The Financial Services Authority’s statement that it is ready to introduce a regulatory framework for UK covered bonds has met with widespread approval and relief from market participants [see FSA takes the covers off, February issue]. The announcement, made at the European Covered Bond Council’s meeting on February 7, ends a two-year period when UK borrowers operated at a disadvantage to many of their continental European competitors.
Good regulation
“We view the introduction of a covered bond regime that is compliant with EU legislation as consistent with our principles of good regulation,” says the FSA’s Paul Sharma, its head of prudential standards.
Consultations are due to be completed in the third quarter of 2006; the FSA will announce the final rules at the start of 2007. The FSA has created a covered bond standing group – a pre-consultation forum that will look at the various issues resulting from the mooted framework. Representing intermediaries on the standing group are ABN Amro, Barclays, Citigroup, Deutsche Bank and Royal Bank of Scotland; the borrower community is represented by Abbey, HBOS and Nationwide.
Significant change
“This change is highly significant. First and foremost, this will mean that UK covered bonds receive a 10% risk weighting, as will covered bonds from other jurisdictions sold to UK investors,” says Tim Skeet, managing director of financial institutions origination at ABN Amro. Skeet explains that with the FSA and the UK Treasury on board there are great hopes for developing a sterling-denominated covered bond sector with the possibility of repo eligibility.
The UK’s slice of the issuance pie is set to grow
Covered bond volume in 2005: €135bln |
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| Source: Royal Bank of Scotland |
UK covered bonds attract a 20% risk weighting under the Capital Requirement Directive – the EU’s version of Basle II. The accepted wisdom is that UK structured covered bond spreads could now narrow compared with the rest of the covered bond sector once a new 10% risk weighting level is priced into the market.
“I think that looking at where UK covered bonds trade relatively to Spanish cédulas or German Pfandbriefe, they definitely have potential to outperform,” argues Stefan Dreesbach, managing director and head of the frequent borrower group at RBS.
Broader acceptance
Much of the covered bond investor base comprises central banks, pension funds, insurance companies, asset managers and bank treasuries that are attracted by covered bonds’ liquidity, credit ratings and covenants. But Dreesbach says that the FSA’s move should lead to a much broader acceptance of covered bonds among UK investors, with greater involvement of bank treasuries.
HBOS circumvented the lack of a UK legislative framework in the summer of 2003 by using contract law to create a structured covered bond. But under this approach such instruments were 20% risk weighed, unlike the 10% enjoyed by the legislatively backed German, Spanish and French covered bonds. It also limited the participation of certain non-bank investors because the UK paper was not covered by the EU’s Directive on Undertakings for Collective Investment in Transferable Securities. Ucits eligibility is only possible when covered bond borrowers operate under a regulatory framework.
A cautious stance
Furthermore, the UK regulator, fearing that covered bond pools could structurally subordinate retail depositors, had taken an extremely cautious stance on these securities by placing a very conservative cap on the amount banks could issue. In fact it was only in August 2005 that the FSA uncapped an unofficial 4% covered bond issuance limit, as a proportion of banks’ balance sheet.
Threshold
Now the FSA has a three-stage framework for UK covered bond issuance. Banks with total covered bond issuance below 4% of total assets do not need FSA approval. But once banks exceed this 4% threshold they are required to inform the FSA on a deal-by-deal basis and might even be asked to hold additional capital. The FSA has an upper limit of 20% of total assets for covered bonds, above which most banks would likely require an increase in internal capital ratios.
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Skeet, ABN Amro: under the new regime UK covered bonds will receive a 10% risk weighting |
The Netherlands authorities have also signalled their intention of regulating structured covered bonds. ABN Amro has a €25 billion structured covered bond programme but, similar to UK banks, these securities are 20% risk weighted.
The Dutch central bank and finance ministry are considering introducing a 10% risk weighting, perhaps this year (covered bonds from Austria, Germany, France, Spain and Luxembourg are already recognized in the Netherlands). This should be followed by a specific covered bond law, which is likely to be introduced at the end of 2007.