The European Commission’s draft covered bond directive, published in mid-March, was designed to strengthen the credit quality of the product.
Unlike the European Banking Authority’s best practice guidelines, which had no legal authority, the final version is legally binding, once implemented by the member states.
Even so, Fitch Ratings said in a report this week that it expects "the status quo of covered bonds to remain largely unchanged" if the principles-based draft goes ahead without much amendment.
This is because most of the directive’s proposals are already embedded in covered bond frameworks or programme documentation.
Given the discretion of national supervisors, it is also likely that differences in liquidity risk will persist between different countries. Thus, for example, in the event of an issuer’s default, the continuity of payments to bondholders may markedly differ.
If collateral is not sufficient to meet the investors’ claim, the residual claim would sit alongside the unsecured claim of the insolvency estate.
That suggests there is a theoretical risk of covered bond investors being bailed in, or in Fitch’s words “bail-in of uncollateralised covered bonds”.
Even so, some sort of liquidity provision should at least be helpful for Spanish and Austrian covered bond programmes. Under existing arrangements, there's no legal requirement for covered bonds from these countries to have liquidity provisions.
An independent asset monitor is present in most jurisdictions, but their roles and duties vary and would “continue to diverge if left to the discretion of national authorities,” said Fitch.
The same can also be said for the role of the special administrator.
The draft directive also misses the chance to address differences in valuation practices. For some jurisdictions, residential properties only need to be valued every three years. In Fitch’s view that is “insufficient in times of stress”.
Despite all these valid qualms, the directive should clear up some of the more glaring inconsistencies and serve as a motivator for national regulators and issuers to get their markets in order.
That’s probably better than the alternative of an overly prescriptive framework that risks disrupting what has until now been a well functioning market.