EU Covered Bond Framework
OSFI to Reconsider 4% Limit?
According to reports in The Cover and The Covered Bond Report, Canada is considering whether to increase the 4% limit imposed on covered bond issuance. This limit was imposed by the Office of the Superintendent of Financial Institutions (OSFI) at the inception of covered bond issuance by Canadian banks in 2007 and remains unchanged today. While the limit is the most stringent currently applied in the covered bond world, Canadian banks have nevertheless been active issuers of covered bonds as can be seen by the table below.
| US$ | EUR | GBP | CHF | A$ | C$ | |
|---|---|---|---|---|---|---|
| Issued (mm)* | 71,600 | 44,037 | 4,375 | 2,075 | 7,450 | 4900 |
| Outstanding (mm)* | 39,600 | 38,613 | 4,375 | 1,400 | 5,100 | 3,300 |
Source: www.us-covered-bonds.com/cdn_issue_details
* As of January 28, 2016.
The current 4% limit is measured as the Canadian dollar equivalent amount of covered bonds outstanding divided by total assets. The table below shows the covered bond issuance capacity remaining for each Canadian covered bond issuer as of December 2015.
| BMO | BNS | CCDQ* | CIBC | NBC | RBC | TD | TOTAL | |
|---|---|---|---|---|---|---|---|---|
| Total Assets (mm)** | 641,881 | 856,497 | 1,318 | 463,309 | 216,090 | 1,074,208 | 862,532 | 4,115,835 |
| Maximum Amount (mm) | 26,100 | 33,600 | 7,400 | 18,200 | 8,300 | 43,500 | 42,400 | 179,700 |
| Outstanding Amount (mm) | 11,600 | 22,200 | 5,400 | 10,700 | 7,300 | 31,300 | 20,900 | 109,400 |
| Used Capacity | 44.3% | 66.0% | 73.1%* | 59.0% | 87.8% | 71.6% | 60.9% | 60.9% |
| Remaining Amount (mm) | 14,500 | 11,400 | 2,000 | 7,500 | 1,000 | 12,400 | 21,500 | 70,300 |
Source: CMHC, Covered Bond Business Supplement, September 2015.
*Note that CCDQ is subject to a different limit, which is set by Autorité des marchés financiers at EUR 5.0 billion.
** As of October 31, 2015.
The Volcker Rule and Covered Bonds
The Volcker Rule became effective on July 21, 2015. There are two aspects to the Volcker Rule: a prohibition on proprietary trading and a limitation on sponsoring or investing in a ‘covered fund.’ It is this second aspect of the Volcker Rule that concerns investors in covered bonds. The Volcker Rule applies to banks in the United States, including the branches, subsidiaries and affiliates of foreign banks. Even if the investor in a covered bond is not a bank subject to the Volcker Rule, if investment in the covered bonds is subject to the Volcker Rule,the secondary market liquidity for the covered bond can be adversely affected.
If the prospectus for the covered bond does not disclose whether an investment in the covered bond is limited under the Volcker Rule, how can you determine whether the Volcker Rule applies? This can be quite a complex analysis. Fortunately, Morrison & Foerster has written a helpful article on analyzing whether a covered bond is subject to the Volcker Rule. See A user’s guide to Volcker Rule complexities.
Comment Letter to Treasury on Restoring PLS Market
On August 8, Morrison & Foerster LLP filed a comment letter with the United States Department of the Treasury in response to a request for comments on the private sector development of a well-functioning private label securities (PLS) market for residential mortgage loans. The comment letter notes that perhaps the easiest way to restore private funding to residential mortgage loans in the United States is to implement a covered bond statute in the United States to enable U.S. banks to issue covered bonds. The letter notes that the conditions necessary to the establishment of a covered bod market in the United States are well advanced and that the market could be established quickly. Based on the development of the investor base in the United States, the SEC’s establishment of disclosure and reporting standards, and the well-developed legislation, creation of a domestic covered bond market would appear to be low hanging fruit that Treasury should take advantage of.
EBA report on favorable capital treatment
On July 1, 2014, the European Banking Authority published a favorable opinion on the preferential capital treatment of covered bonds. The EBA also delivered a companion report entitled EBA Report on EU Covered Bond Frameworks and Capital Treatment. See also the press release from the EBA. The EBA concluded that the favorable capital treatment under the capital requirements regulation (CRR) for bank investments in covered bonds was appropriate, but called for some “further qualifying criteria for their preferential treatment.” The EBA recommended against the use of aircraft liens, residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS) as cover pool assets after December 2017. The opinion and the report were delivered to the European Commission in response to a request for advice.
With respect to favorable capital treatment the EBA said:
“Due to the good historical default/loss performance of covered bonds in the EU, the dual recourse principle embedded in covered bond frameworks whereby the covered bond holder has a claim on the issuing institution and a priority claim on the cover assets, the special public supervision for the protection of the bondholders mandated by the UCITS Directive and the existence of qualifying criteria in Article 129 of the CRR, the EBA considers the preferential risk weight treatment laid down in Article 129 of the CRR to be, in principle, an appropriate prudential treatment. “