Not cleared from scrutiny; further information requested; drawn to the attention of the Treasury Committee
(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
5.1In March 2018 the European Commission proposed a new EU-level regulatory framework for covered bonds, a type of debt obligation issued by banks that offers bondholders extra security in case the issuer goes insolvent. Covered bonds are seen 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 issuer of the bond cannot make their contractual payments. Germany and Denmark are the largest markets for this type of debt instrument globally, with outstanding volumes totalling approximately €383 billion (£333 billion) each. The UK market is estimated to amount to €121 billion (£100 billion) of outstanding covered bonds.
5.2The 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 financial services legislation 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 (see “Background” below). However, the EU has not to date substantively regulated matters relating to the issuance of covered bonds, such as prudential, governance or transparency requirements.
5.3To address divergent national regulatory practices with respect to the technical aspects of the covered bond market, and increase their uptake in- and outside of the Single Market under a harmonised regulatory framework, the European Commission has now proposed a Directive with minimum harmonising standards for the issuance of all covered bonds within the European Union, and 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 parallel proposal to amend the Capital Requirements Regulation) in a way that the purchase of a covered bond issued outside the Single Market would not. We have described the substance of the proposed regulatory framework in more detail in paragraphs 5.25 to 5.27 below.
5.4The 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, which would mean 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 European Economic Area (EEA) would remain entitled to an existing, more limited prudential relief with respect to their liquidity buffer. The new Directive would, however, 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 proposal would also allow individual EU countries to prohibit banks from including non-EU assets in their cover pool.
5.5The Economic Secretary to the Treasury (John Glen) submitted an Explanatory Memorandum with the Government’s views on the proposal in April 2018. The Government is broadly supportive of the proposed legislation, but will seek to use the UK’s part in the legislative process before Brexit in March 2019 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”. The Minister also “notes” the Commission’s intention to assess the need for a third country ‘equivalence’ regime to recognise non-EU covered bonds as meeting EU criteria for prudential reliefs at some stage in the future, but makes no further comment on the matter.
5.6The UK market for covered bonds forms only a small part of its capital markets, but with £100 billion outstanding it is nonetheless significant. We note that the Minister has not raised any substantive concerns about the impact the new EU regulatory framework for such bonds may have on the existing UK regulatory approach. It is unclear whether this is because the proposals would not materially alter the current framework, or because the legislation is not expected to have an impact on the UK due to its withdrawal from the European Union. We note in this regard that the Government has sought a post-Brexit transitional arrangement during which EU law would continue to apply, which may include the new Covered Bonds Directive should it take effect during this period.
5.7Broadly speaking, the impact of the new legislation in the context of the UK’s EU exit, based on the current state of the Article 50 negotiations, can be summarised as follows:
5.8The situation as described above may change as a result of the negotiations between the Government and the EU on a new trade agreement on financial services, where the UK is seeking a horizontal presumption of mutual recognition of regulatory standards combined with a mechanism to assess continued alignment of regulatory outcomes on an on-going basis. There has been no substantive indication from the European Commission or the remaining Member States that they would contemplate such a radical departure from the existing case-by-case ‘equivalence’ approach to preferential treatment of non-EEA financial services providers within the Single Market. It would fundamentally alter the regulatory ‘perimeter’ that separates those states subject to Single Market legislation from those states that are not, and likely create friction with the EU’s other trading partners that either commit to applying EU law to secure market access (such as Norway, Iceland, Ukraine) or rely on the ‘equivalence’ process (for example Canada, the US, and Japan).
5.9In any event, it does not appear—in the case of Covered Bonds or any other sector of the financial services industry—that the Government’s preferred outcome would fundamentally alter the trade-off between continued preferential treatment of UK financial services and products within the Single Market, and constraints on regulatory autonomy after Brexit (unless it calculates that the EU-27 will in the end be willing to take a very flexible approach to regulatory alignment—and therefore give the Treasury greater leeway to legislate differently from the EU—to preserve their businesses’ access to the UK’s capital markets despite the potential impact on the regulatory cohesion of the Single Market). Time will tell whether the EU’s position on the Government’s offer will shift, and the European Scrutiny Committee will keep developments in the negotiations under close review to ensure that any commitments made by the Government for post-Brexit regulatory alignment with the EU are subject to on-going parliamentary oversight.
5.10Given the continued uncertainty about the future of regulatory cooperation and alignment with the EU on financial services after the UK leaves the Single Market, we retain the proposed Directive and Regulation under scrutiny and ask the Minister to keep us informed of developments in the legislative process (particularly with respect to the inclusion of an ‘equivalence’ regime by either the Council or the European Parliament). We also ask for his next update to us to include information, if available, on the volume of UK-issued covered bonds held by investors elsewhere in the EU. We draw the proposals to the attention of the Treasury Committee.
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. 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.
5.11Covered bonds are debt obligations issued by credit institutions and secured on the back of a ring-fenced pool of assets (the “cover pool” or “cover assets”) which bondholders have direct recourse to as preferred creditors. This is called “double-recourse protection” for bondholders: if the issuer fails, the bondholder has a direct and preferential claim against certain earmarked assets and an ordinary claim against the issuer’s remaining assets:
5.12Furthermore, the cover pool is usually made up of high-quality, low-risk assets (for example residential mortgage loans and public sector debt). The covered bond pool is also dynamic (unless the issuer defaults): the issuing entity is under an obligation to ensure that the value of the assets in the cover pool at least matches at all times the value of the covered bonds and to replace assets that become non-performing, or otherwise do not meet the relevant eligibility criteria. As such, covered bonds are seen as a safe investment compared to unsecured bonds.
5.13These core features reduce the risk of investments in covered bonds, which allows banks to issue them more cheaply because their reliability means a lower rate of return is possible. This, in turn, means they have more capital available to provide loans to businesses, consumers and the public sector. The lower risk associated with covered bond has also led to certain regulatory reliefs for financial firms which invest in them under EU law:
5.14The UK covered bond market was established in July 2003 under UK general law. In March 2008 the Treasury introduced dedicated covered bond legislation (Regulated Covered Bond Regulations 2008) for the UK market, where assets backing the bond are transferred to a separate legal entity (a ‘Special Purpose Vehicle’ or SPV) and form collateral for the bonds. The total volume of covered bonds outstanding in the EU at the end of 2014 was €2.5 trillion (£2.2 trillion). Within the EU, Germany and Denmark are the largest markets with outstanding volumes of €384 billion and €383 billion respectively. The UK’s market is estimated at €121 billion (£100 billion), with fifteen issuers (compared to 79 in Germany). France, Spain, Sweden and Italy are also major issuing country. As of 2015, there were 317 active covered bond issuers globally, of which 261 in the EU.
5.15At present, covered bonds are only partially regulated at EU-level. As noted, they confer certain prudential and regulatory benefits on banks and investment funds who purchase them in light of their lower financial risk. However, EU law does not comprehensively define the term ‘covered bond’ for general purposes or substantively address prudential or conduct requirements for their issuance. As a result, covered bond markets in the EU remain largely fragmented along national lines and their volumes varies greatly between individual Member States.
5.16According to the Commission, this fragmentation “constrains standardisation in underwriting and disclosure practices and creates obstacles to deep, liquid and accessible markets, in particular across borders”. In its 2013 Green Paper on the “long-term financing of the European economy”, the Commission also asked for stakeholder views on the “pros and cons of developing a more harmonised framework for covered bonds” in the EU to stimulate their issuance by banks and uptake by investors. It also saw an opportunity to create a regulatory regime easily recognised outside of the EU, in the same manner as the ‘UCITS’ label for investment funds, which would make EU-issued covered bonds more a attractive investment prospect for non-EU investors.
5.17In 2012 the European Systemic Risk Board, which monitors the build-up of macro-economic risks in the EU, also called on the European Banking Authority (EBA) to identify and monitor best practices in the covered bond market “so as to ensure robust and consistent frameworks Union”, with a view to ensuring that the prudential reliefs banks enjoy when investing in covered bonds remained justified. Moreover, in its 2015 Capital Markets Union Action Plan, the European Commission also undertook to “assess whether and how to build a pan-European covered bond framework, building on national regimes that work well” to overcome “obstacles to market depth, liquidity and investor access, in particular on a cross-border basis”.
5.18A public consultation, however, revealed concerns about an overly prescriptive approach at European level:
“Harmonisation based on a ‘one size fits all’ approach could impair well-functioning markets and reduce flexibility and the range of products on offer, they also expressed cautious support for targeted EU action, provided that harmonisation is principles-based, builds on existing frameworks and takes account of the specificities of national markets”.
5.19The EBA published its final report on covered bonds in December 2016. It recommended that the European Commission should produce a legal proposal to set ‘harmonised minimum quality standards of regulated covered bonds’, as well as amendments to banks’ ability to claim prudential relief for holding covered bonds under the Capital Requirements Regulation.
5.20In June 2017, the Commission confirmed that it had decided to prepare a legislative proposal for an EU-level regulatory framework for covered bonds. It also published an outline of the options it had identified for a legislative approach. These included a non-regulatory option; minimum harmonisation requiring modification of existing national regimes; full harmonisation to replace existing national regimes; and a ‘29th regime’, a regulatory framework for a specific covered bond product that would operate in parallel to national regulations. A majority of Member States expressed support for an EU-wide framework based on the EBA’s 2016 report (see above), as long as the resulting legislation was “principles-based”. The Commission therefore ultimately opted for the ‘minimum harmonising’ approach, having concluded that maximum harmonisation would unnecessarily disrupt existing, well-functioning national markets (and likely struggle to gain majority approval within the Council).
5.21In addition to its proposals on covered bonds, the Commission is also in the early stages of preparing additional legislation for a “European Secured Note” (ENS). This would be a debt instrument with the same dual-recourse structure for investors as covered bonds, but with a cover pool consisting of “non-traditional” (i.e. more risky) non-mortgage assets, namely loans to small businesses and infrastructure bank loans. The Commission considers a separate regulatory framework necessary to “protect the strong reputation covered bonds earned in the last decades in European financial markets” from being ‘tainted’ with the higher risk profile of similar instruments that use lower-quality collateral. A dedicated legislative proposal is not expected before the European elections in May 2019, as the Commission has said it will launch a consultation exercise by the end of 2018.
5.22The Commission presented its draft legislation on covered bonds in March 2018, alongside a number of other proposals as part of its Capital Markets Union Action Plan. They are based largely on the recommendations made by the European Banking Authority in 2016.
5.23As noted, the purpose of the proposals is to encourage the issuance and purchase of covered bonds across the Union, particularly in Member States where no market for them currently exists, and to attract more foreign (i.e. non-EU) investment by offering a standardised European regulatory framework (in the same way that the UCITS Directive does for collective investment funds). This would contribute to increased cross-border flows of capital and investment within the Single Market, and allow issuing banks to fund more loans in support of the wider economy in a “safe and efficient” way.
5.24The covered bond proposals consist of a Directive, which contains the “core elements” of the new EU-wide minimum standards for covered bonds (to be supervised by Member States’ national financial regulators), and a Regulation to amend the existing capital requirements framework to make the prudential relief banks enjoy when investing in covered bonds more restrictive. Issuers which comply with the new framework will be entitled to use the label ‘European covered bonds’ when marketing their product, in addition to any country-specific designation in use domestically in their home Member State.
5.25The Economic Secretary to the Treasury (John Glen) submitted an Explanatory Memorandum on the proposals on 11 April 2018. In the section below, we have described the substance of the proposed legislation and the Government’s views on the different elements thereof.
5.26The Directive would create minimum standards for any covered bond—which it defines as “debt obligations issued by credit institutions and secured against a ring-fenced pool of assets to which bondholders have direct recourse as preferred creditors”—issued in the European Union. Broadly speaking, these standards would be as described below.
5.27In his Explanatory Memorandum, the Minister expresses the Government’s support for “additional consistency in the regulatory treatment of covered bonds” given the “existing diversity of legal, regulatory and supervisory covered bond frameworks across the EU”. He adds that the Government “will seek to ensure that 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”.
5.28The low-risk nature of covered bonds is derived from the extra security its holders enjoy even if the issuing bank goes insolvent and defaults on debt payments. However, the proposed legislation would not change national insolvency regimes or the treatment of covered bonds in cases the issuing bank goes insolvent. In particular, the proposal does not alter the 2014 Bank Recovery & Resolution Directive, which excludes the asset pool for covered bonds from being ‘bailed in’ (i.e. sold) to recapitalise the issuing bank (except for any collateral in excess of what is needed to cover the bond payments). Similarly, derivative contracts included in the cover pool also serve as collateral and cannot be terminated upon the issuer’s insolvency or resolution. This seeks to ensure that the cover pool “remains unaffected and adequately funded”.
5.29With respect to the prudential relief for banks that invest in covered bonds, the proposal to amend the Capital Requirements Regulation would introduce new requirements on minimum over-collateralisation and substitution assets:
5.30The Minister’s Explanatory Memorandum states that the Government welcomes the “strengthening of the eligibility criteria for qualifying covered bonds to receive preferential treatment”, and that it will seek to ensure the new legislation “promotes financial stability, but also provides the necessary incentives to appropriately support covered bonds markets”. He also supports the Commission’s proposed ‘grandfathering’ provisions, which will prevent unintended consequences for existing covered bonds from a change in the regulatory regime.
5.31In the context of the UK’s withdrawal from the EU, the interaction of the proposed regulatory framework with non-EU covered bond regimes is also pertinent. Under current EU capital requirements rules, banks within the Single Market investing in covered bonds issued outside the European Economic Area (EEA) can in some cases benefit from preferential treatment when determining part of their liquidity buffer. However, this falls short of the full prudential relief available when they invest in EEA-issued covered bonds.
5.32The new Covered Bonds Directive would apply to EU-based banks only. While the legislation is likely to be extended to Norway, Iceland and Liechtenstein in due course as part of their obligations to adopt the Single Market acquis under the EEA Agreement, there is no “equivalence” regime contained in the proposal. As such, the ‘European Covered Bond’ label, and more importantly the associated regulatory reliefs for financial firms that purchase such bonds, would not apply to non-EEA covered bonds.
5.33However, the 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”. Where equivalence was granted, covered bonds from an ‘equivalent’ third country would trigger the same prudential and regulatory reliefs as EU bonds. The creation of an equivalence regime, if not included in this proposed Directive by the European Parliament and the Member States in the Council, would require a new legislative proposal in due course.
5.34The other element of the Covered Bonds Directive that is relevant in the Brexit context is the definition of ‘eligible assets’ banks could use for the dual recourse mechanism. The proposed legislation would allow banks to include assets in their cover pool for covered bonds that are located outside of the EU, for example loans issued in the UK after it leaves the Single Market. However, individual EU countries would be entitled to prohibit use of non-EU assets at their own discretion. If a Member State does allow it, their national regulator would have to “[verify] whether the assets located outside of the Union meet all the [quality] requirements [that apply to the other assets held in the pool] and that the realisation of such assets is legally enforceable in a way similar to assets located within the Union”.
5.35In sum, for the UK the Directive will have different implications depending on its status in or outside of the Single Market:
5.36In his Explanatory Memorandum the Minister only “notes the Commission’s openness to develop a third country equivalence framework in the future”, but does not indicate whether the Government will push for the inclusion of an equivalence regime at this stage. He does not indicate how the Government’s recent high-level proposal for a new trade agreement on financial services with the EU, based on bilateral market access and mutual recognition of regulatory standards without legislative harmonisation, could impact on the UK’s regulation of covered bonds. The Committee will continue to monitor developments in the trade negotiations with the EU closely to ensure that any commitments the Government may enter into for continued de facto application of EU legislation are identified as they arise and any such requirements for alignment made subject to parliamentary scrutiny.
None. These are new proposals.
40 If there are insufficient assets in the asset pool to meet obligations to covered bond-holders where the issuer has defaulted, they become unsecured creditors of the failed issuer for the residual amount.
41 €1 = £0.88415 or £1 = €1.13103 as at 28 February.
42 The Covered Bonds Directive, after its adoption, is likely to be incorporated into the EEA Agreement and thus apply in Norway, Iceland and Liechtenstein as well.
43 See Commission Delegated Regulation (EU) 2015/61 (the Liquidity Coverage Requirement Regulation).
44 The creation of an equivalence regime, if not included in this proposed Directive by the European Parliament and the Member States in the Council, would require a new legislative proposal in due course.
45 If a Member State does allow inclusion of loans to non-EU entities in the cover pool, their national regulator would have to “[verify] whether the assets located outside of the Union meet all the [quality] requirements [that apply to the other assets held in the pool] and that the realisation of such assets is legally enforceable in a way similar to assets located within the Union”.
46 submitted by HM Treasury (11 April 2018).
47 See Article 7 of the Proposed Directive.
48 See for more information the speech by the Chancellor of the Exchequer, “” (7 March 2018).
49 The General Affairs Council of 20 March 2018 discussed the use of reviewed and improved equivalence frameworks to form the basis for any EU-UK agreement on financial services. Similarly, the European Council of 23 March 2018 the UK-EU trade agreement should “address (…) trade in services, with the aim of allowing market access to provide services under host state rules, including as regards right of establishment for providers, to an extent consistent with the fact that the UK will become a third country and the Union and the UK will no longer share a common regulatory, supervisory, enforcement and judiciary framework”.
50 Article 129 of the Capital Requirements Regulation.
51 The Prudent Person Principle, a legal principle under the Solvency ii Directive, requires asset managers to only make investment decisions for their customers that a “prudent person” would make.
52 The 2008 UK regulations transposed Article 22(4) of the 1985 UCITS Directive as amended, which provided: “Member States may raise the 5 % limit laid down in the first sentence of paragraph 1 to a maximum of 25 % in the case of certain bonds when these are issued by a credit institution which has its registered office in a Member State and is subject by law to special public supervision designed to protect bond-holders. In particular, sums deriving from the issue of these bonds must be invested in conformity with the law in assets which, during the whole period of validity of the bonds, are capable of covering claims attaching to the bonds and which, in the event of failure of the issuer, would be used on a priority basis for the reimbursement of the principal and payment of the accrued interest.”
53 See .
54 EU law refers substantively to covered bonds only in the UCITS Directive, with the sole purpose of demarcating for which types of bonds UCITS investment funds can exceed normal limits on investment in securities issued by a single body (see article 52(4) of the current ). The related regulatory reliefs for banks and insurers refer back to the definition contained in the UCITS Directive.
55 See Commission document COM(2013) 150, “” (25 March 2013).
56 ESRB Recommendation of 20 December 2012 on the funding of credit institutions (ESRB/2012/2).
57 The outcome of the public consultation is summarised in the Commission’s accompanying its covered bond proposals.
58 See (20 December 2016).
60 See .
61 See the Commission proposal for a Directive ().
62 Similarly, the Commission concluded that a non-regulatory approach was unlikely to have an effect; and that a ‘29th regime’ for an EU covered bond product would suffer from low uptake. It has proposed parallel product regimes in this way for the pan-European personal pension product (PEPP) and the new Crowdfunding Regulation.
63 According to the Commission, the Member States support this dual approach “subject to clear differentiation of ESNs from covered bonds and further analysis”. The European Parliament in July 2017.
64 In parallel to the Covered Bonds proposal the Commission also tabled new legislation on crowdfunding, non-performing loans and assignment of claims. We are considering those separately in the near future.
65 Such as German Pfandbriefe.
66 submitted by HM Treasury (11 April 2018).
67 This definition would replace the one currently contained in the UCITS Directive, and the references to it in the Capital Requirements Regulation and the Solvency II Directive.
68 The Directive would also allow multiple banks to pool cover assets under certain conditions. This is intended to encourage issuance by smaller banks and give them access to the covered bonds market if they would be unable to accrue sufficient collateral by themselves.
69 For example, in the UK, the cover pool is maintained by a special purpose vehicle (SPV) that is legally separate from the issuing bank.
70 See article 44(2) of the Bank Recovery & Resolution Directive.
71 See Commission Delegated Regulation (EU) 2015/61 (the Liquidity Coverage Requirement Regulation).
72 I.e. the conversion of the assets into cash to pay the holders of a covered bond if the issuing bank is unable to make their contractual debt payments.
73 See article 7 of the proposed Directive: “Member States may allow credit institutions issuing covered bonds to include assets located outside of the Union in the cover pool. (…) Where Member States allow for [their] inclusion (…), they shall ensure investor protection by verifying whether the assets located outside of the Union meet all the requirements set out in Article 6 and that the realisation of such assets is legally enforceable in a way similar to assets located within the Union”.
74 See for more information the speech by the Chancellor of the Exchequer, “” (7 March 2018).
Published: 1 May 2018