in the future. Over the last two centuries the asset class has made a significant contribution in Europe to supporting the real economy and ensuring financial stability. The Industry has demonstrated that through market initiatives such as the Covered Bond Label and the recently proposed European Secured Note (ESN), it is possible to build, from the bottom up, proposals based on market consensus in order to initiate pan-European solutions which enhance transparency, comparability, convergence of markets and best practices. Furthermore, it has been possible to do this without over-regulating and, thereby, potentially jeopardising the capabilities of lenders to support the growth agenda.

More work needs to be done, but we believe that the initiatives underway will strengthen the asset class and facilitate the convergence of market and supervisory best practices. The increased recognition by policymakers and regulators of the central role that the asset class plays for the banking system and also for wider financial stability reinforces the need for an appropriate regulatory framework for covered bonds at both European and international levels. This will be our objective for the coming years.

This article was originally published in the July-August 2016 edition of the EMF-ECBC newsletter Market Insights & Updates. Please note that any views or opinions expressed in this article are those of the authors and not necessarily those of the EMF-ECBC.  This article does not constitute investment advice.