Not cleared from scrutiny; further information requested; but scrutiny waiver granted
(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.
Article 114 TFEU; ordinary legislative procedure; QMV
(a) (39544), 7064/18 + ADDs 1–2, COM(18) 94; (b) (39555), 7066/18 + ADDs 1–2, COM(18) 93
13.1In March 2018, the European Commission proposed a . Its aim is to address divergent national regulatory practices with respect to the technical aspects of the EU’s covered bond market and increase their uptake within and outside the Single Market under a harmonised regulatory framework. The proposal forms part of the wider efforts to construct a European Capital Markets Union (CMU), a set of legislative and non-legislative initiatives to widen the EU’s pool of capital across Member State borders.
13.2Covered bonds are a type of debt obligation issued by banks. They areseen as very safe investments because they are secured against a ring-fenced pool of high-quality, low-risk assets (typically residential mortgages), which 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.
13.3The 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 ) 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 EU has not to date substantively regulated matters relating to the actual issuance of covered bonds, such as prudential, governance or transparency requirements.
13.4Concretely, the proposed EU 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 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 to amend the Capital Requirements Regulation) in a way that the purchase of a covered bond issued outside the Single Market would not.
13.5The Economic Secretary to the Treasury (John Glen) submitted an with the Government’s views on the proposal in April 2018. The Government has been broadly supportive of the proposed legislation but will seek to “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”.
13.6In the context of Brexit, it was especially relevant that the Commission proposal does 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. Were such a mechanism included, it could mean for example that bonds issued in that country would trigger the same prudential and regulatory reliefs as EU-issued covered bonds. Instead, EU banks investing in covered bonds issued outside the EEA would remain entitled to an 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.
13.7The new Directive 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.
13.8The European Scrutiny Committee first considered the proposal , and retained it under scrutiny pending the outcome of the legislative process (and in particular to see whether the Government would be able to successfully push for ‘equivalence’ provisions in the Directive). We summarised the possible impact of the new legislation in the context of the UK’s EU exit as follows:
13.9The Economic Secretary provided further updates to the Committee’s by letters dated , and . The Minister’s letters provide information on Member States’ deliberations on the proposal in the Council, and the likely substance of the amendments they will seek to make to the text of the Directive in future negotiations with the European Parliament.
13.10The Minister’s latest letter confirmed that EU Finance Ministers were expected to endorse a common position—a so-called ‘general approach’—when the EU Council meets in Brussels on 4 December 2018. Following discussions within the Council, the Minister explained the general approach (which is still under negotiation) was likely to recommend several amendments to the Commission proposal for negotiation with the European Parliament. The areas affected would be:
13.11The Council has discussed ways of ensuring a balance between introducing EU-wide harmonised requirements for the quality of assets against which covered bonds are secured (so there is a guaranteed level of quality of the pool) against the need to consider the “specificities and differences across national covered bond regimes” (which are well-developed and established in a number of EU countries, notably Denmark and Germany).
13.12In particular, a sub-set of EU countries has argued that the eligibility requirements for assets included in the cover pool (against which covered bonds are secured) should be more flexible, in particular for countries where many counterparties may not qualify for the highest credit rating (the so-called ‘credit quality step’) required by the original Commission proposal. The Council is therefore likely to support 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.
13.13Although the UK has “reservations over the inclusion of exposures with a lower rating (credit quality step 3) into the covered bond framework, [other] Member States have supported this” and therefore room for further changes ahead of the Council meeting in December 2018 is limited. The Treasury also “expect[s] that the compromise text will provide a Member State option to include loans involving public undertakings” in the cover pool, subject to certain safeguards on safety and soundness criteria”.
13.14To avoid the imposition of duplicated prudential requirements incumbent on banks under the Covered Bonds Directive (the liquidity buffer) and the existing Capital Requirements Regulation for banks (the Liquidity Coverage Requirement), EU countries are looking for an exemption allowing them to dis-apply the liquidity buffer provisions altogether where the LCR requirement already applies.
13.15The Government supports the approach to avoiding a duplication of prudential requirements between the CBD and the CRR, with the Minister explaining in his latest letter that, if these requirements are not reconciled, “firms will be subject to a double liquidity requirement for covered bond outflows”.
13.16To ensure that covered bonds issued before the new Directive takes effect remain valid (even if they are not compliant with all its requirements), the original Commission proposal contained a transitional measure in Article 30 that would maintain the validity of such bonds so long as they were in compliance with the applicable national rules when issued.
13.17In addition, the Member States want to make an amendment to create a specific grandfathering provision for covered bonds sold by the technique of ‘tap issuance’. This means that a bond, after it has been issued, can be reopened for additional offerings to the market after it has been initially introduced. The Minister informs us that “this technique is uncommon in the UK but used more widely in other Member States”, and without a specific amendment pre-issued bonds in this category would not “reach the volumes originally intended, resulting in lower levels of liquidity and discouraging investors”. The Government therefore supports this change.
13.18Equivalence is a mechanism under EU financial services law that allows the regulatory regime of a non-EU country to be declared ‘equivalent’ to that of the European Union. The effects of such a determination vary sector-by-sector, but can create preferential levels of market access for firms from the ‘third country’ in question to operate within the EU, or remove regulatory hurdles for European banks or investment firms to engage in transactions with firms from that country. Equivalence can, however, be unilaterally withdrawn by the EU if it believes the regulatory approach of a non-EU country has stopped delivering equivalent outcomes.
13.19Once the UK leaves the Single Market, whether in March 2019 in a ‘no deal’ Brexit scenario or at the end of any transitional period under the Withdrawal Agreement, UK-issued bonds will automatically cease to be covered by the new Directive and could not be marketed a ‘European Covered Bond’ within the EU. As the Commission proposal for a Covered Bonds Directive contains no equivalence mechanism, there will be no legal mechanism for UK-issued bonds to be treated in the same was as EU-issued bonds for the purposes of the Directive. Consequently, EU banks and investment firms would no longer benefit from prudential reliefs if they purchase UK covered bonds, decreasing the latter’s attractiveness to institutional investors within the EU.
13.20The Government had sought the introduction of an equivalence mechanism into the draft Directive during the legislative process in the Council, but has been unsuccessful. The Economic Secretary has nevertheless “welcomed the Commission’s openness to developing a third country regime in the future”, and has secured the support of other Member States for a review of the possibility of introducing equivalence for covered bonds within two years after the Directive takes effect (rather than three years, as originally proposed by the Commission). This is likely to bring the date of the review forward from 2023 to 2022.
13.21We also understand that the European Parliament’s Economic & Monetary Affairs Committee has called for an equivalence mechanism for covered bonds. However, it remains to be seen whether it will be included in the final Directive, given there does not appear to be sufficient support for the immediate introduction of ‘equivalence’ among the remaining Member States.
13.22As noted, EU Finance Ministers are expected to adopt a ‘general approach’ on the Directive at the Council meeting on 4 December 2018. This would serve as the basis for future negotiations with the European Parliament on the final text of the legislation (the proposal is subject to the ordinary legislative procedure, meaning it must be jointly agreed by the Parliament and the Council).
13.23In light of this, the Minister says he believes “there is a pathway to reaching a compromise that would serve as a robust EU framework and reflects the well-functioning UK covered bond market”. The Government therefore expects to support the general approach at the December Council meeting, and has therefore requested the Committee grant a scrutiny waiver enabling it to vote in favour.
13.24On the European Parliament side, the Economic and Monetary Affairs Committee adopted its position on the covered bonds proposal on 20 November 2018. Consequently, the Government expects negotiations between the Parliament and the Council on the final text of the Directive “to commence [soon] for an overall agreement to be found before the end of this European Parliament’s term” in spring 2019. The Directive would then most likely become applicable at some point in late 2020, as the Member States have called for a transposition period of 18 months.
13.25We thank the Minister for the comprehensive information he has provided on the Covered Bonds Directive throughout the legislative process, in particular in relation to the question of an ‘equivalence’ regime for third country issuers and the prudential requirements that will underpin the ‘safe’ nature of a covered bond issued within the EU under the new legislation.
13.26Given the ambition for adoption of the Directive before the European Parliament elections in spring 2019, it is likely the new legislation would become applicable during the UK’s post-Brexit transitional period (if the draft Withdrawal Agreement is ratified). At that point, EU law would apply as if the UK were still a Member State, and consequently the Directive would have to be transposed into domestic law. As such, it is right that the Government has been actively involved in the legislative negotiations and we are pleased the Treasury believes the compromise found with other Member States would not disrupt the UK’s existing market for covered bonds. We hope the outcome of the upcoming negotiations with the European Parliament will not affect that overall assessment.
13.27The implications of the Directive for the UK after it leaves the Single Market currently appear negligible. The UK would be free to disregard the provisions of the Directive as Parliament sees fit. However, by extension UK-issued covered bonds—while they could still be sold to EU-based investors—would also no longer entitle EU financial market participants to any prudential or regulatory reliefs, potentially making them less attractive for international investors. If the Directive included a mechanism for granting ‘equivalence’ to the covered bonds regime of a non-EU country, such preferential treatment could be extended to bonds issued outside of the EU. We note however that there the prospect of an equivalence regime being included in the first iteration of the Directive seems remote, given that there has been no widespread support for it among Member States. However, a Commission review would take place early in the next decade to assess whether one should be established.
13.28It is also clear from the Minister’s letters the Government is actively seeking the introduction of an equivalence mechanism for covered bonds. This is linked clearly to the Political Declaration on the future UK-EU partnership, which unequivocally states that post-Brexit trade in financial services between the two will take place on the basis of ‘equivalence’. This will effectively allow both sides to determine, autonomously, in which sectors financial services firms from the other party should have preferential access to its domestic market, including in areas like investment services, clearing of derivatives and—potentially at a future stage—covered bonds. Those decisions could also be modified or revoked unilaterally.
13.29We reiterate our concerns that reliance on equivalence for post-Brexit UK-EU trade in financial services is potentially problematic. It 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. This is a matter that Parliament should keep under review as it monitors the substance of the equivalence decisions, work on which would begin in spring 2019 shortly after the UK’s formal withdrawal from the EU.
13.30With respect to the Covered Bonds Directive specifically, given that the Government appears to be satisfied overall with the direction of travel in the Council, we are content to grant the Minister a scrutiny waiver to enable the UK to support the adoption of a general approach. We ask the Minister to write to us again to inform of us the outcome of the trilogue process with the European Parliament in good time before formal adoption of the final legislation in 2019.
(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), + 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), + ADDs 1–2, COM(18) 93.
86 Credit quality steps (CQS) map a financial institution’s credit rating against the systems used by the two largest credit rating agencies (S&P and Fitch’s). CQS3 is the lowest investment-grade rating.
87 This exemption would be optional for Member States to use at their own discretion.
88 Under the Commission proposal, assets held to cover the liquidity buffer for covered bonds could not be used to count towards a bank’s general Liquidity Coverage Requirement (and vice versa).
89 The European Parliament Committee voted on the proposal on 20 November 2018.
90 The transitional period would last until 31 December 2020, but could be extended for an (unspecified) period of time under Article 132 of the Withdrawal Agreement.
91 See .
92 See our on prudential requirements for investment firms for more information on equivalence for investment services.
93 See the separate chapter of this Report on supervision of central counterparties for more information on equivalence for clearing of derivatives.
Published: 4 December 2018