On December 20, 2016, the EBA published recommendations for harmonizing the EU framework for covered bonds. For banks investing in covered bonds that meet certain criteria, the CRR sets preferential risk weights to be applied. The recommendations are set out in a report which builds on the EBA's 2014 Report on EU covered bond frameworks and capital treatment. The aim of the recommendations is to ensure that only financial instruments which comply with certain harmonized structural, credit risk and prudential standards are capable of being covered bonds, and as such have access to the special regulatory and capital treatment provided. Harmonizing the EU framework on covered bonds is part of the Capital Markets Union initiative launched by the European Commission in September 2015.
The EBA is proposing a three step approach. The first step would entail the introduction of an EU covered bond directive which would apply across different financial sectors and be based on the minimum harmonization principle. The directive would define the "covered bond" as an instrument recognized by EU financial regulation and would include requirements on: (i) the dual recourse of a covered bond, segregation of cover assets and bankruptcy remoteness of a covered bond; (ii) the coverage principle, liquidity risk mitigation and cover pool derivatives; (iii) a system of special public supervision and administration; (iv) transparency and disclosure; and (v) the additional conditions for the soft bullet and conditional pass through structures to meet in order to qualify as covered bonds.
The enhancement of the conditions set out in the CRR for preferential risk weight treatment of banks' investments in covered bonds would be the second step. This would include assessing the existing conditions on the eligibility of covered assets (which the EBA recommends should not be widened) and loan-to-value (LTV) limits for mortgage cover pools as well as establishing limits on substitution assets and requirements on overcollateralization.
The third step would involve specific areas of the covered bond business becoming subject to voluntary convergence such as composition of the cover pools, requirements for cover pools with underlying assets/obligors located in jurisdictions outside the European Economic Area, LTV measurement and frequency of revaluation, and stress testing by the covered bond issuer. This would be attained through non-binding instruments, and the recommendations would not have an impact on the eligibility of the covered bonds for the preferential regulatory and risk weight treatment.
The report is available at: http://www.eba.europa.eu/documents/10180/1699643/EBA+Report+on+Covered+Bonds+%28EBA-Op-2016-23%29.pdf .
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