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ESNs can help the ECB exit QE


If the European Central Bank (ECB) is serious about eventually scaling back its quantitative easing programme and encouraging a return to normal market funding, it will need all tools at its disposal. That suggests there is scope for an instrument that delivers a low cost of funding and supports the European economy. European Secured Notes (ESNs), which are likely to form part of the European Commission’s capital markets action plan, which is to be unveiled this Thursday, could provide the answer.

ESNs are a funding tool based on the same dual recourse structure as covered bonds, but secured on loans to small and medium sized enterprises or infrastructure loans, instead of residential mortgages.

The concept was pioneered by Commerzbank in February 2013 with a €500m deal. Even though ESN’s legislative frameworks subsequently came into place in Italy and Turkey, nothing has been issued in Europe since then. 

In July 2018, the European Banking Authority (EBA) published a report setting out the case for establishing a legal framework, and that November Richard Kemmish Consulting published a feasibility study on behalf of the Commission that outlined the market’s worthy potential.

The idea was once again brought to the fore this month when the European Parliament’s economic and monetary affairs committee (ECON) called on the Commission to develop a legislative proposal, bringing with it a new sense of urgency.

The European Covered Bond Council (ECBC) has been forming an ESN taskforce, led by Intesa San Paolo’s head of European regulatory policy, Stefano Patruno. The taskforce, which is split into several different work streams, including asset eligibility, potential structures and prospective regulatory treatment. 

The various streams plan to meet in the second half of October, at which point they will coalesce and confer ideas, according to said to Luca Bertalot, secretary general of the ECBC.

“The work stream members comprised a broad range of regions with specialist knowledge from inside and outside the ECBC, in addition to the European Investment Bank, European Commission, and European Bank for Reconstruction and Development who are acting as observers,” he said. 

The Commission is expected to canvas the EBA to consider appropriate regulatory treatment, and will also consult with the ECB to consider potential liquidity and repo eligibility treatments. 

As the ECB will want to encourage a return to normal market conditions, it is likely to be open to a dialogue that helps ensure credit continues to flow to the most important parts of Europe’s economy where liquidity is presently most constrained. 

Richard Kemmish from Richard Kemmish Consulting believes ESNs are likely to be favoured by banks that have a limited or small portfolio of residential mortgages. These could, for example, include small and medium sized Italian banks and possibly issuers in Central and Eastern Europe, such as those in Poland.

Although there are three covered bond programmes operating in Poland, many other potential issuers have been deterred due to the high cost, which includes setting up a separate mortgage issuing subsidiary.

Though discussions are still at an early stage, Kemmish and Bertalot both say that issuance structures, like UK or Italian covered bonds that use special purpose vehicles to ring fence assets, could be less costly and more straightforward for ESN issuance than setting up a separate banking entity, which is required in France and Poland. 

Aside from Italy, a number of smaller financial institutions across southern Europe that have limited mortgage portfolios and more limited excess deposits could also be interested. Unlike the national champions, the cost of funding for these banks tends to be higher, so an instrument that prices halfway between senior unsecured and covered bonds could be of interest.

The motivation to issue is likely to become even more compelling when the ECB begins to withdraw its quantitative easing programme and normalise repo arrangements, as credit spreads will likely steepen, particularly for smaller banks with lower credit ratings. If, for example, the spread between senior unsecured and covered bonds stood at 100bp, then issuing an ESN at 50bp could be persuasive.

The ECB’s dominant presence in financial markets over the past decade has led many market participants to conclude it will never really leave. Even so, since it is in the ECB’s interest to promote a balanced and healthy financial system without excessive reliance on emergency and temporary liquidity facilities, it should see some sense in promoting ESNs with the provision favourable repo arrangements.

“ESNs could provide a useful tool to help banks access cheap market funding when the ECB finally winds down asset purchases,” Kemmish agreed.

This point was also picked up by Moody’s which, in a report on September 17, said that ESN funding “could imply lower cost for banks than unsecured debt issuance, and also facilitate asset and liability management via extended maturities on the liability side”.

For these reasons, ESNs are likely to form an important component of the capital markets union (CMU). The Commission is expected to unveil its CMU action plan this Thursday, which Bertalot said “could already pave the way for potential support to prospective capital market structures, such as ESNs”.

Although this is a market that will not necessarily be developed in a short time frame, the fact that the Commission is getting involved and is very attentive “shows a willingness to collaborate to find a viable solution”, Bertalot said.

But when all is said and done, the eventual utilisation of ESNs will depend on a range on a range of factors, such as their prospective regulatory treatment or the way the European banking sector’s loan to deposit ratios evolve.

This year Europe’s largest banks experienced strong deposit inflows which, along with ECB measures, reduced their need for covered bond funding, let alone ESN funding.

Even so, ESNs stand to provide vital funding in the transition to normalised market conditions, no matter how distant that presently seems.

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