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To do or not to do?

21 October 2015
Richard Kemmish

Where do I even start? The European Commission’s consultation paper on the covered bond market is so vast in scope, so fundamental in importance and contains such potential to really mess things up, or to make things better, that it is difficult to know where, or how much time I can go on about it.

Perhaps we should start at the end. What will actually happen as a result of this?

Some people seem to think that the outcome is binary: either Commission will do nothing or that they will publish a covered bond directive (or worse, regulation) telling everyone in Europe how to structure covered bonds. Most people then go on to say that this is a function of whether Commission is convinced that the covered bond market needs reforming. I’m not sure that this is correct. Empirically, the covered bond market clearly doesn’t need reforming (I’ll return to this topic), but whether it would benefit from any type of reform is another question entirely.

But the outcome of this process really isn’t that binary.

There is no ‘do nothing’ proposal on the table. The closest that we have is the ‘do least’ proposal, namely that the basic balance of legislative power should remain the same. Member States continue to draft their own covered bond law, if it happens to meet a set of criteria that define the outcome the Commission wants then they can grant preferential treatment for certain classes of investors. Member states are free to diverge from Commission’s desired outcome – for example, aircraft pfandbrief – they just don’t get the full benefits of EU prudential rules as a result.

This approach is only slightly flawed by the fact that EU level covered bond laws aren’t entirely about investor treatment – their carve out under the resolution directive for example, which fortunately for aircraft pfandbrief is based on the broader definition of what a covered bond is.
But in addition to leaving the current model intact the ‘do least’ proposal says that Commission should encourage us all to adopt the EBA’s ‘best practice’ guidelines. At the risk of comparing covered bond market participants to donkeys, encourage can either mean ‘encourage with a carrot’ or ‘encourage with a stick’. The EBA when first drafting these proposals, and the text of the consultation, both point towards the carrot interpretation: conform to best practice and your investors will get better prudential treatment. The EBA consultation was initially only about the risk weight of covered bonds for bank investors, but it isn’t difficult to imagine other carrots on offer.
I don’t know much about herding donkeys (actually nothing) but I imagine that if they don’t fancy a carrot today then a stick based behaviour encouragement strategy usually isn’t very far behind. It also isn’t difficult to imagine Commission’s stick based options.

But what of the ‘do something’ option?  Actually that is three different options, which – thanks to my self imposed word limit - I will have to cover in my next post.

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