Scope Ratings provided feedback to a European Banking Authority questionnaire that was issued in response to a Call for Advice from the European Commission on the performance and review of the EU covered bond framework. The Covered Bond Directive (CBD) had also called for a report on the introduction of European Secured Notes (ESNs).

Scope believes the CBD has delivered a number of benefits to the EU’s covered bond markets. “Harmonising legal frameworks has been credit-positive, particularly for smaller and less developed markets as there are fewer uncertainties about their legal strengths and better clarity on regulatory oversight,” said Mathias Pleissner, Scope’s deputy head of covered bonds. “The Directive has enhanced levels of sophistication, introduced improvements to liquidity and market depth and eased cross-border activity.”

The CBD has some limitations, however. As a principles-based framework, it primarily focuses on covered bond issuance activities without addressing wider aspects such as issuers’ business profiles, the specifics of individual mortgage market or insolvency regimes. As a result, assessing the credit quality and risk attributes of covered bonds in the EU still requires investors and rating agencies to factor in issuer, market and country specific factors.

“In our view, covered bonds and corresponding European legal frameworks would benefit from stronger and better aligned market-risk-management guidelines; clarity on liquidity access for covered bonds that are in an orderly and stand-alone wind down; and more dynamic over-collaterisation (OC) rules. Given the dynamic nature of cover-pool composition and mismatches, OC levels should also be dependent on a covered bond’s risk profile,” Pleissner said. “We would consider it credit-positive for banks if covered bond funding were more closely entrenched with prudential frameworks to reduce banks refinancing imbalances.”

ESNs could boost more competitive SME funding
European Secured Notes (ESNs), introduced as part of the capital markets union project could, from a macro perspective, offer funding benefits to banks and ultimately to SMEs, which are the backbone of the European economy.

“We support the development of ESNs as a potential driver for cheaper SME funding,” said Karlo Fuchs, head of covered bonds. “However, there is a caveat. ESNs will not allow banks to increase the volume of SME financing at a time where risk weights for SME portfolios will increase and thus tie up capital. This compares unfavourably to securitisations, which can be used to free up capital and increase banks’ SMEs lending capacity.”

Figure 1: SME preferred funding options 

Source: European Commission Survey on Access to Finance of Enterprises (SAFE), December 2023

Banks will need to consider carefully the extent of which they want to use ESNs. The higher velocity and shorter tenors of SME loans will require more management attention than longer-term mortgage refinancing. In the absence of common standards, too, costly structuring efforts may initially challenge their economic viability.

“The key to success will be a pan-European regulatory framework similar to the CBD aided by supervision and lower risk weights to support the product’s growth and foster investor confidence. Harmonised and comparable risk measures for SME exposures across Europe are also needed for transparency and comparability as well as regulated eligibility criteria,” Fuchs said.

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