S&P Global Ratings believes the legal frameworks for covered bonds in France address the main legal issues we consider under our covered bonds criteria, which enable us to potentially assign higher ratings to French covered bond programs than those on the parent banks.

Overview Of The French Legal Frameworks

The French covered bond legislation encompasses SFH and SCF, two core legal frameworks. An additional framework is exclusively dedicated to the Caisse de Refinancement de l'Habitat. The SFH and SCF frameworks--the focus of this publication--are enshrined in the French Monetary and Financial Code.

The SFH framework restricts eligible collateral to residential loans and substitute assets; it is dedicated to the issuance of "obligations de financement de l'habitat" (OHs). The SCF framework permits multiple collateral types, including public-sector exposures, residential loans, commercial real estate loans and substitute assets. Covered bonds issued by SCFs are named "obligations foncières" (OFs).

SFHs and SCFs--the covered bond issuers--are specialized credit institutions licensed and supervised by the Autorité de Contrôle Prudentiel et de Résolution (ACPR), the French banking regulator. They are wholly owned affiliates of a bank, provide refinancing to the banking group to which they belong, and are insulated by law from the bankruptcy of their parent. SFHs and SCFs are managed by the parent bank and have no employees or other resources. As regulated entities, they are subject to regular monitoring by a cover pool monitor (specific controller) to ensure compliance with regulatory obligations.

Covered bondholders have dual recourse to receive payments on the covered bonds: to the SFH/SCF's parent bank while it is solvent, and then to the cover pool assets if the parent bank becomes insolvent.

Assets can be segregated within the SFH/SCF by way of a transfer of security to a loan granted by the SFH/SCF to the parent bank (secured loan structure, see chart 1) or through a true sale where they are sold outright to the SFH/SCF (see chart 2).

In the secured loan structure, the SFH/SCF issuer uses the covered bond issuance proceeds as a loan to the parent bank. This then transfers the collateral assets to the SFH/SCF as security for the loan. Collateral will remain on the parent bank's balance sheet so long as it is solvent. Once the parent bank becomes insolvent, security over the collateral--which will be granted pursuant to the EU Collateral Directive as implemented in French law--will be immediately enforceable and transferred to the SFH/SCF. The terms of the loan typically match the terms of the covered bonds, enabling the SFH/SCF issuer to make full and timely payments on the covered bonds.

Chart 1

Chart 2

Table 1

Implementation of the EU Covered Bonds Directive

The EU Covered Bonds Directive was transposed into French legislation by enacting changes to the French Monetary and Financial Code by means of decree-law (ordonnance) n. 2021-858 dated June 30, 2021; decree (décret) n. 2021-898 dated July 6, 2021; ministerial decree (arrêté) dated July 7, 2021; and decree (décret) n. 2022-766 dated May 2, 2022. These amendments apply as of July 8, 2022. A further amendment was made through decree (décret) n. 2023-102 dated Feb. 16, 2023.

The main changes are:

• Soft bullet maturity extensions are allowed if the parent/sponsor defaults on the interest/principal payment on a secured loan, if the SFH/SCF defaults on the interest or principal payment on the covered bonds' scheduled maturity date, or if the SFH/SCF or parent/sponsor bank were to become subject to insolvency proceedings.
• Soft-bullet maturity extensions--if due to SFH/SCF default--cannot invert the maturity order of outstanding bonds. However, the inversion of repayment order is not forbidden if the extension was triggered by parent/sponsor bank payment default or its insolvency proceedings.
• Premium covered bonds require enhanced monitoring by the specific controller to ensure compliance with article 129 of the Capital Requirements Regulations.
• SFH/SCF run off costs until last bond redemption are now included in the calculation of the 5% regulatory overcollateralization ratio.
• Enhanced disclosures and reporting.

Considering the French legislation was already well-aligned with the EU Directive, updates were limited and have not changed the conclusions of our analysis of the legal frameworks.

In our view, SFH and SCF frameworks achieve effective protection of covered bondholders, flexibility to include multiple asset types, clear rules on minimum overcollateralization, liquidity coverage, and maturity mismatch requirements.

We believe the two frameworks address the main legal aspects we assess when looking at covered bond legislation, in particular the cover pool assets' isolation from risk of bankruptcy or insolvency of the issuer, or its parent (see "Covered Bonds Criteria," published Dec. 9, 2014). We conclude that both legal frameworks could lead us to assign a rating to French covered bond programs above the rating on the parent or sponsor bank, subject to a review of each program's structure, documentation, and specific features, in accordance with our criteria for covered bonds.

The Five Key Factors In Our Assessment

When assessing a covered bond program's underlying legal framework, we focus primarily on the degree to which cover pool assets are isolated from risk of bankruptcy of the issuer--or its parent or sponsor bank in the French case--for the covered bondholders' benefit. We also consider whether the bankruptcy will likely have other detrimental effects on the timely and full satisfaction of the covered bondholders' claims. Under our criteria, if our analysis concludes covered bonds are not likely to be affected by the issuer's bankruptcy, we may assign a higher rating to the covered bonds than the rating on the issuer.

In line with our criteria, we reviewed five key aspects of France's covered bond legislative frameworks: the segregation of the cover pool assets and cash flows; risk of payment acceleration to bondholders, a payment moratorium, or forced covered bond restructuring; overcollateralization limits; the treatment of hedging arrangements; and access to funding after the issuer's bankruptcy.

Segregation of the cover pool assets and cash flows

When evaluating this factor, we examine whether the cover pool assets are fully available to meet the covered bonds' obligations. Under the French legal frameworks, we understand that, until redemption of the covered bonds, covered assets cannot be used for any purpose other than the repayment of the bonds and other secured claims, such as derivative contracts used for hedging purposes. Specifically, segregation is achieved by the parent (or any other group entity) transferring eligible assets to the SFH/SCF. Bankruptcy of the parent cannot be extended to the SFH/SCF.

Under the SFH/SCF legislation, OF/OH holders benefit from a statutory priority right of payment, i.e., a legal privilege over the SFH/SCF's eligible assets. If the SFH/SCF becomes insolvent, the OF/OH and other privileged debts--such as exposures to derivative counterparties for the hedging of interest rate and foreign currency risk--are paid according to their payment schedule and have priority over any of the program's other debts or nonprivileged creditors, in relation to the program's assets. All privileged debts rank pari passu. Until such privileged liabilities' full payment, no other creditors may act against the SFH/SCF's assets.

Therefore, if a parent bank becomes insolvent, cover pool assets are ringfenced and must primarily be used to satisfy the covered bonds' obligations.

Third-party execution risk.   As part of our asset isolation analysis, we examine to what extent the issuer or parent's third-party creditors might be able to enforce claims against the cover pool assets. As explained above, cover pool assets are segregated to the SFH/SCF and, therefore, the parent bank's creditors have no recourse to the assets. Under article L.513-11 of the French Monetary and Financial Code, holders of OFs/OHs and other privileged debts have preferred creditor status and the right to be paid before other creditors who have no rights to SFH/SCF assets until the preferred creditors' claims are fully satisfied. The law specifies that, until OF/OH holders and holders of other privileged claims (e.g., derivative counterparties) are paid in full, no other creditor may assert any right on or claim to any of the issuer assets.

Commingling risk.   This refers to the risk that collections received on the cover pool assets fall into the bankrupt parent's general estate and are either lost or frozen, and therefore unable to be paid to covered bondholders.

French legislation does not address commingling risk, so we consider it in our rating analysis. Our considerations depend on the covered bond program's asset segregation technique.

Preinsolvency, in the secured loan structure, collections generated by the collateral do not belong to the SFH/SCF until parent bank insolvency. However, for true sale structures collections belong to the SFH/SCF from the transfer date. The two asset segregation methods lead to different exposures to preinsolvency commingling risk.

Postinsolvency commingling risk (notification risk) also depends on the asset segregation technique. Programs employing true sale tend to structurally mitigate commingling risk by using bank accounts with appropriately rated banks according to our counterparty criteria (see "Counterparty Risk Framework: Methodology And Assumptions," published on March 8, 2019). For programs that transfer assets by way of security, debtors tend to continue to pay into the parent bank account until notified otherwise (usually on parent insolvency). Accordingly, commingling risk arises, which we analyze on a transaction specific basis, including the presence of any structural mitigants.

Setoff risk.   Setoff risk occurs when borrowers are entitled to setoff amounts owed to them by the issuer or parent against their repayment obligations under the loans. French covered bond legislation does not mitigate setoff risk and, hence, we need to assess it by looking at the relevant considerations in French law. This analysis is performed on a program basis, and we would normally expect to receive legal comfort on the absence of setoff risk in the context of each program. Otherwise, we would consider if alternative mitigants for the program apply, such as setoff reserves.

Risk of asset removal without replacement following parent bankruptcy.   This is when an asset no longer satisfies the eligibility criteria following parent bankruptcy and would be removed from the cover pool without replacement. Upon parent bank insolvency, security on the assets will be enforced and, hence, the parent bank will not be able to remove any assets from the SFH/SCF.

Risk of payment acceleration to bondholders, a payment moratorium, or forced covered bond restructuring

Acceleration of payments.   The French covered bond legislation (article L.513-11.3) specifically states that covered bonds with legal privilege cannot be accelerated because of SFH/SCF insolvency. In the event of SFH/SCF insolvency proceedings (safeguard procedure, judicial reorganization, or liquidation), all claims benefiting from the privilege (including interest) must be paid on their due dates and before all other claims. Until full payment of all such preferred claims, no other creditors may take any action against the SFH/SCF's assets.

Furthermore, the legislation does not allow automatic termination of hedging agreements upon issuer insolvency.

A moratorium or forced restructuring.   Covered bond investors are not exposed to the risk of issuer moratorium as the law (article L.513-11.2) specifically states that privileged covered bonds are paid at their contractual maturity, notwithstanding any issuer insolvency proceedings. Furthermore, the law states that insolvency proceedings at the parent cannot be extended to SFHs/SCFs. Specific derogations to the French Bankruptcy Law--applicable to covered bonds issued by SFH/SCFs--imply that a forced and legally binding restructuring of the insolvent company's debts is not possible in France. By implication, we understand a moratorium, forced restructuring, or forced rescheduling of the payment obligations of the issuer, or its parent, should not apply to covered bonds. Therefore, this should not affect the timely payment of interest and principal to bondholders.

Overcollateralization limits

The French legal frameworks specify minimum overcollateralization ratios for the covered bonds via various coverage tests (5% nominal value, liquidity over the next 180 days, cash inflows from asset collections covering covered bond payments, and SFH/SCF servicing costs until the last bond maturity). However, the parent bank can voluntarily provide higher overcollateralization levels. As the assets included in the cover pool (including the overcollateralized portion) are segregated from the parent, they would not be released to the parent's insolvency estate.

Voluntary overcollateralization is not specifically regulated under French legislation. As a result, we understand the segregation applies to all the assets transferred (whether by true sale or pursuant to a transfer by way of security) to the SFH/SCF. In addition, we understand the law disapplies the parent bank's insolvency officer from seeking to claw back transfers made to the SFH/SCF during the hardening suspect period, unless it can prove fraud. Accordingly, once transferred, an asset should not be subject to successful clawback into the parent's insolvency estate.

Treatment of hedging arrangements

Under French legislation, the SFH/SCF issuer may enter hedging transactions on cover pool assets and covered bonds if they are used to cover interest rate, foreign exchange, or liquidity risk. In such circumstances, those hedging agreements will benefit from the privilege. The law (article L.513-11.1) specifically defines the assets which are allocated in priority to the payment of privileged claims. These assets include sums resulting from derivative contracts, after setoff where applicable. By law (article L.513-11.3), swaps will not automatically terminate upon the SFH/SCF's insolvency or give the swap counterparty statutory termination right.

Access to funding after the parent's bankruptcy

If a parent bank becomes insolvent, French legislation states that, depending on the situation, a provisional administrator--appointed by French banking regulator ACPR--may oversee or advise managers, or be given full power. The administrator can use the same asset-liability management tools usually available to SFH/SCFs, such as asset disposal, issuing nonprivileged liabilities, and entering into repurchase agreements with the central bank. The law aims to provide continued management of the SFH/SCF until repayment of all privileged liabilities.

Related Criteria

• Counterparty Risk Framework: Methodology And Assumptions, March 8, 2019
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022