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Is Article 6 the answer?

30 July 2018
Richard Kemmish

Article 6 of the proposed covered bond directive allows national definitions of eligible assets. So why do we need a separate ESN legislation?

A friend asked me recently why the European Commission is going to such lengths to look into dedicated legislation for European Secured Notes when article 6 of the proposed covered bond directive allows national discretion over the ‘high quality assets’ that qualify for cover pools. Particularly as ESN legislation and regulation must be so nationally focussed given the differences in the underlying assets in different countries – much greater than the differences in mortgages across Europe – that decisions need to be made on a national, not union-wide level.

It’s a valid question. The easiest answer – that article 6 might be amended as it has attracted so much criticism for the discretion that it grants – isn’t really sufficient.

The first point is that it is a national discretion, not a pan-European rule. For ESNs to really work they have to have some degree of commonality across Europe. Not too much given the national differences I mentioned, but enough to be a recognisably common asset class with, for example whichever of the EBA’s best practice recommendations are appropriate applied.

Also, I’ve found cases where the regulator doesn’t see a need for ESN legislation whilst some issuers in their country do. An EU wide ESN framework, rather than a set of national discretions, makes it easier for issuers to ask for the funding tool.

Then there are the rules that make article 6 vaguely tolerable. At least article 6 requires some kind of valuation of the underlying assets and some form of security. In the case of loans to SMEs some have security, some don’t. Quite often this is not a material determinant of credit quality (I’ve heard it argued that it is the opposite – unsecured loans have higher credit thresholds than secured and the enforcement of the security is often very problematic). The rules in article 6 are too restrictive for the reality of the SME market (and too loose for the conservative voices in the covered bond market).   

Finally, the first objection to ESNs in most countries is the risk of harming the existing, perfectly functioning, covered bond market. I think that this risk is overstated. But if ESNs are seen to be a national subset of the covered bond market (in the same way that ship mortgage covered bonds are currently), the ability to ring-fence the product in the minds of investors and avoid any potential contagion from a default is more difficult.

You could argue that if investors don’t like ESNs they can just avoid them. But if ESNs were to be structured under article 6 I suspect that the main index providers would count them in the covered bond indices against which most investors are measured. This wouldn’t be the case if ESNs were governed by a totally separate set of rules.

Yes, article 6 could be used to introduce SME backed covered bonds. But the resultant market would not be harmonised, properly structured and would generate very real contagion risks for us all.


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