Regulatory environment is taking shape

Dr. Louis Hagen, President of the Association of German Pfandbrief Banks (vdp) and Chairman of the Board of Management at Münchener Hypothekenbank, on the challenges facing Pfandbrief banks, the harmonization of covered bonds and sustainability in the financial sector

Op-ed published in the special supplement of the Börsen-Zeitung on August 25, 2018.

It is now roughly a decade since the outbreak of the economic and financial crisis. However, the extensive changes to the regulatory environment which followed as a result and are having a lasting and massive impact on the business of banks are still underway. The future regulatory environment is increasingly taking shape: the European harmonization of covered bonds has seen significant progress and the Basel III reform project has been clearly mapped out and finalized. Yet other projects are still in the early stages, and new topics are on the horizon.

As far as the Pfandbrief banks are concerned one of the most important regulatory projects is undoubtedly the harmonization of the national rules for covered bonds, the objective of which is to make the European market for covered bonds even more homogeneous, more transparent and therefore more attractive for Pfandbrief investors and issuers. The legislative procedure is already at an advanced stage. In March of this year, the European Commission published a proposal for a covered bond directive and a regulation on hardening the conditions of Article 129 of the Capital Requirements Regulation (CRR). With its principles-based approach, the draft fulfills central demands made by the Pfandbrief banks.

Still room for improvement

In the view of the Association of Pfandbrief Banks (vdp), however, the details are in need of further improvement. Whereas the cover assets for traditional covered bonds are precisely defined under the CRR, this is not true of the cover assets for the other covered bonds under the directive. For example, the draft directive envisages a considerably broader definition of business that is eligible as cover than it does for traditional covered bonds such as Pfandbriefe, and also than is currently the case under the UCITS Directive (Directive on undertakings for collective investment in transferable securities). This is intentional in principle, and it may be appropriate. But the Pfandbrief banks believe that the requirements need to be more detailed and more strictly defined in the legislative procedure going forward in order to clearly limit the scope for extending the range of assets that are eligible as cover and to prevent the covered bond asset class as a whole from being watered down.

It is crucial that covered funding does not become arbitrary. This would benefit neither the product, nor the investors, nor the issuers – nor the policymakers who set out with the aim of giving banks an additional stable funding instrument.

The European Parliament's decision on the directive has to be presented by the first quarter of 2019 to ensure that the legislative procedure can be finalized by the current European Commission before its period in office expires. This will leave the member states 12 months, i.e. until early 2020, to transpose the directive into national law. In addition, the Pfandbrief banks would like the question of a possible maturity extension for Pfandbriefe in the event of a Pfandbrief bank's insolvency – which market participants have been discussing for some time now – to be included in the amendment of the Pfandbrief Act, which will be due by then in any case.

Another important topic for the Pfandbrief banks is the finalization of the Basel III reform package, which, following a lengthy process, is now also on the home stretch. The compromise reached in December of last year now gives banks a certain degree of planning security. It was also possible to book a number of successes of a technical nature in the final phase of the negotiations. For instance, alleviations were included at the last minute concerning how the output floor is calculated; these changes soften its impact on Pfandbrief-specific business operations.

At the same time, however, the agreed output floor requirement of 72.5% continues to place a significant burden on a large number of banks and makes low-risk operations in particular – such as parts of real estate finance – considerably less attractive. For this reason, the Pfandbrief banks believe that relief measures will be needed when it comes to transposing the reform package into European law – for instance with regard to the risk weights in commercial property financing. Before transposition into law, which will not begin in Europe before 2020, the quantitative and qualitative impacts on the banks’ business models will be examined, which fuels hope for transposition with a sense of proportion. In this context, to ensure fair competition, it will be important prior to transposition in Europe to look at how the United States is treating the decisions from Basel.

The Pfandbrief banks also expect action from Brussels with regard to the development of a methodology for determining the mortgage lending value (MLV) in Europe. The latest revision of the CRR provides for the harmonization of the determination of the MLV in Europe by the end of 2019 in the form of a regulatory technical standard (RTS). A proposal from the European Banking Authority (EBA) on the design of such a methodology is not to be expected within the next year, i.e. not before the summer of 2019. The Pfandbrief banks take the view that an EBA guideline would be more efficient and more effective than a regulatory standard in harmonizing the determination of the MLV across Europe.

After all, there has already been a draft RTS. However, that attempt ultimately failed. Instead of a full harmonization of the methodology for determining the MLV via technical standards, a principles-based procedure under an EBA guideline would only set the risk parameters, yet leave the specific design of the valuation methodology that is actually implemented in the responsibility of each individual country. In this way, national market features could continue to be taken into consideration. Property markets structures do, after all, differ from one country or even region to the next and follow different cycles. An EBA guideline could then also initiate a wider range of different methodological rules to determine the MLV of a property in Germany so that here, too, the very different region-specific market developments could be captured more accurately. Pfandbrief funding could thus be put on a firm footing in the long term.

Example of sustainability

The determination of the MLV is an especially conservative and long-term oriented banking practice and is – like the Pfandbrief – a good example of sustainability in the financial sector. The recent past has seen both its importance in the capital markets and the high esteem it enjoys in political circles grow strongly. Just a few months ago, in early March of this year, the European Commission published its Action Plan on financing sustainable growth. The main objective is to steer more capital towards sustainable investments. From the perspective of the vdp, the central elements of the Commission’s catalogue of measures are the classification of green (and social) assets, agreement on standards for green bonds, the formulation of duties for institutional investors and asset managers, and the importance of taking account of sustainability aspects in connection with capital backing.

The vdp welcomes, in principle, the European Commission’s plans for a sustainable financial system and shares its objectives. In order not to jeopardize the future development of the dynamic, young asset class, however, the requirements stipulated by Brussels ought to be sufficiently flexible. Moreover, before less strict capital adequacy rules are introduced, a thorough examination needs to be made of whether a stable relationship actually exists between green or generally sustainable assets and a lower default risk which might justify preferential treatment in terms of capital requirements. This is one issue covered, for example, by the EeMAP initiative (Energy-efficient Mortgages Action Plan) launched by the European Covered Bond Council. During the pilot phase, in which a number of Pfandbrief banks will also be actively involved, the probability of default and loss in the case of sustainable mortgages is to be assessed over the next two years.

Fit for digitization?

The wide-ranging and extensive regulatory projects at the European level may be subject to dispute over the details and their transposition into law may be arduous. There is no doubt, however, that appropriate European rules are of great importance for the stability of the financial system as a whole, for the protection of covered bonds, and for the long-term success of the Pfandbrief banks. Yet more needs to be done, particularly in the latter case, as the technological disruptions we are witnessing at the moment present the banks, too, with major challenges.

In this context, the FinTech Action Plan proposed by the European Commission in early March of this year was a call from Brussels. Under the action plan, support Is to be given to the financial sector in the use of new technologies like blockchain, artificial intelligence or cloud services more quickly and more efficiently for their own operations. To this end, the regulatory framework for financial services is to be reviewed to identify obstacles to digitization and financial innovations. The Pfandbrief banks welcome this initiative, even though it may still be lacking in specifics at present, as it is crucial that technical and legal obstacles to digital processes along the banks’ value chain be removed in terms of the disruptions and upheavals that digitalization entails.

All of the points described above demonstrate that roughly ten years after the outbreak of the economic and financial crisis, although the regulatory environment for banks is being increasingly fleshed out and planning security is gradually growing, there is no let-up for banks – despite the fact that many feel a need for some respite. The pace of change remains fast. The Pfandbrief banks accept this challenge and can rely on the vdp to act in their interests in the best way possible and at all levels.