“The stamp of the Pfandbrief Act is discernible”

The Chief Executive of the VDP on the harmonization of the European Covered Bond – A critical view is taken of some details of the new EU rules: "At the center of debate is the definition of eligible assets to be funded by step 2 covered bonds."

published in Börsen-Zeitung, 27 November 2018
The interview was conducted by Bernd Wittkowski.

Mr. Tolckmitt, after six years, the harmonization of European covered bond laws is on the home stretch. Now that the report of the European Parliament’s Committee on Economic and Monetary Affairs has been presented and the Member States in the Council are likely to reach an agreement this week, the trilogue negotiations come next. How do you view the present state of play?

Let me start with the “old world”. Since the 1980s we have had the very general definition of covered bonds in Article 52 of the European UCITS Directive (Undertakings for Collective Investments in Transferable Securities). Covered bonds were mentioned for the first time in 2006, in the EU Capital Requirements Directive (CRD), and since 2013, Article 129 of the EU Capital Requirements Regulation (CRR) stipulates which assets may be included in cover for covered bonds so that they receive privileged treatment in terms of capital backing. Now we are getting a two-step regulation with a far higher level of detail.

In the first step we find traditional products such as the Pfandbrief.

Yes. A more stringent version of Article 129 gives these products special privileges that are permanently locked in by the revised definition. All the main privileges in place today are already tied to compliance with Article 129. This means that, in future, these products will be separated from those that are issued on the basis of the new directive.

That’s step 2.

Exactly. This is where the UCITS definition is replaced by a covered bond directive in which the key features of this product are anchored: cover assets, special supervision, insolvency regime, liquidity requirements, derivatives, maturity extension, disclosure requirements etc. – in short, everything that is to constitute a covered bond. Any product that meets these criteria will in future qualify as a “European Covered Bond”. The privileges are based on these, although they don’t go as far as they do under step 1.

“European Covered Bonds” – is that the official name of the new covered bonds?

There was a lengthy discussion over the name. The EU Commission had suggested labelling a directive-compliant covered bond a “European Covered Bond” – regardless of whether the product also satisfied the provisions of Article 129. This idea was not well received by everyone, however. For one thing, the English abbreviation “ECB” is already taken. Moreover, we took the view that different quality levels call for different names. Mr. Lucke, the European Parliament rapporteur, picked up on that and proposed calling the premium segment “European Covered Bond (Premium)”.

And in German?

Whether or not the Anglo-Saxon name prevails for the new products is of no consequence to the German Pfandbrief. It’s a premium product according to the CRR and an established brand in its own right.

You mentioned the privileges for covered bonds. What are these primarily?

The covered bond has received a number of privileges in European regulation over the last ten years or so: a separate risk weight or a decoupling from the bank’s risk weight, exemption from bail-in, inclusion in the liquidity buffer on a level with government bonds or privileged treatment compared with other asset classes in insurance regulation. If exceptions of this kind are made for a privately issued capital market product, it is only logical that regulators will keep an eye on that product and ask every so often whether the privileged treatment is justified.

Is a stricter European framework needed to ensure this?

Yes it is, because if it were possible to repeatedly question this special treatment, this would be disadvantageous not only for investors and issuers, but actually for everyone concerned. That’s why we were very open toward this project from the outset and gave it our constructive support, as did the Federal Ministry of Finance – though only provided that the product quality was not diluted across the various jurisdictions.

And was that achieved?

The result that is now on the cards is largely in keeping with our objectives. It protects and strengthens the quality, in particular, of the core group of covered bonds, meaning the Pfandbrief, say, and the obligation fonciere - securities which are typically backed by mortgages and public sector cover assets. The new rules shield these products from whatever else that can in future bear the name “covered bond”. This is why we believe that the privileged treatment can be preserved for this core group on the basis that has now been created.

A decision was made against full harmonization as well as against a “29th regime”, that is, a European regime alongside 28 national regimes, and in favor of a principles-based regulation. This is acceptable for you, isn’t it?

Full harmonization and the 29th regime were bound to fail, if only because there is no single European insolvency law. You might say that the Pfandbrief Act is nothing but a special insolvency law that lays out how Pfandbrief creditors are to be treated compared with a bank’s normal creditors if worst comes to worst. So these proposals were relatively quickly dismissed. Full harmonization would have neutralized the German Pfandbrief’s distinguishing features. The danger would have been considerable that a standardized product might emerge that was no longer as practical or market-oriented as the national products that had evolved in line with market needs over decades. Investors appreciate having a variety of products to choose from.

So the third option was left.

That is principles-based regulation, which sets out guidelines within which national products can position themselves and evolve further. This is what we in Germany – bearing in mind our claim to having, in the Pfandbrief, the segment’s quality benchmark – can quite easily continue to do in future by amending the Pfandbrief Act. All in all, that’s a successful solution for investors and issuers alike.

European regulation is modeled on German law, is it not?

The stamp of the Pfandbrief Act is discernible in both the directive and the CRR. Just consider the security mechanisms. The quality features enshrined in the CRR are to our liking. That’s harmonization at a high level. We will continue to comply with the CRR definition with the mortgage Pfandbrief, the public Pfandbrief and, probably, the ship Pfandbrief, which means we will enjoy full preferential treatment. The directive, too, contains many features which we welcome, such as the EU-wide introduction of a liquidity buffer. And, for the first time, it is spelled out what special public supervision is and what it is tasked with. In the past, no one knew for sure what was meant by it – with the result that every country had its own way of doing things, and each complied with the UCITS.

Looking at the positions that the VDP has taken in the past, however, you cannot be fully satisfied with the outcome.

We do indeed take a critical view of the current stage of discussions in individual points. Our central point of criticism concerns the definition of the group of directive-compliant assets that will in future be eligible for refinancing with step 2 covered bonds.

In our opinion, a covered bond that is not of quite such a high quality and does not enjoy all the privileges must also be distinct from bonds in in a lower segment to make it clear that it offers higher quality than, for example, senior unsecured or – coming to the “new world” – senior preferred bonds. If the investor first has to analyze at length what exactly it is that he’s buying, because he doesn’t know the composition of the cover pools, he will demand a higher risk premium. The question that then arises is what the value added of this product consists of.

What might qualify as a step 2 covered bond?

One might think of Luxembourg's lettre de gage publique. In terms of the assets, it is defined further as the German public Pfandbrief, but it is referenced on a high-quality cover asset. Or one might consider refinancing mortgage loans in the region of 60 to 80% of the mortgage lending value with such a covered bond. Nor would I rule out using this instrument to refinance infrastructure investments if suitable quality or standardization criteria and approaches to collateralization could be found which guarantee the high quality of such a covered bond.

Where would you draw the line?

Let me give you an example. Luxembourg has only just launched, in a very noteworthy initiative, the innovative lettre de gage for renewable energy plants. But now, every effort is being made to place these issues directly under the directive. Technically speaking, these are essentially project finance exercises with – as it were – a green coat of paint. Cover assets are being accepted that are secured in some way or other. There is no register, the cash flows are determined by politics and are not reliable, and the plants have a life of 12 to 15 years, yet at the same time they have a relatively fast technical deterioration. And in the vast majority of cases, these plants are located on real estate that is leased, not owned by the operators – or they’re located out at sea or, in the case of solar panels, perhaps in Africa. That doesn’t make access any easier. And there’s no track record yet – not even a single bond issue.

Are you saying that Luxembourg takes a very relaxed view on collateral?

In this particular case, yes. According to Luxembourg law, the registration of collateral can be substituted by an attorney’s legal opinion which declares that access is assured in the event of the bank’s insolvency. I fail to see the logic by which it should be permitted to refinance plants of this kind with a privileged covered bond. That is not the quality that the market rightly expects and deserves.

Is the diluting of the quality of covered bonds harmful to the Pfandbrief?

The Pfandbrief is clearly set apart due to its additional features under Article 129. Diluting the quality would first harm the actual product of the second category. If, however, something were to go wrong with these covered bonds in terms of the directive, a very real danger would undoubtedly arise of the effects spilling over onto the market as a whole. 

So you are afraid that the dam would burst if a loosening were permitted?

I really am concerned about this. If it is possible to create “collateral” by obtaining a legal opinion, it will only be a matter of weeks before resourceful investment bankers or attorneys hit on the idea of applying this procedure to other asset classes. Before you know it, we’ll be doing it to the traditional consumer loan, and we’ll end up with a covered bond which can basically be secured by anything. This will not do the product any favors. Regulators see this too, and won’t go along with it. This makes me think of the history of securitizations – a great product, but unfortunately it was perverted during the wild years.

Is this a fate that might also befall the step 2 covered bond?

Absolutely. There is that threat if the product is opened up as far as possible and the players don’t handle it responsibly. Limits need to be set. That’s crucial to make the new covered bond class attractive.

Who should set the limits?

That’s something only legislators can do. We called to have the eligible assets listed in the directive, as in the CRR. This did not happen. Instead, it was decided that a general definition and certain eligibility criteria be applied. That limits the scope for issuers and structurers, at least to an extent.

What about the scope that national legislators have?

The CRR is directly applicable. The directive must be transposed into national law. This enables German legislators to say: we want this, but we don’t want that. However, I am sure there are financial centers elsewhere in Europe that will be creative in this respect. Yet the wider the group of assets is, the more difficult it would become for the product, from the market perspective, to find its place in the refinancing mix of banks. Pre-crisis, the refinancing mix of Pfandbrief banks mainly consisted of Pfandbriefe and senior unsecured bonds. Soon they will have Pfandbriefe, step 2 covered bonds, senior preferred, senior non-preferred and then subordinated bonds as well. Every product will have to find its own place, and vague definitions won’t make that any easier. And the refinancing advantage for the various products has to somehow justify the effort put into the respective issue; otherwise, no one will use it.

If the status of other countries’ products is improved because of the new regulation, will this lead to more competition for the Pfandbrief?

Not directly, and certainly not to the extent our issuers might fear it would. It is correct to say that other products will gain in status. But the demand for German Pfandbriefe was often significantly in excess of supply in past years. And there will be clear regulatory differences in future, too, so I’m not worried about demand from investors who want to buy a Pfandbrief and only a Pfandbrief. Therein lies the advantage of principles-based regulation. We will, of course, continue our efforts to make the Pfandbrief stand out in the crowd. The work that issuers have done over the last decades will go on, though in slightly more corseted circumstances. I have no doubt that we are well positioned to successfully defend the Pfandbrief’s quality leadership.

Besides the different legal frameworks, which will continue to exist in future, what role does the regional origin of the covered bond play?

A considerable role. The core investors in covered bonds actually want to buy government bonds. They buy covered bonds instead, because they generate a slightly higher yield, but – mark you – as a substitute for government bonds of the same country. That‘s why a key factor behind demand for covered bonds will always be how the market assesses the issuer’s country of origin. And that is another reason why I don’t expect to see a major change in demand structure.

What became of the European Secured Notes (ESN) that were to be used along the lines of the covered bond model to refinance other assets such as loans to SMEs or infrastructure finance projects?

It looks as though the European Secured Notes are not going to fall under the covered bond directive. This EU Commission is to return to this question as a priority issue in the next legislative period. We would have liked to see a three-step approach, above all in view of the quality discussion. Non-privileged ESNs, or at least far less privileged ESNs would clearly have been suitable for, say, green infrastructure financing, and the European Covered Bonds – as products of the middle segment – would then have been clearly set apart from lower quality instruments.

If the new rules turn out the way it currently seems they will, what will change for your member banks?

To put it flippantly: not a lot. That’s because the directive is relatively heavily modeled on our Pfandbrief Act. Of course, individual points of the Pfandbrief Act will need to be adjusted. If step 2 covered bonds, which were hitherto unknown in Germany, are introduced, this will create additional options for banks. But in their day-to-day business they will scarcely notice that there is such a thing as covered bond harmonization. Above all – and this is the crucial point –, they will not need to be aware that investors assess covered bonds differently. The Pfandbrief will not suffer any disadvantages; privileged treatment is permanently assured. That is all most gratifying.

You had to remove quite a few obstacles before this gratifying outcome was achieved – for example, the separation of cover pools for residential and commercial properties.

In some draft stage or other, at the special request of a Polish bank – that’s how Europe works – a requirement was anchored that would have forced us to separate cover pools according to commercial and residential real estate. Today, of course, we have mixed cover pools, but that would have had obvious implications for the German Pfandbrief. Now we have a right to choose, but no [mandatory] separation. And indeed, that was not the only obstacle.

Do you expect the trilogue negotiations to present any great potential for conflict?

There are not many points on which the Commission, Parliament and Council disagree. I can imagine that the assets question may be put back on the agenda. But all the parties concerned realize that the negotiations have to be conducted quickly if agreement is to be reached before the end of the legislative period. We are optimistic that this can happen by March 2019. But there’s always a residual risk.

A residual risk of coming too close to the date for the European elections in May and then progress stops?

It could get very close. For a time it seemed uncertain that the project would be passed, simply because too many dossiers were still open – you might say the pipeline was blocked. So far, though, I am optimistic not least because the Commission has to produce a tangible result with regard to the capital markets union. Not much has been achieved in this matter so far.

You mentioned that Bernd Lucke, professor of macroeconomics and former spokesman of the Alternative for Germany party (AfD), is the competent rapporteur in the European Parliament. How do you rate his performance?

I am very taken by his professionally grounded work. Mr. Lucke really has applied himself to this highly complex topic. He and his team have accumulated an impressive amount of expertise, which, given that he’s a member of a relatively small parliamentary group with a modest apparatus, makes his performance all the more laudable. Incidentally, as far as I can judge, cooperation between rapporteur and shadow rapporteurs in the European Parliament is absolutely issue-oriented and totally unproblematic across the parliamentary groups.

On a personal note "In the service of quality"
by Bernd Wittkowski

We wrote a year ago that the Association of German Pfandbrief Banks (VDP) seems to be at peace with itself. And it is in peace, in calm – which should by no means be confused with inactivity – that strength, of course, lies. Calm and strength, stability and continuity are epitomized at the helm of this cross-pillar association with over 40 member banks by Jens Tolckmitt, in particular. Chief Executive of the VDP since June 2009, he also serves on the Board of Directors of the product-oriented interest group of these residential and commercial finance providers and lenders to the state and its institutions.

Jens Tolckmitt, who was born in 1971, graduated in economics. He enjoys an excellent reputation among member banks, domestic and foreign investors as well as other market players, among regulators, rating agencies and supervisors, in the political arena and, last but not least, with the specialist media. As a lobbyist for the Pfandbrief community, he is a man who is driven, in the best sense, by his convictions. Tolckmitt treads softly, but his work is extremely effective. Knowledgeable to the last detail, communicative and yet convivial in how he imparts the somewhat abstruse subject-matter, he is vigorously and successfully committed to safeguarding the high quality standards of the Pfandbrief, which he promotes – worldwide – as one of the major exports that Germany as a center of finance has to offer.

From 2003 until 2009, Tolckmitt served as the sole Managing Director of the Association of Foreign Banks in Germany. Prior to that, from 1998, he worked for the Association of German Mortgage Banks, the predecessor organization of the VDP, finally heading the Association’s capital markets department.