Co-published Covered bonds guide: ICMA Q&A


format and associated risk, if they do not view it as a ‘covered bond’. The debate will continue to rage around


the use of the expression ‘covered bond’. The ECBC labelling initiative aims to lift such debate into a different place – a labelled covered bond is a historic covered bond, an unlabelled one, therefore, is not. But irrespective of investor reception,


there is currently a notable regulatory focus on sourcing new ways to accelerate the flow of funds to SMEs and European companies, in particular. There are growing concerns among EU regulators about the ability of such entities to refinance, given banks’ recent and ongoing retrenchment from the loan market and dramatic deleveraging. In such a context, market participants


Tim Skeet, ICMA


“ www.iflr.com


look to covered bonds as a form of quasi- securitisation that appeals to a broader and deeper investor base. But it’s questionable whether the name


of the product matters, in a world where investors are expected to more closely assess each instrument themselves. Arguably it’s up to them to decide what


The underlying asset class in SME ‘covered bonds’ is much more difficult to understand and evaluate


underlying assets are small corporate loans. It is the furthest we have been from the original concept. It is structured around an asset class that is much more difficult to understand and evaluate. The risk dynamics are thereby very different from those of a traditional covered bond, which is structured around highly granular and well-understood real estate assets or public sector loans. Opinion is divided as to what this


instrument is. Some view it as a ‘covered bond’. Others consider it to be a form of asset-backed that shares certain characteristics with covered bonds – namely bullet redemptions, and a dual recourse funding mechanism – but without the specific legal framework. More traditional market participants might be reticent to buy into the product’s


are the products they will or will not buy and the names they give to them. It remains to be seen whether the


creation of SME-backed covered bonds in some way compromises or undermines the robustness of this market. That’s the existential question in some ways.


So do you think we should call these instruments covered bonds? It was a German institution that successfully created the first of these, and in a sense that answers the question. SME-backed covered bonds do behave


more like traditional covered bonds, with the exception that the underlying asset class is different, and more difficult to assess. I supported the original contractual-


based UK covered bonds but equally, I worked hard to get them pushed into a legal framework. Certainly, intellectually I like the idea of SME-backed covered bonds. I like the idea that we can get investors to buy a dual recourse instrument that they will see as less risky than outright securitisation, which gives them more yield, but also provides a mechanism for directing financing to a vital part of the European economy. Increased levels of transparency are


critical to ensuring there is adequate disclosure of risk to investors. We need to make more information readily available for investors, so they know what they are


buying and can both evaluate and price that risk on a sustainable, consistent basis. Consider what other sources of finance


could plug the current funding gap for SMEs. There are a number of important dynamics to contemplate here. And for several major investors, banks have unique attributes in this regard, that are difficult to replicate elsewhere. For example, banks are able to leverage themselves up. They are also often best placed to evaluate the risk associated with funding these small, often unknown, companies, given their historic relationships with, and lending activity to, these entities. Therefore they need to be involved in processing and assessing the lending. Further, banks are well placed to


“


restructure the loans in the event of difficulties or default. That’s an important


Increased levels of transparency are vital


factor, given SME loans have a higher relative default rate and less reliable historic performance data compared to the more usual underlying assets for covered bonds. A covered bond, by its very nature, is constantly substituting good assets for bad, thanks to the fully dynamic nature of the collateral pool. Assuming that the issuer is still healthy and functioning, the nature of the collateral is always going to be high quality because the bad loans will come out and good loans will go back in. You need to have institutions with the ability to warehouse a certain volume of these substitutions. Regardless, I think we’re likely to hear


more of these forms of assets in the future. The market is becoming more sophisticated. Its participants should not worry excessively about instruments’ labels but rather they should focus on analysing the real nature of the risk. That’s desirable and hopefully the direction of travel for investors in future.


IFLR/July/August 2013 57


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