January 03, 2019

ECB published its opinion (CON/2019/1) on the legal framework for covered bonds in Estonia. This opinion was issued in response to a request from the Estonian Ministry of Finance for an opinion on its draft law on the covered bonds framework. The purpose of the draft law is to set up a legal framework for the issuance of covered bonds by credit institutions and to foster the Estonian capital markets and increase financial stability.

ECB welcomed the aim of the draft law to establish a legal framework for issuing covered bonds, thus diversifying the sources of potential financing for credit institutions and further developing the financial markets in Estonia. ECB is favorable to the additional licensing and supervisory regime to be introduced for credit institutions intending to issue covered bonds. Also welcomed were the mandatory appointment of the cover pool monitor and its specified duties, which include ensuring that the stress tests conducted on portfolios of covered bonds comply with applicable regulations, that there are sufficient cover assets, and that the cover assets comply with the requirements set out in the law. 

The draft law does not include any statutory maturity extension triggers and allows for contractual maturity extension triggers if they meet specific conditions. Moreover, the draft law does not specify the circumstances which the issuer cannot control and which would be a pre-condition for maturity extension. In the experience of ECB, it is not possible to fully exclude discretionary triggering of a maturity extension. By allowing the extension triggers to be contractually defined, the proposed directive could result in significant heterogeneity across covered bonds, which hinders harmonization.

Additionally, ECB welcomed the detailed specification of the requirements for the cover pool assets including the primary cover pool assets, the substitution assets, and the liquid assets; this should help ensure that the covered bonds are of high quality. ECB notes that the cover pool liquidity buffer should cover the entire net liquidity outflow for 180 calendar days, as liquidity buffers should also cover potential issuer insolvency scenarios. Therefore, it is suggested that Section 21(3) of the draft law be clarified to make it clear that the cover pool liquidity buffer covers the full net liquidity outflow of the covered bond program for 180 days, not just the largest negative result on a daily basis over the next 180 days.

Under the proposed directive, member states are expected to lay down rules for derivative contracts that could be included in the cover pool. This would include at least the eligibility criteria applicable to hedging counterparties. The draft law lays down general conditions for eligible counterparties. The drafting notes to the draft law specify that the aim of these conditions is to ensure that a counterparty of any hedging arrangement is also sufficiently solvent during turbulent market conditions. ECB welcomes the consideration given to this issue, but more specific qualitative and quantitative conditions could be introduced to ensure that the hedging counterparty used is sufficiently solvent and that potentially costly re-hedging would not have to be undertaken. These could include triggers related to the creditworthiness of the hedging counterparty for collateralizing the derivative exposure or for the replacement of the hedging counterparty. Additionally, ECB welcomes the disclosure obligations introduced into the draft law but considers that the issuers should be obliged to include further information in their reports.

 

Related Link: ECB Opinion (PDF)

Keywords: Europe, EU, Estonia, Banking, Securities, Covered Bonds, Opinion, CON/2019/1, Financial Stability, ECB

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