Friday, April 27, 2012

FSA Official Urges SEC and Other Regulators to Clarify Impact of Volcker Rule Proposed Regulations on UK Covered Bond Market

UK Financial Services Authority officials are concerned that, in the absence of clarification, the proposed regulations implementing the Dodd-Frank Volcker Rule provisions may unintentionally interfere with U.K. covered bond structures and as a result have potential negative implications for U.K. banks and possibly the U.K. economy more widely. In a letter to the SEC, CFTC and the banking agencies, David Lawton, Acting Director of Markets, said that the proposed regulation prohibiting banking entities from sponsoring or retaining as principal an ownership interest in a covered fund, and/or entering into a transaction with a related covered fund for which it serves as sponsor, investment manager or investment advisor could apply to U.K. covered bond structures given the wide definition of "covered fund" which, in the absence of further clarification, could potentially include the asset pool owners in UK covered bond structures; and the points of connection between U.K. banking entities and U.K. asset pool owners.

Moreover, some of the transactions entered into by the issuing bank may be interpreted as a "covered transaction" with a covered fund for the purposes of section 23A of the US Federal Reserve Act. The UK official also noted that asset pool owners could also fall under the definition of " banking entity" since the issuing bank is typically one of the asset pool owner's members. The UK FSA does not believe it is the intention of the regulations to interfere with UK covered bond structures or indeed covered bond structures in other jurisdictions, but these uncertainties, if not appropriately addressed, could adversely impact the ability of U.K. banks to finance thcmselves through covered bond transactions.

The FSA official urged the SEC, CFTC and banking agencies to clarify the scope of U.K. covered bonds under the proposed regulations. A lack of such clarification will serve to create uncertainty for market participants, he reasoned, which would be detrimental for these institutions. In particular, special focus should be given to the definitions of "covered fund" and "banking entity" to ensure that these derinitions do not inadvertently capture the asset pool owners in covered bond structures. 

Covered bonds are a type of secured bond that is usually backed by mortgages or public sector loans. In the U.K., regulated covered bond structures involve a separate special purpose vehicle which holds the collateral pool and guarantees payments under the covered bonds pursuant to a guarantee which is secured over such pool (the asset pool owner). In order for such covered bonds to achieve the intended economic effect of holding dual recourse, to both the bank issuing the instrument and the collateral pool, the issuing bank (which would fall under the definition o["banking entity" under the proposed Volcker regulations, enters into a number of transactions with the asset pool owner. This includes transactions where the bank takes on credit exposure to the asset pool owner (e.g. through derivatives and securities lending transactions, provision of loans and/or investment in securities of the asset pool owner).