By Karlo Fuchs, Head of Covered Bond Ratings, Scope Ratings
Scope Ratings expects in its 2017 outlook that the credit performance of covered bonds will continue to improve, thanks to the enhanced regulation and supervision that is strengthening the credit fundamentals of European banks, the anchor point for this asset class’ credit quality. The regulatory improvements lead not only to safer business models for issuers, but to stronger capital and liquidity profiles as well. At the same time, the European Central Bank’s (ECB) quantitative easing continues to support financial stability in Europe and benefits borrowers’ asset quality, and ultra-low interest rates are prompting issuers to lengthen the maturities of new covered bonds, thereby reducing their covered bonds’ main risk – the asset-liability mismatch.
Rating Stability: The New Normal for Covered Bonds?
The credit quality of the large European banking groups that we rate continues to converge into the single A range. This reflects not only the increasingly level playing field on which banks operate, but also the converging prudential requirements, which leads to more uniform regulatory metrics. Scope’s European banking outlook for 2017 notes that: ultra-low rates will continue to challenge earnings; existing overcapacity remains the industry’s Achilles’ heel; and better capital levels are not matched by higher earnings.
Most banks have started to adapt to the new environment, and changes to issuers’ credit quality in 2016 have been very limited. Also, the bank rating changes have not affected our covered bond ratings. On aggregate, we see relative stability for the banks’ credit quality to continue in 2017.
At the same time, the widened national implementation of MREL guidelines and the resulting ability to bail-in certain parts of a banks’ liability structure, will result in further upgrades of the bank rating as preferred creditors will benefit from a more ample capital structure in a default like scenario.
Our ratings of banks in Germany, Belgium, the UK and Switzerland already reflect this ability to bail-in certain forms of senior bank debt. We expect ICSRs of banks in France, Spain, Italy and Sweden to also improve once national regulators have clarified their view on MREL liabilities and banks have the ability to issue this new type of senior unsecured – but bail-inable – debt.
Improved ICSRs will bolster the resilience of existing covered bond ratings against issuer downgrades and recourse to the cover pool, and its importance for the covered bond rating, will further reduce. Already today most covered bonds rated by Scope are based on ‘fundamental support’. A bank rating in the single A range, combined with our favourable view on the countries’ legal frameworks and resolution regimes, supports covered bond ratings without taking recourse to the cover pool.
Only two of the 23 covered bond programmes we rate (Bankia SA’s Cedulas Hipotecarias, AAA/Stable, and Dexia Kommunalbank Deutschland AG’s Öffentliche Pfandbriefe, AA-/Stable) rely on the cover pool recourse to achieve and maintain current ratings.
Covered Bond Volumes to Stabilise in 2017
Our expectation of the continuation of net negative supply for covered bonds in 2016 has largely been confirmed. We expect the European covered bond market to end 2016 at close to EUR 2.3tn, following the height of EUR 2.7tn in 2012.
We do not believe that a return to sustainable growth is already likely in 2017. European credit demand remains soft and headline risk will persist in 2017. The ECB’s monetary policy continues to provide ample liquidity to the banking system and, although the deleveraging of balances sheets has slowed, it is not over. Further, French, Italian, Spanish or Swedish banks are likely to start issuing bail-inable senior debt in 2017, which will also reduce the need for covered bond funding.
Our baseline assumption is that the European economy will continue to grow – albeit at a slow and potentially volatile pace. The 2016 Brexit vote has already provided uncertainty and closed the markets for some time, and its method of execution remains unclear. Socio-political risk will persist, and it remains to be seen whether the unexpected (e.g. Donald Trump winning the US elections) will also become the new normal for 2017. The results of the 2016 referendum in Italy and the 2017 elections in France and Germany will be important European milestones in that context. It is still unclear whether the results will introduce stability and certainty for the eurozone and its GDP growth, or amplify volatility and dampen growth prospects.
The persistent uncertainties, in combination with low growth prospects, make our issuance outlook bearish, and we expect that current volumes of outstanding covered bonds will stabilise – at best.
Low Interest Rates Unlikely to Spur Innovation
A long-term funding market is not the most likely candidate for product innovation, and the ultra-low interest rates are even less conducive in this respect. As long as spread differentials between asset classes remain low, we do not believe incentives for issuers are high enough to establish new dual-recourse funding alternatives using the covered bond blueprint.
In 2016, we have not seen any repeat of a real covered bond for small and mid-sized enterprises (SMEs), and the concept of a covered bond like the European Secured Note (ESN) only remains a theoretical option. Also, the first-time issuance of the
export-credit-based Cédulas de Internacionalización has not yet been repeated in Spain, and we do not think that structured covered bonds by Deutsche Bank will find followers in Germany.
We see merit in innovations that improve the credit quality of covered bond products but currently most innovations are driven by issuer-specific situations, and thus are unlikely to see a more widespread use. We hope that the EBA’s harmonisation proposal, and the changes to the ECB’s collateral policies do not discourage issuers from further improving the product or allowing banks to establish dual-recourse funding products with a high credit quality.
Improving Covered Bond Frameworks
Fundamental support factors, such as national legal frameworks that govern covered bond issuance, have great importance for a covered bond’s credit quality. Changes to existing covered bond frameworks over the last two years have been cosmetic in nature and were not material enough to lead us to reassess the fundamental support we take into account in our covered bond ratings.
We expect the European Commission’s harmonisation agenda to increase the number of changes to national covered bond legislations – with first movers already starting to appear in 2017. While some legislation may only need subtle amendments, others might be forced into more fundamental changes when trying to translate the EBA’s core covered bond principles into national frameworks. A full alignment across Europe will be a lengthy process and unlikely to be completed before the end of the decade.
Differences in Legal Frameworks Highlight Need for Harmonisation
In November 2016 the European Banking Authority (EBA) held a hearing on the harmonisation of covered bonds. They presented a legal framework analysis which illustrated that differences in the frameworks persist – also highlighting that investors need to be aware of these when investing on a pan-European basis.
In some European countries, e.g. Slovakia, the bankruptcy remoteness of the cover pool is not a given, and investors could face an acceleration of covered bonds upon the insolvency of the issuer. In others, e.g. Spain, the collateral provided in the cover pools might no longer comply with loan-tovalue limits, as compliance is tested at origination and no cover pool revaluations based on house price development are required by law. Further, in most European covered bond countries investors have to rely on the voluntary disclosure of issuers, which can be infrequent and not comparable across countries, making it difficult for investors to compare the pools’ resilience.
The EBA’s November 2016 draft of their harmonisation proposal addresses many of these issues and provides a sound basis for the further development of this asset class. In contrast to the European commission’s initial idea of a prescriptive 29th regime, the proposal provides a mix of core principles applicable to all covered bonds that seek regulatory recognition and allows some further voluntary convergence.
The European Commission is ultimately in the driver’s seat to put harmonisation into practice. In our view, a lot of the EBA proposals will eventually be adopted by all the Member States. We believe investors will welcome the lower degree of divergence in the credit quality of covered bonds issued in the Member States, and harmonisation might even help encourage covered bond investment across borders, without the risk of surprises. However, harmonisation might also result in an underestimation of prevailing differences in risks: the diverging economic situation in Member States, diverging dynamics of bank fundamentals, as well as the dynamics driven by the management of risks between covered bond programmes of different issuers.
EBA’s Harmonisation Proposal to Improve Minimum Credit Quality
The EBA’s covered bond harmonisation proposal addresses diverging practices in legal frameworks and will help to provide a clearer definition for the asset class in three steps:
To avoid a covered bond being affected by a potential restructuring of its issuer, the EBA proposes the following key features to establish a covered bond:
- A clearly defined dual-recourse principle, the clear and valid segregation of cover assets, and the bankruptcy-remoteness of the covered bond
- Requirements on the coverage of covered bond repayments, mitigation of liquidity risk, and cover pool derivatives
- A more clearly defined system of special public supervision and administration
- Transparency requirements for the issuer, including specific conditions for ‘soft bullet’/ conditional pass-through (CPT) covered bonds.
From a rating perspective, we view positively the heightened awareness for a cover pool’s inherent liquidity provision. In particular, we consider as credit-positive the requirement to provide liquidity for the first six months within the covered bond
structure. It will reduce pressure for the cover pool administrator to sell parts of the cover pool at distressed
prices – effectively destroying value.
Soft-bullet structures are likely to become the issuance format of choice for most issuers as they allow issuers to reduce the amount of ‘liquid’ assets held within the covered bond structure.
We understand that the enhanced clarity surrounding the special supervision and administration will provide investors with more clarity surrounding the worst case: a ‘stand-alone’ cover pool having to service outstanding covered bonds. We believe that enhanced transparency and homogeneity will be welcomed by investors. They often lack resources to commission legal opinions or engage in discussions with regulators or insolvency practitioners – elements that typically allow rating agencies to gain sufficient comfort on the cover pools status upon an issuer’s insolvency.
We also view positively that the EBA positions covered bonds as a ‘credit product’. Quarterly cover pool reporting will become obligatory for issuers highlighting that the evolution of risks needs to be regularly monitored by investors.
To achieve preferential risk weightings under the CRR/CRD IV as well as Solvency II, the EBA proposes to add: more-detailed credit measures into the regulation (including definitions for eligible cover assets); the requirement to keep the loan-to-value thresholds current; and a one-size-fits-all minimum overcollateralisation of 5%.
We believe the exclusive definition of eligible cover assets does not bode well for the acknowledgement that covered bonds are a credit product. From a credit-risk standpoint, we firmly believe that even SMEs can support high credit quality instruments – in particular when originated in the normal course of business and maintained on the balance sheet of the issuer. The absence of a clear Europe-wide definition of what constitutes an SME, and the challenge to establish a similar, transparent credit-risk indicator for SME’s (as e.g. the LTV for mortgages) currently does not facilitate the restriction of cover assets to the prime segment – for now. In light of the European Commission’s Capital Markets Union (CMU), which aims to foster SMEs, and our view that markets might agree on comparable creditrisk indicators for SME’s over time, we believe the final proposal should not rule out the widening of eligible assets to granular pools of assets with a predictable risk profile.
Further, an increased one-size-fits-all overcollateralisation creates a false sense of security for investors. Even within the same jurisdiction and within the limits of the same covered bond regime, the combination of and interaction between risks (credit risk, residual market risk and, notably, asset-liability mismatch risk) can significantly vary between issuers and their covered bonds. We do not believe that uniform requirements across issuers will provide the same credit protection. Similar to the Pillar II requirements in normal banking regulation, supervisors should have the ability to establish and publish individual overcollateralisation levels that allow a cover pool to withstand a pre-defined level of stress.
‘The cherry on top’
The proposal highlights areas that national regulators could focus on to improve their frameworks, in order to foster investor acceptance. This includes the restriction to a single asset type or geographic focus, or the way and frequency that loan-to-value is measured (difference between market value and prudent mortgage-lending value).
We believe the additional stress-testing requirements, currently only part of the voluntary convergence, should become an integral part of preferential risk weightings.
The ECB: A Role Model for Investors?
As of end November 2016, the ECB was the single largest covered bond investor, with holdings of more than EUR 200bn accumulated during the third covered bond purchase programme (CBBP3). The ECB already holds 30% of eligible covered bonds on its balance sheet (up from about 18% a year ago), and its holdings in individual issuances can be as high as 70% of the outstanding volume. Any ECB action will have a significant impact on the market and liquidity of this asset class.
The CBBP3 has already had a significant impact on the covered bond market, resulting in a significant spread compression between ‘core’ and ‘peripheral’ markets. In the view of many investors the missing credit spread differentiation has converted covered bonds into a ‘rates’ product. The ECB has almost siphoned off primary and secondary markets and itself needed to reduce the volume of monthly purchases under the programme. Still, the programme has been extended by nine months, to end in December 2017.
Investors feel crowded out. They cannot replace maturing covered bonds as the ECB is active in primary and secondary markets. The end of the CBBP3 will have a significant impact on the covered bond market, and a well-timed and well-managed end is of crucial importance.
The ECB’s annual update of the collateral framework seems simple as the changes are rather subtle, for example, to collateral haircuts. However, we believe the update provides something to consider for traditional covered bond investors. The ECB highlights two aspects that diligent covered bond investors should always monitor: 1. how does the credit quality of covered bonds evolve over time; and 2. what is the impact of maturity extensions (soft bullets, as well as conditional-pass-through covered bonds – CPTs).
The ECB’s changes will make more information available to investors, who will then become able to validate their credit views. The enhanced transparency will benefit the market, as pricing will eventually again have to reflect credit differences rather than the current supply-demand imbalances.
- New disclosure requirements for rating agencies
Regulators generally try to reduce reliance on ratings, but these still play a crucial role for the ECB’s haircuts in the collateral framework. Forming an independent credit opinion for covered bonds is, in contrast to ECB-eligible securitisations, not really facilitated, as issuers do not provide a very high level of transparency on their cover pool risk structure. Regular and very detailed reporting is not required in most covered bond legal frameworks, and the industry has only recently made progress with the introduction of the ECBC’s Covered Bond Label as well as a more standardised reporting format (the Harmonised Transparency Template – HTT).
Most investors rely on the credit assessment performed by credit rating agencies (CRAs), and the level of sophistication investors apply for their own assessments can vary significantly. Monitoring the composition of the cover pool is a starting point, but what matters is the impact of those changes on the covered bonds’ credit quality. While CRAs might have diverging views on the level of credit risk and the impact of market risk, we believe that the regular provision of different views will give investors the needed insight into a covered bond programme’s resilience against adverse shocks.
- Consultation on the treatment of soft bullets and CPTs
The ECB also announced that in the second half of 2017, it will look into soft-bullet or conditional pass-through covered bonds, including those issued at floating rates.
Retained covered bonds have been a lifeline for some banks in terms of providing liquidity, and we welcome that the ECB currently does not intend to go as far as the Swedish central bank, which disallowed the use of ‘self-issued’ covered bonds as collateral.
In terms of financial stability, we view positively that the use of such instruments will not become prohibited, and will only become an economically less-interesting liquidity option. At the same time, we view the widened application to publicly placed soft bullets or CPTs as a double-edged sword.
Soft bullets and CPTs allow a mitigation of liquidity risk, and we expect their use to become the new standard. We believe the ECB needs to find a well-balanced change to its haircut framework to facilitate the increased use of such credit-positive issuance formats.
Scope Ratings’ full covered bond outlook can be accessed here. This Article was originally published in Market Insights & Updates – EMF-ECBC Monthly newsletter in December 2016.