The European Commission is expected to publish draft legislation that sets out a principles based covered bond framework in the first quarter of 2018 — but whether it leads to any material improvement in the credit profile of the covered bond market, as Moody’s has suggested, remains to be seen.
In a recent note to clients, analysts at Bank of America Merrill Lynch doubted that “harmonisation will go far enough to make the credit impact material”.
Entrenched national positions could easily foster disagreements on relatively basic standards such that “even the lowest-denominator harmonisation would be difficult to achieve”.
A few general guidelines may be articulated under the principles-based approach such that no single country or issuer really needs to change anything.
That would mean that an actual harmonised definition on a whole host of credit metrics — such as loan to value calculations, asset coverage tests and overcollateralisation ratios — may not necessarily be set down firmly, leaving issuers and their regulators with plenty of wiggle room.
Since there has never been a covered bond event of default, detailed programme documentation has never been properly tested.
If recent history has told us anything, the impact of bank resolutions on covered bonds tends not to be harmonious at all but differs between jurisdictions and within them on a case-by-case basis, with outcomes invariably determined at a political level.
Covered bonds are supposed to be easy to understand, transparent and safe — so introducing a basic level of harmonisation should be straightforward.
But the closer you look at actual programme documentation, the more complex they seem to become. The details of rating triggers in relation to commingling and set-off risk, for example, seem obscure and technical, but create real inconsistencies across Europe.
Should investors really care about such minutiae if, in the final analysis, when a covered bond is split from an insolvent bank, everything becomes subject to overarching political will?
A harmonised framework should enforce a level playing field, but if there are no consequences for failing to apply the rules and only costs attached to their application, there can be no real motivation for change beyond pieties.
Covered bond harmonisation may end up without teeth, as only an exercise in moral suasion, a scheme that is designed to influence and persuade — but no more than that.