Covered bonds harmonisation: recent EBA recommendations and resolution by the European Parliament


Financier Worldwide Magazine

January 2018 Issue

Covered bonds are ‘dual recourse’ instruments issued by banks. They establish an unlimited payment liability by the issuing bank, which is ‘covered’ by a pool of assets that is segregated from the bank’s insolvency estate and protected from enforcement by the bank’s general creditors. In most jurisdictions the assets eligible for the pool are either mortgages, which are subject to strict valuation criteria and a loan-to-value ratio which usually ranges between 60 percent and 80 percent, or are loans to public sector entities, in particular, central governments and municipalities, or entities whose liabilities are guaranteed by them. Historically, covered bonds have been a popular low-risk investment for retail and institutional investors alike, and have played an important role in funding the mortgage market. Since the turn of the century, covered bonds have been a key funding instrument of the banking industry and have helped the industry to weather the financial crisis, due to their eligibility for refinancing at the European Central Bank.

Currently, covered bonds are not broadly regulated or harmonised by EU law. This means that each jurisdiction has, more or less, defined its own format of covered bonds, which is aligned to the local insolvency law and, in the case of mortgage covered bonds, local mortgage and property law. Often, these local types of covered bonds have grown historically over long periods. Not harmonising covered bond law makes sense, as neither insolvency law (other than for the restructuring and resolution of financial institutions), nor property and mortgage law are currently broadly harmonised. Also, there is no need for broad harmonisation, as the European market for covered bonds has worked well so far, making an enormous contribution to the provision of liquidity to Europe’s financial industry.

Regardless of the absence of full harmonisation, EU law addresses covered bonds in a number of ways. For instance, a very broad definition of covered bonds is contained in the UCITS directive, to privilege covered bonds against the general ‘per issuer’ investment limits otherwise imposed on investment funds. Art. 129 Capital Requirements Regulation (CRR) cross-refers to the UCITS directive to define covered bonds which, when held by a CRR institution, benefit from a lower risk weighting for the purpose of solvency and full or partial exemption, subject to the discretion being exercised by supervisors or Member States, from large exposures. Covered bonds may also be used for liquidity coverage ratio (LCR) purposes as a liquid asset that contributes to a bank’s liquidity ratios, and enjoy certain privileges under the European market infrastructure regulation (EMIR). Finally, covered bonds are exempt from ‘bail-in’ in case of the resolution of a bank under the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism Regulation (SRMR).

Recently, the EU has started a push to harmonise some, if not all, areas of covered bond laws, under the umbrella of the EU’s capital markets union. The action plan provided the basis for a consultation on an EU-wide framework for covered bonds, including similar structures for loans to SMEs. The consultation showed that full harmonisation was not desired; on the contrary, the market expressed a strong preference for preserving the current multitude of covered bond structures within the EU. Any harmonisation would have to take this into account, and would limit itself to certain principle-based aspects. In its notice of 8 June 2017, the European Commission announced the submission of a legislative proposal for an EU-framework of covered bonds in the first quarter of 2018, including (potentially) the introduction of ‘European Secured Notes’ (ESNs) as an instrument to fund SMEs and infrastructure.

These activities have been accompanied by recommendations for harmonisation made by the European Banking Authority (EBA). The EBA analysed covered bond frameworks in 22 member states, including recent market trends, and recommended a three step approach for harmonisation – the EU-legislative act, amendments to the CRR and voluntary convergence. In particular, Art. 52(4) UCITS directive should be defined in more detail, and the information requirements in Art. 129(7) CRR applying to the privileged investment in covered bonds should be expanded to provide for added transparency. Further recommendations include more specific rules in Art. 129 CRR for the suitability of cover assets, limits for substituting assets, loan-to-value (LTV) limits for mortgage pools and minimum over-collateral. Proposed voluntary convergence includes the composition of cover pools and requirements for cover assets with a non-Member State relation, the calculation of LTVs and stress tests by covered bond issuers.

Most recently, the European parliament (EP), on its own initiative, adopted a decision on 4 July 2017 to define an EU-wide framework for covered bonds. The parliament pointed out that a mandatory harmonisation of national covered bond models or their replacement by a European model could lead to unintended negative consequences for markets and confirmed that a more integrated European framework should be limited to a principle-based approach, to safeguard the existing multitude of covered bond models embedded in national laws.

The parliament called on the Commission to present an EU framework directive defining ‘premium covered bonds’ (PCBs), ‘ordinary covered bonds’ (OCBs) and ESNs. PCBs would have to fulfil at least the current standards for favourable regulatory treatment set out by Art. 129 CRR. OCBs, while not fulfilling Art. 129 CRR, would not fall below the standards currently set by Art. 52 para. 4 of the UCITS directive. The EU framework directive is expected to be complemented by a proposal for a revision of the European legislation which specifies the regulatory treatment of these instruments.

The parliament, while calling for an EU framework that clearly distinguishes between the two types of covered bonds on the one hand and covered bonds and ESNs on the other, stressed that independently of a potential preferential treatment, PCBs, OCBs and ESNs should, throughout the life of the instruments, comply with a set of common principles. According to the EP, such common principles should comprise full backing by cover pool assets, dual recourse, effective segregation of cover pool assets, bankruptcy remoteness, overcollateralisation (by levels defined by national law), maximum LTV levels (as defined by European or national law), liquidity buffer, special public supervision framework and transparency requirements.

As to PCBs, the parliament called for an alignment of the definition of PCBs with the requirements for preferential treatment, such as eligible assets and maximum LTV levels, set out in an amended Art. 129 CRR.

Furthermore, the parliament called on the EBA to issue recommendations on certain important features of PCB, OCB and ESN regimes, such as eligibility criteria for assets (substitution assets), LTV ratios and minimum effective overcollateralisation levels for different asset classes.

The European Commission’s proposal for a directive is scheduled for the first quarter of 2018. It remains to be seen if it will strike the right balance between the harmonisation of a European framework and adequate leeway for the continued consideration of specificities of national covered bond regimes and property markets in the Member States.


Friedrich Jergitsch is a partner and Stella Klepp is a senior specialist regulatory at Freshfields Bruckhaus Deringer LLP. Mr Jergitsch can be contacted on +43 1 515 15 ext. 218 or by email: Ms Klepp can be contacted on +43 1 515 15 ext. 578 or by email:

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Friedrich Jergitsch and Stella Klepp

Freshfields Bruckhaus Deringer LLP

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