Harmonization of covered bonds must not lead to a dilution of the high-quality product

The European Commission’s project of harmonizing the national rules for covered bonds is nearing completion.

viewpoint: Jens Tolckmitt, Chief Executive of the Association of German Pfandbrief Banks, published in Frankfurter Allgemeine Zeitung, 25. May 2018

What began in 2013 with the Green Paper on long-term financing and advanced in March of this year to the Commission’s proposal for a directive and a regulation is now close to being finalized. This marks a major milestone in the reform of covered bonds, an asset class which originated in Germany and which has, in the Pfandbrief, to date the most prominent of covered bonds with the longest-standing tradition and the highest quality. Since the financial crisis, covered bonds have numbered among Europe’s key instruments in bank funding.

The aim of the reform efforts is to give the European covered bond market greater homogeneity and transparency, thereby making it even more attractive for investors and issuers. For EU member states that currently do not have a covered bond regime in place, the aim is to make it easier overall to introduce the product at the national level and thus to benefit from this cost-efficient, long-term and secure source of funding. At the same time, a uniform legal framework is to be created to protect the asset class and a foundation laid to ensure preferential regulatory treatment for covered bonds in European law on a permanent basis. To achieve these objectives, the European Commission proposes a uniform definition stipulating the structural features of what should constitute covered bonds. Besides this, supervisory tasks and duties are to be concretized and the rules covering the use of a new label – “European Covered Bonds” – are to be defined: all covered bonds that meet the new definition would be classified under this label.

The outcome of this years-long procedure represents a considerable achievement, and the German Pfandbrief banks support the Commission’s proposed legal package – not least because uniform, high quality standards are likely to anchor the demonstrably crisis-proof asset class more firmly in the perception of investors and justify its permanent preferential regulatory treatment in all major European legal frameworks.

One especially important aspect is that the proposed directive is principles-based, meaning that only specific core principles of covered bonds will be harmonized.

There will be no full harmonization at a low quality level, which was to be feared for a while. Instead, the proposal calls for a minimum degree of harmonization based on the national regimes – at a high level, and yet in a way that leaves sufficient scope to ensure that tried and tested national products like the Pfandbrief are preserved and their quality is heightened further. It is crucial for Germany that the proposal should contain all the main quality characteristics of the traditional, tried and tested covered bonds and, as far as possible, be consistent with the currently valid, strict standards of the German Pfandbrief Act.

So far, so good. However, a glance at the details of the Commission’s proposal reveals an urgent need for improvement in a small number of – key – points. This is true, for example, of the definition of those assets that may be used as cover and in respect of which investors have a priority claim in case of an issuer’s default. The popularity and success of the tradition-steeped covered bonds are attributable to their stability and extreme safety – which, in turn, makes them attractive for the issuers. The particular level of safety stems, above all, from the clearly specified number of high-quality asset classes that are eligible as cover, namely real estate-secured mortgages loans, public sector bonds as well as ship and aircraft mortgages. The basic definition now proposed by the European Commission is deliberately couched in broader, more general terms to enable the funding of new asset classes, thus making the covered bond product more flexible in how it might be used.

Although the Commission’s proposal explicitly calls for high-quality cover assets, the exact requirements are so broadly formulated that they open the door to arbitrariness and, consequently, to a dilution of the long-established quality products. The potential advantages of a broader application of the product do not make up for this weakness. The need for improvement here is clear.

From the Pfandbrief banks’ perspective, the requirements have to be laid out in considerably greater detail and in stricter terms in order to unequivocally limit the leeway for expanding the range of eligible assets. One solution might be to include in the directive an explicit list of assets that qualify as cover instead of the proposed general definition.

A second aspect is related to the first and is, for the German Pfandbrief banks, no less critical: the plan to introduce the “European Covered Bonds” label for all covered bonds that comply with the new directive, which – for the reasons above – is more broadly worded compared with the status quo. It would be misleading if this category were to include all the products that fall under the directive, as that would suggest that the label refers to a strictly regulated and therefore secure product comparable to traditional covered bonds like the Pfandbrief. This lack of clarity could put the traditional covered bonds in particular at a disadvantage, as they would officially be lumped together with presumably less secure products.

The German Pfandbrief banks believe that one feasible solution might be to introduce two labels, as this would indicate that differences of substance exist between the two categories, and that two separate security classes in fact exist. For example, the label “Ordinary Covered Bonds” would seem appropriate for the covered bonds that comply with the new directive, while the traditional product could be labeled “Premium Covered Bonds”, thereby emphasizing their quality advantage.

Only if these two serious shortcomings in the European Commission’s draft directive are convincingly resolved as the project is carried forward, and the details of this long-running reform project are framed in the most precise and strictest terms possible, can the overarching objective – where the Pfandbrief banks are concerned – of every legal innovation also be achieved, i.e. not to jeopardize the extensive preferential regulatory treatment afforded covered bonds thanks, amongst other things, to their high level of security and reliability, but to place it on an even firmer footing. For only if their quality is assured beyond doubt can covered bonds fully bring their strengths to bear in the interests of all concerned – investors, bank customers, issuers and, not least, politicians – and, as planned, play their part in building the capital markets union and in financing additional growth of the real economy.