Monday, April 18, 2011

UK Authorities Propose Major Legislative Changes to UK Covered Bond Regime

With Congress seriously considering legislation establishing a US covered bond market, the UK Treasury and Financial Services Authority have proposed significant changes to the UK covered bonds legislative regime to enhance transparency, introduce consistent standards, exclude securitizations as eligible assets, allow issuers the option of single asset type investment pool, and create a formal asset pool monitor. Covered bonds are a category of secured bonds issued by banks and typically backed by mortgages or public sector loans that provide long-term, stable funding from a diverse investor base. They are often used in place of securitization.

Regulation plays a very important role in the covered bond market. Most covered bond markets across the world are underpinned by dedicated legislation setting out criteria for the assets that can back a covered bond, a process for managing investors’ recourse to those assets if the issuer of the covered bond fails, and a system of regulatory oversight. The UK’s covered bond legislation is set out in the Regulated Covered Bonds Regulations of 2008.

As the designated supervisor of UK regulated covered bonds, the FSA assesses all applications by financial institutions to be issuers of covered bonds, and assesses applications to register individual bonds or programs. Only deposit taking institutions with their registered office in the UK can register as regulated covered bond issuers.

A key requirement of the UK’s regulated covered bond regime is that issuers must provide the FSA with regular, comprehensive information about their covered bond programs. After the initial introduction of the UK regime in 2008, the FSA placed additional requirements on issuers in relation to the information they must provide to the FSA on an ongoing basis.

The Regulations set out which assets are eligible for inclusion in covered bond asset pools. They currently allow securitizations of residential and commercial mortgages to be included in covered bond asset pools. This is in line with the relevant provisions of the European Banking Consolidation Directive. However, many other jurisdictions, such as Germany, take a stricter approach than the Directive and do not allow securitizations to be included.

The rationale for excluding securitizations is that the complex structure of securitizations can make it more difficult to analyze the likely performance of a covered bond. However, since covered bonds are typically low-yielding products, noted the authorities, it is not cost-effective for most investors in them to conduct the detailed analysis needed to fully understand this additional complexity. Instead, investors may choose to uniformly mark down their assessment of a covered bond that contains securitizations. Thus, the government proposes to amend the legislation to exclude securitizations as eligible assets.

UK covered bonds benefit from high levels of transparency, such as detailed reporting about the quality of covered bond asset pools and disclosure of legal documentation. This transparency, however, is not driven by any feature of the Regulations and is instead a result of market practice. The lack of regulation in this area means the format of disclosure is not consistent across all issuers, increasing the barriers to comparing and evaluating the relevant data for investors. A lack of regulation also means investors may not have as much confidence in the quality of this disclosure or recognize it as a key feature of UK covered bonds as if the disclosure was enforced by regulatory requirements.

The Government proposes to authorize the FSA to direct publication of information in order to ensure consistent reporting and disclosure for UK covered bonds, in
line with guidance provided by the FSA. This will reduce the costs for investors of using the information issuers provide and increase its reliability. A better informed market will benefit from more efficient pricing, which will benefit issuers with high quality covered bonds.

In the UK, the regulatory component of overcollateralization levels is determined by FSA stress testing assessing the performance of the covered bond program against a range of possible adverse scenarios to determine how much overcollateralization is needed to ensure that the program can continue to meet its liabilities under these stresses. Some other jurisdictions take a different approach and impose a statutory fixed minimum level of overcollateralization that issuers must meet.

The Government would legislatively require that issuers maintain a fixed minimum level of overcollateralization in covered bond asset pools. Treasury and the FSA envisage setting the fixed level in line with the fixed minimums in other jurisdictions, which would be well below the current levels of overcollateralization in the UK. This means the new requirement will have no material impact on issuers, but will reduce investor uncertainty.

In practice, overcollateralization in these countries is, like in the UK, far higher than the typical fixed minimum levels used, and is driven by rating agency requirements and investor preferences. A fixed minimum level is, however, more transparent and readily understood by investors than a variable level. It also provides a floor to the possible levels of overcollateralization on which investors can rely. The absence of a minimum in the UK introduces a degree of uncertainty and makes the UK regime harder to compare with other jurisdictions

UK covered bonds benefit from a high degree of external scrutiny, including an annual external audit of the program. But the external audit is not currently a statutory requirement. Some jurisdictions include a formal requirement in their regulation for an asset pool monitor, which performs a similar function to an external auditor.

The Government proposes to require issuers to appoint a formal Asset Pool Monitor, with duties similar to that of existing auditors. This is intended to make the presence of external scrutiny of UK covered bond programs more apparent to investors without imposing major changes on issuers. The lack of such a requirement in UK Regulation may be putting UK issuers at a disadvantage compared with competitors

The Regulations currently allow a range of asset types to be included in a covered bond asset pool, including residential mortgages and commercial mortgages. Some jurisdictions require issuers to maintain asset pools with only a single type of asset in them.

The Government proposes to give UK covered bond issuers the option to formally declare their covered bond program as a single asset type program. Such programs would only be allowed to include assets of a single type. Issuers would still be able to retain the current flexibility in the Regulations to mix and change asset types by declaring their program a mixed asset type program.

Treasury and the FSA considered removing the option for mixing asset types altogether, which would bring the UK fully into line with some other jurisdictions. But they rejected this option because it is unnecessary to go this far to address the problem identified. Since mixing asset types may in future meet the needs of some issuers and investors, reasoned the authorities, removing this option from the Regulations may constrain the potential for innovation and growth in the covered bond market.