Documents considered by the Committee on 27 March 2019 Contents

8Regulation of covered bonds

Committee’s assessment

Politically important

Committee’s decision

Cleared from scrutiny; drawn to the attention of the Treasury Committee

Document details

(a) Proposal for a Directive on the issue of covered bonds and covered bond public supervision and amending Directive 2009/65/EC and Directive 2014/59/EU; (b) Proposal for a Regulation amending Regulation (EU) No 575/2013 as regards exposures in the form of covered bonds

Legal base

(a)Articles 53 and 114 TFEU; ordinary legislative procedure; QMV (b) Article 114 TFEU; ordinary legislative procedure; QMV



Document Numbers

(a) (39544), 7064/18 + ADDs 1–2, COM(18) 94; (b) (39555), 7066/18 + ADDs 1–2, COM(18) 93

Summary and Committee’s conclusions

8.1Covered bonds are a type of debt obligation issued by banks. They are very safe investments because they are secured against a ring-fenced pool of high-quality, low-risk assets (typically residential mortgages), which the bond holders can access directly as preferred creditors if the bank issuing the bond cannot make its contractual payments. The UK market is estimated to amount to €121 billion (£107 billion) of outstanding covered bonds, making it a relatively small player: the primary issuers in Europe are Germany and Denmark, which each had outstanding volumes of roughly €380 billion (£327 billion) in 2015.84

8.2The low-risk nature of these bonds allows the issuing bank to offer a low interest rate, making them a relatively cheap way of raising capital that can then be used to finance business and consumer loans. For the same reason, EU prudential legislation (the Capital Requirements Regulation) contains certain regulatory and prudential reliefs for EU-based financial institutions, such as investment funds, banks and insurers, which purchase covered bonds issued by EU banks. However, the European Union has not to date substantively regulated or harmonised the legal aspects governing actual issuance of covered bonds themselves, such as prudential, governance or transparency requirements.

8.3Since 2015, the EU has been engaged in the process of constructing a Capital Markets Union (CMU) where barriers to cross-border flows of capital are dismantled with the ultimate aim of providing European businesses with cheaper and more varied access to finance. This process, which has been strongly supported by the UK Government, included an assessment of the feasibility of an EU-level legal framework for the issuance of covered bonds, because of concerns that divergent national regulatory practices limited sales of such bonds to other EU Member States or even investors outside the Single Market. The underlying logic was that a potential European legal framework would make it cheaper for EU banks to issue such bonds, in turn increasing available capital for business loans.

8.4In March 2018, the European Commission therefore proposed an EU-level regulatory framework for covered bonds.85 Concretely, a new Directive would set minimum harmonising standards for the issuance of all covered bonds within the European Union (such as who can issue them and how the cover pool must be designed). Products that are compliant can carry the label ‘European Covered Bond’ (ECB). Purchase of such an ECB by an EEA-based investment fund, bank or insurer would trigger the application of the existing regulatory or prudential reliefs (the latter of which will be subject to tighter requirements under a parallel proposal to amend the Capital Requirements Regulation) in a way that the purchase of a covered bond issued outside the EU would not.86

Parliamentary scrutiny of the Covered Bonds Directive

8.5The Economic Secretary to the Treasury (John Glen MP) submitted an Explanatory Memorandum with the Government’s views on the proposal in April 2018. The Government was broadly supportive of the proposed legislation and said it would seek “ensure that [the] proposals will enhance comparability, transparency and market stability by helping investors better understand the profile and risks of a programme as they undertake their due diligence”.

8.6The European Scrutiny Committee first considered the proposal on 25 April 2018, placing it in the particular context of the UK’s withdrawal from the European Union. Because of Brexit, we noted it was especially relevant that the Commission proposal did not contain an ‘equivalence’ provision which would allow the EU to recognise the regulatory framework for covered bonds of a “third country” (like the UK after it leaves the Single Market) as equivalent.87 Were such a mechanism to be included, bonds issued in an ‘equivalent’ country would trigger the same prudential and regulatory reliefs as EU-issued covered bonds.88 In the absence of an equivalence framework, EU financial institutions investing in covered bonds issued outside the Union—for example by British banks after it leaves the Single Market—would remain entitled to the existing, more limited prudential relief with respect to their liquidity buffer. The proposal would also allow individual EU countries to prohibit banks from including non-EU assets in their cover pool.

8.7In our previous Report on this matter, we also took note of the post-Brexit transitional period being sought by the Government. Under the text of the draft Withdrawal Agreement published in March 2018, which remained mostly unchanged in the final version published eight months later,89 the UK would stay in the Single Market and Customs Union until at least December 2020, even after it had formally ceased to be a Member State of the EU, to avoid disruption to trade and transport links with the remaining Member States. In return however, it would continue applying EU law, including new legislation which only took effect during the transition. In light of this, we concluded that—should the Withdrawal Agreement be ratified—the new Covered Bonds Directive could apply to the UK as if it were still a Member State (meaning it would have to be transposed into UK law in full, overriding any existing regulatory framework where the two were incompatible). By extension, UK-issued bonds would also trigger the new, more generous prudential reliefs when purchased by financial institutions in the EU (at least until the end of the transition period).

8.8The Economic Secretary provided further updates to the Committee on progress towards adoption of the Covered Bonds Directive by letters dated 6 August, 11 October and 21 November 2018. The latest of these confirmed that Member States were expected to endorse a common position before the end of 2018, which contained several amendments to the Commission proposal for discussion with the European Parliament. As set out in more detail in our Report of 28 November 2018, the Council’s amendments focussed on the eligibility requirements for the quality of assets—mortgages—included in the cover pool and liquidity buffer which bank covered bonds; the avoidance of duplicate prudential requirements under the Covered Bonds Directive and the existing Capital Requirements Regulation; and the possibility of an ‘equivalence’ regime granting similar prudential treatment to covered bonds issued by a non-EU country.

8.9On the European Parliament side, the Economic and Monetary Affairs Committee adopted its position on the covered bonds proposal on 20 November 2018. While the Parliament broadly supported the thrust of the Commission proposals, MEPs also called for a two-tier system of labels—”premium” and “ordinary”—for covered bonds depending on the quality of the assets backing them, and an equivalence mechanism to facilitate the sale of covered bonds issued outside the EU to European investors.90 Negotiations between the Parliament and the Council on the final text of the Directive began in late 2018.

The final agreement on the Covered Bonds Directive

8.10By letter dated 18 March 2019, the Economic Secretary informed us that the Parliament and the Member States had reached final agreement on the Covered Bonds Directive on 27 February 2019. With respect to the substance of the final legislation, the Minister notes that:

8.11The Directive and accompanying prudential Regulation are due to be formally adopted by the Council and the European Parliament in the near future, potentially in April 2019. It would take effect some 30 months later, i.e. in autumn 2021. This procedural timetable means that the Government may not be represented when the legislation is formally approved by the Council of Ministers, because it will have no right to be represented after the UK ceases to be a Member State (even if the transitional period in the Withdrawal Agreement takes effect).94

8.12In his letter, the Minister asks for the file to be cleared from scrutiny so that Government—if still able to do so—can support its adoption in the Council. He notes that “the agreement upholds the high standards of the UK covered bonds market”, and it would therefore be “in the UK’s interest to vote in favour of the final legislation”. However, the final agreement does not contain an ‘equivalence’ regime as sought by the UK, which would have allowed covered bonds issued outside the EU to attract the same prudential reliefs as European ones if they originated in a country with a similar regulatory approach. However, the legislation mandates the European Commission to review whether the introduction of such a ‘third country’ framework would be appropriate in 2023, two years after the Covered Bonds Directive takes effect. Any legislative proposal to introduce an equivalence regime into the legislation would require further negotiations between the European Parliament and the Council.

8.13The likely impact of the new legislation in the context of the UK’s EU exit is as follows:

8.14If an ‘equivalence’ framework were to be introduced into the Directive in the future, the Government would have to decide whether to align UK law to the EU legislation to the extent necessary to obtain an equivalence declaration from the European Commission. This would reduce the scope for changes to the UK’s domestic regulations on covered bonds, unless the Government was willing to risk having the equivalence decision revoked by the EU.

8.15It is interesting in this context that the Treasury in late 2018 published its Financial Services (Implementation of Legislation) Bill, under which it would have the power to implement the EU’s new covered bonds legislation by means of Statutory Instruments in the event of a ‘no deal’ Brexit.96 The Government has argued it merits being implemented swiftly in the UK, even without an EU legal obligation to do so, because the new framework for covered bonds “represents an improvement on the current regime”.97 The Bill is currently awaiting its third reading in the House of Commons. Exactly what changes the Government would want to make to the UK’s covered bonds regime in a ‘no deal’ scenario using these powers is unclear.

Our conclusions

8.16We thank the Economic Secretary for his latest update on the EU’s new Covered Bonds Directive. It is now clear that, if the UK’s Withdrawal Agreement on exiting the EU—and with it the post-Brexit transitional period—is ratified by Parliament, the new legislation could apply in the UK in full from autumn 2021 until the end of any extended transition period (which could be as late as 31 December 2022).

8.17In light of this, we welcome the Minister’s reassurance that the Government supports the substance of the new legislation as now agreed, and considers it compatible with the UK’s existing regulatory regime. Although the Treasury initially expressed concerns about widening the eligibility requirements for the asset pool for a covered bond appear, we note that the two-tiered labelling system will allow investors to differentiate between bonds backed by different classes of assets. However, it does not appear that individual Member States—and the UK, during any transitional period—could only permit issuance of ‘premium’ covered bonds within the meaning of the Directive, or restrict the marketing of ‘ordinary’ covered bonds issued in other EU countries.

8.18From previous correspondence with the Minister, it was also clear the Treasury had sought the introduction of an equivalence mechanism for covered bonds in the Directive. This would have allowed the European Commission to grant the same prudential reliefs to a ‘third country’ bond as will be accorded to their EU-issued counterparts, if the European Commission was of the view that that country’s regulatory regime achieves the same outcomes in ensuring the safe nature of investing in covered bonds. The Government’s approach was clearly linked to the Political Declaration on the future UK-EU partnership, which unequivocally states that post-Brexit trade between the two across the spectrum of financial services in general should take place on the basis of sector-by-sector equivalence as permitted by EU and UK law (rather than a system of mutual recognition initially sought by the Treasury in the earlier stages of the Brexit negotiations).98

8.19Although we have repeatedly expressed concerns about the implications for the UK’s regulatory autonomy of relying on equivalence to access the EU’s much larger market for financial services after Brexit,99 we note that the final Covered Bonds Directive in fact does not, the Government’s efforts notwithstanding, contain such a ‘third country’ regime. This means that there will be no legal mechanism for UK-issued covered bonds to attract the same prudential reliefs when bought by EU-based institutional investors after the UK leaves the Single Market, even if the UK voluntarily implements the Directive to the letter. This is likely to make UK covered bonds less attractive to prospective institutional investors in the European Union, since it would require a higher amount of regulatory capital. More generally, we are concerned that this development is indicative of a lack of appetite on the EU’s part to introduce a wider and more stable equivalence regime to underpin its future trade in financial services with the UK. It is noteworthy in this respect that the Political Declaration on the future UK-EU partnership only commits the EU to keeping its equivalence frameworks “under review”.100 Individual EU Member States could also decide to exclude assets from eligibility in the cover pool if they are located outside the EU, which will include UK assets after it leaves the Single Market.

8.20We have also taken note of the inclusion of the Covered Bonds Directive in the scope of the Financial Services (Implementation of Legislation) Bill, allowing it to be implemented by the Treasury by means of regulations in a ‘no deal’ Brexit scenario (in which case there would be no EU legal obligation on the UK to do so). It is unclear what changes the Government wishes to make to the UK’s existing regulatory framework in this area using its powers, especially now that there is no prospect of the UK securing an ‘equivalence’ determination in return for applying the Directive voluntarily. We urge the House to consider any future statutory instruments carefully to ensure the Government does not use them to make substantial regulatory changes that ought to be introduced via primary legislation.

8.21In view of their imminent adoption by the Council, we are content to now clear the Covered Bonds Directive and the accompanying prudential Regulation from scrutiny. We also draw these developments to the attention of the Treasury Committee.

Full details of the documents

(a) Proposal for a Directive on the issue of covered bonds and covered bond public supervision and amending Directive 2009/65/EC and Directive 2014/59/EU: (39544), 7064/18 + ADDs 1–2, COM(18) 94; (b) Proposal for a Regulation amending Regulation (EU) No 575/2013 as regards exposures in the form of covered bonds: (39555), 7066/18 + ADDs 1–2, COM(18) 93.

Previous Committee Reports

See (39544), 7064/18 + ADDs 1–2, COM(18) 94: Twenty-fifth Report HC 301–xxiv (2017–19), chapter 5 (25 April 2018) and Forty-sixth Report HC 301–xlv (2017–19), chapter 13 (28 November 2018).

84 See Commission document SWD(2018) 50, p. 6. In 2015, the UK was the seventh largest market for covered bonds in the EU, after Germany, Denmark, the Netherlands, Spain, Sweden and Italy.

85 The Commission confirmed such a proposal was forthcoming in its mid-term review of the Capital Markets Union, published in June 2017.

86 The amended version of the Capital Requirements Regulation would state that “preferential treatment” would be available for holders of covered bonds “as referred to” in article 2 of the new Directive, which in turn refers to “ covered bonds issued by credit institutions established in the [European] Union”.

87 Decisions formally recognising the regulatory framework of a non-EU country in a particular financial sector as ‘equivalent’ to the applicable EU rules are taken (and can be revoked) by the European Commission, with the support of a qualified majority of Member States.

88 The new Directive as proposed by the Commission would require the Commission to assess within three years of the new framework becoming operational “whether a general equivalence regime for third-country covered bond issuers and investors is necessary or appropriate”. The Minister ‘noted’ this fact in his Explanatory Memorandum, but made no further comment on the matter.

89 The key difference between the draft Withdrawal Agreements published in March and November 2018 is that the latter contained a mechanism for an extension of the transitional period, from 31 December 2020 to 31 December 2022, by mutual agreement between the UK and the EU.

90 The European Parliament Committee voted on the proposal on 20 November 2018.

91 This discussion was driven by the position of countries where many counterparties may not qualify for the highest credit rating, and by extension, not for inclusion in the cover pool for covered bonds. The Member States—the UK’s concerns notwithstanding—therefore supported an amendment allowing the use of derivative counterparts qualifying only for a lower credit rating (‘credit quality step 3’) under “specific conditions”. Similarly, some Member States have called for the option of including exposures to banks with a lower credit rating and short-term exposures in the liquidity buffer (the ring-fenced liquid assets that ensure issuing banks have sufficient capacity to make covered bond repayments even if they go insolvent), although individual Member States would have the ability to exclude such assets from eligibility for the liquidity pool in their domestic legal frameworks.

92 As explained by the Minister, the asset criteria in article 129 of the CRR outline the requirements for covered bonds that are afforded a preferential prudential treatment, reflecting the risk they pose. The label for “ordinary covered bonds” will be given to other assets that do not meet CRR article 129 but meet other specific requirements.

93 The European Parliament wanted such lower-quality exposures limited to 5%, whereas the Member States in the Council had called for 10%.

94 Following the Decision of the European Council of 22 March 2019, the UK’s exit date as a matter of European law has been pushed back from 29 March 2019.

95 Article 132 of the Withdrawal Agreement allows the UK and the EU to jointly decide to extend the transition period once for a maximum period of two years, i.e. until 31 December 2022.

96 The Government will not have the power to implement the Covered Bonds Directive by regulations under the European Union (Withdrawal) Act 2018 because the EU legislation will not be in force on the day the UK is due to leave the European Union.

97 Memorandum from HM Treasury on the Financial Services (Implementation of Legislation) Bill to the Delegated Powers and Regulatory Reform Committee (accessed 27 February 2019).

99 In particular, relying on equivalence—which is unilaterally declared and revoked—could either see the UK constrained to stay in tandem with development of EU financial services law without any say over future amendments (given that the UK exports more financial services to the EU-27 than vice versa), or risk losing market access for its financial services industry at short notice where it diverges from the EU’s regulatory approach in a given area.

100 We have reached similar conclusions in this Report’s separate chapter on the EU’s Investment Firm Review, where an existing equivalence regime on ‘third country’ market access for wholesale investment services has been made less, not more, accessible for the UK after Brexit.

Published: 2 April