Article 503 of the Capital Requirements Regulation (CRR) tasks the European Banking Authority (EBA) with reporting to the European Parliament and Council on whether the current own-funds (i.e. regulatory capital) treatment of covered bonds is appropriate, and in particular, whether the preferential risk-weighting for covered bonds backed by residential mortgages (and other assets) contained in Articles 129 and 496 of CRR is appropriate (the risk-weight can be as low as 10% in some cases - contrast this with the lowest available risk weight for RMBS which is 20% under the Standardised Approach). In addition, the recent European Systemic Risk Board (ESRB) Recommendation on funding of credit institutions tasked the EBA with identifying best practice in covered bond frameworks and reporting back. The EBA's detailed Report is intended to address both of those requests, and provides a comprehensive overview of national covered bond frameworks across the EU, identifies the key features and practices that define a prudentially sound covered bond framework, and provides advice on the overall conditions justifying the preferential risk weighting treatment of certain types of covered bond in the EU. The EBA provides a thorough comparative analysis of the current legal and regulatory frameworks in place across the EU, covering the legal and bankruptcy framework, features of the cover pool, valuation of mortgage assets and loan-to-value criteria, the management of asset/liability risks, monitoring, segregation and the bankruptcy-remoteness of covered bonds. A review of supervisory practices draws comparisons between competent authorities' approaches to supervision prior to issuance, on an ongoing basis and in a default/resolution scenario. A chapter devoted specifically to transparency reviews the main industry initiatives on disclosures relating to covered bond issuance. Three chapters provide detailed information on the features of specific cover pool assets, and a cash flow sensitivity model is included that has been developed to analyse the sensitivity of covered bonds' historical performance. Concerns relating to the issue of encumbrance are also considered. Two types of Recommendation are embedded throughout the Report. First, the EBA's "principles of best practice" for covered bonds are that they must feature these key areas: a dual-recourse mechanism; asset segregation and bankruptcy-remoteness; features of the cover pool; valuation of cover assets and LTV limits; asset and liability risk management in relation to coverage principles and over-collateralisation; asset and liability risk management in relation to stress testing, use of derivatives for hedging and liquidity risk mitigation; covered bond monitoring; role of the competent authority; and disclosure to investors. The second set of recommendations are for the European Commission to consider in developing a possible revised regulatory framework for covered bonds, and focus on complementing the existing provisions (in Article 129 CRR) with the EBA's recommended new provisions on liquidity risk mitigation, a possible new minimum regulatory over-collateralisation level, enhancements to the role of the competent authority and improved disclosure. Further, the EBA recommends the further convergence of national legal and regulatory frameworks for covered bonds, and the ongoing monitoring of the preferential risk-weighting for covered bonds, particularly after the entry into force of the EU Recovery and Resolution Directive.
Overall, the EBA recommends that the existing preferential risk-weighting for covered bonds contained in the CRR is appropriate (save for some concerns around cover pools composed of RMBS and CMBS, for which lower risk-weights should not be allowed beyond 31 December 2016). In addition, the EBA recommends that it is not appropriate to include aircraft liens in cover pools, and extra criteria (relating to lien restrictions) are recommended for pools backed by residential loans secured by guarantees. It is expected that the European Commission will use the EBA's recommendation to maintain a low risk-weighting for covered bonds to justify its decision to allow covered bonds to be used to make up the bulk of banks' Liquidity Coverage Ratios (LCR) in due course (with RMBS, as you may be aware, currently restricted to 15% of overall High Quality Liquid Assets for the purposes of the LCR, and subject to other quality controls and minimum haircuts).