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European Secured Notes: applying covered bonds technology to SMEs

07 September 2015
Giada Vercelli

The Capital Markets Union green paper indicates a shift of intentions. While in the aftermath of the financial crisis the objective was to achieve financial stability, now the goal is to fuel sustainable growth. As CMU is re-focusing finance towards a more balanced economy, new products are emerging to include SMEs as collateral. Proposed in seven different models by the ECBC-European Covered Bonds Council, European Secured Notes mimic the covered bonds’ dual recourse. In Italy, Unicredit is considering this new debt tool to kick-start affordable credit for SMEs. Luca Bertalot, Secretary General of the European Mortgage Federation and the European Covered Bond Council discusses the new ESNs with Euromoney’s Giada Vercelli ahead of the new product launch event in Milan in October.

EC : How is the covered bonds industry changing the nature of private sector lending to the real economy?
LB: There is a clear new focus of the Commission on the growth agenda and we believe that in this context it would be crucial to deploy all possible options to trigger growth and ensure financial stability. Against this background, there is a natural role to be played by the banking sector, acting under public supervision, with its long standing capabilities and tradition of managing risks, particularly with regards to long-term financing. Additionally, the crisis has demonstrated, with the success of covered bonds, the importance of having a robust countercyclical private sector source of long-term financing that is able to ensure access to capital markets and lending to the real economy in distressed scenarios. The development of a dual recourse instrument, the European Secured Note (ESN), for collateral not traditionally used in the covered bond space (e.g. SME and infrastructure financing), can pave the way for the creation of a new distinct pan-European asset class - a cross between securitisation and a covered bond, which could provide both investor protection and regulatory recognition.

EC: ESNs: some of the best features of the covered bond market can be applied outside the covered bond market as is happening with the European Secured Note. What progress has been made?
LB: In the context of the Capital Markets Union debate, we analysed the potential for the creation of a new financial instrument in the EU that could benefit from the market best practices of both traditional covered bonds (for funding purposes) and securitisation (for funding and risk-sharing purposes). This instrument, with the proposed name of the European Secured Note (ESN), would cover a funding segment located between the traditional covered bond and the high-quality securitisation spaces, and would complement the long-term funding toolkit for European lenders financing SME loans and potentially other types of assets, such as infrastructure loans.

EC: What will these products look like? Would securities backed by small-business loan pools be compliant to the strict requirements needed to earn the ‘covered-bond’ label? 
LB: This proposed financial instrument would have anti-cyclical features as it could also combine a robust legal and supervisory framework, dual recourse and standardised asset data disclosure. Indeed, two major implementation structures/options are presently identified for this potential financial instrument: (i) an on-balance sheet dual recourse instrument with a dynamic pool for long-term financing purposes; or (ii) an off-balance sheet dual recourse instrument with a static pool that could also offer risk sharing (and capital relief) as a response to deleveraging needs, as well as promoting risk transfer and risk-sharing.

EC: Why do we need ESNs?
LB: This proposed instrument, which ideally would be embedded in national legal supervisory frameworks (UCITS compliant), could contribute to the CMU growth objective by ensuring a substantial and positive regulatory recognition for this financial instrument that, regardless of the structure, focuses on SMEs. Regulatory incentives could be tangible in terms of eligibility for LCR, ECB and Bank of England repo, lower risk weight for the SME asset class in CRR and Solvency II, CRA III Regulation, bail-in exception, etc. Various modalities and options for the national implementation of this instrument should allow regulators, supervisory authorities and market participants to identify the best way of introducing this instrument in the different market and legislative environments. This would: (i) facilitate a rapid legislative implementation of common pan-European qualitative standards with a bottom-up approach; (ii) guarantee homogenous and comparable characteristics; (iii) facilitate lenders’ and investors’ due diligence; and (iv) create the preconditions for a future pan-European cross-border SME financing landscape.

EC: Besides Italy, do you see some countries being more receptive than others? What are the dynamics behind different levels of engagement to ESNs?
SME funding is a crucial topic for the entire Union as highlighted in the Capital Markets Union. Indeed, you are right the current legislative debate on the Obbligazione Bancaria Collateralizzata (OBC) is putting Italian banks in a front-runner position. However we also see interest from several Spanish stakeholders, for example. As in Italy, in Spain it would possible to introduce the ESN using the new securitisation law as a legislative vehicle. We see that these examples could be of interest to other countries where we have already seen an SME debate taking place in recent months. More precisely, I’m referring in particular to the Netherlands, France, Germany and Austria but we see interest also from other countries. It is also important to highlight that the ESN is a long-term funding solution which is not only limited to SME finance, but which could also be useful for the infrastructure sector. With all these potential upcoming legislative and market developments at a national level, we should be able to create an overarching common European framework and set comparable qualitative standards in terms of legal protection, asset disclosure, eligibility criteria and public supervision. UCITS compliance is, for me, the legal pillar on which the entire ESN initiative is based. Public supervision is an element of trust for investors ensuring proper market confidence and the appropriate level of regulatory recognition.

EC: Then new forms of asset-based instruments such as ESNs may be used for intra-bank financing using covered bonds technology, for example, to facilitate the flow of liquidity within large multinational banks. Are we looking at a political decision here to reallocate resources and funding within the European Union?
LB: The establishment of a common pan-European instrument like the ESN in several countries will definitely trigger a cross border funding market, which will also facilitate the flow of liquidity within large multinational banks. At the present time we are experiencing an extraordinary situation in terms of liquidity and monetary policy, but we as an industry should take advantage of this timeframe and invest energy in the coordination of market initiatives which can help to design new funding solutions in the spirit of the Capital Markets Union bottom up approach, and to avoid unnecessary regulatory burdens and costs.The market is ready to coordinate this initiative but regulators should also play a role by being deeply involved in every discussion and leading legislative developments for the creation of a common European long-term funding instrument which is able to support the real economy.

EC: What is the ECBC’s interest in making this new market happen?
LB: The ECBC proposes to act as the market catalyst in developing this pan-European initiative which should have, among other things, a transparent and comparable European-level market platform infrastructure setting, eligibility criteria, risk parameters and IT solutions. Finally, the ECBC would welcome the intervention of the European Commission and other European institutions as catalysts of this initiative by (i) supporting and coordinating institutional interventions which would ensure the implementation of a common set of guidelines at national level, (ii) promoting the national and supranational institutions’ potential role in investing in or in guaranteeing some of the tranches of the off-balance sheet instrument proposed, (iii) considering in the future a preferable regulatory treatment of such a potential instrument, e.g. via repo or capital requirements, and (iv) setting clear guidelines in terms of micro foundations, e.g. SME categorisations and definitions.

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