Since it took effect in 2022, the EU's harmonized covered bond framework has increased transparency in the market and increased protection for investors. Standards for asset quality, disclosure, and supervision have all improved. That said, although S&P Global Ratings considers the framework to be broadly credit positive, it has had little direct impact on our ratings.

The biggest change to our ratings analysis is that the framework introduced a mandatory liquidity buffer and allowed notes to include extendible maturity features. Under our criteria, in some programs this increased the number of unused rating notches--the number of notches that the issuer rating can be lowered without triggering a downgrade of the covered bonds. The ratings were unaffected.

Overcollateralization levels remained broadly stable, even in Spain, where the framework significantly reduced the legal minimum overcollateralization requirement. Although this initially raised concerns about available investor protection, in practice, issuers have maintained overcollateralization levels that we consider commensurate with our ratings.

Chart 1

Isolating The Impact Of Harmonization Is Challenging

Extensive use of nonstandard measures to affect monetary policy during and after the pandemic has significantly distorted covered bond markets since the transposition of the CBD. At its peak, holdings under the European Central Bank's (ECB's) third covered bond purchase program (CBPP3) exceeded €300 billion--more than a third of outstanding covered bonds that were eligible. Similarly, more than €700 billion of covered bond issuance was registered as collateral under the ECB's targeted long-term refinancing operations (TLTRO), at its peak.

Given the scale of these distortions, isolating the specific impact of the CBD on financial markets presents a significant challenge. For example, euro-denominated covered bond issuance more than doubled in 2022, compared with the previous year. However, the increase stemmed from the need to repay central bank liquidity, rather than the effects of the CBD.

Chart 2

Although covered bond spreads between countries have narrowed since their peak in 2018-2019, we attribute the compression to the ECB bond purchases and strong demand for ECB-eligible collateral.

Chart 3

The CBD Has Yet To Open Up New Markets

The geographic distribution of covered bond issuance and investors has not significantly changed since the CBD came into effect. German-speaking countries and France still dominate both the supply of and demand for euro-denominated covered bonds, followed by the Nordic countries and the Netherlands, Belgium, and Luxembourg.

Chart 4

Chart 5

The geographic distribution of covered bond issuance and investors has not changed significantly since the CBD came into effect. EU countries that lacked dedicated covered bond legislation before the CDB was implemented locally (for example, Croatia and Bulgaria) have yet to issue new covered bonds. That said, ample liquidity has discouraged the issuance of covered bonds in Central and Eastern Europe (see: "Covered Bonds In New Markets: Issuance Holds Up In 2024," published on April 29, 2024.) We expect that, once funding needs arise, issuers in these countries will make use of the CBD's dedicated framework.

Third-Country Equivalence Is Still Theoretical

The CBD defines a pathway to achieve third-country equivalence, which would align the regulatory treatment of covered bonds issued by credit institutions inside and outside the European Economic Area (EEA). However, the process has yet to be defined and questions about the outcome are still outstanding.

Countries implementing the Basel III reforms can choose to grant preferential risk weights for covered bonds purchased by banks outside Europe--but not all have chosen to do so. Covered bonds issued by credit institutions outside the EEA and purchased by European investors still receive less favorable regulatory treatment than covered bonds issued by EEA-based credit institutions.

European authorities are likely to demand close alignment between any third-country covered bond framework and the CBD before they give covered bonds issued outside the EEA the same favorable regulatory treatment that is available for bonds issued inside the EEA.

Three steps are needed to achieve third-country equivalence:

• A report from the European Commission (EC) justifying the introduction of an equivalence regime and defining the technical requirements.
• A legislative proposal (directive or regulation) transposing these requirements into a legal act and empowering the EC to take a decision on implementation.
• A thorough assessment of the third country's covered bond framework, upon which recognition of equivalence will depend.

Main beneficiaries

Should a third-country equivalence regime come into effect, we anticipate that EEA investors and non-EEA issuers would be the main beneficiaries. Over the past decade, more than 75% of euro-denominated covered bonds issued outside the EEA have been bought by EEA investors, on average. Third-country equivalence would therefore increase diversification opportunities for EEA investors, while offering third-country issuers a broader investor base and reduced funding costs.

More broadly, a third-country equivalence regime could support higher issuance volumes outside traditional EEA markets, supporting the entire covered bond market by increasing its depth and systemic importance. In addition, improved liquidity and a broader investor base could help develop local capital markets and even potentially help bolster national economies by funding housing market growth.

Credit impact

From a ratings perspective, higher volumes are generally credit positive because they increase liquidity and, potentially, the systemic support available to covered bond markets. That said, expansion could also introduce credit risks.

The growing global success of covered bonds could prompt more non-European issuers to label dual-recourse issuance as covered bond issuance, irrespective of whether a third-country equivalence regime has been established. A properly designed equivalence regime would mitigate this reputational risk and help market participants recognize covered bond products that follow international best practices.

Considerations in developing a new regime

Under the CBD, the EC must report on the feasibility of developing a third-country equivalence regime, but it does not define how to assess equivalence. We expect the EC's assessment to extend beyond technical equivalence criteria to encompass more general financial policy criteria. Specifically, we anticipate that the EC will consider:

• Risks to the reputation of the EU financial sector and its long-term stability, given the regulatory objectives and outcomes of the third-country regime;
• The compatibility of wider external policy priorities and concerns with EU policy priorities and international standards; and
• Any corresponding requirements for recognition or equivalence from the third country.

The EC issued a call for advice to the European Banking Authority (EBA) in July 2023, which will respond by June 2025. If the Commission makes a legislative proposal, it would then have to be adopted through an ordinary legislative procedure. We do not anticipate that the EU will implement a third-country equivalence regime until 2026 at the earliest.

Many countries are already closely aligned

According to the European Covered Bond Council's preliminary analysis, many existing third-country frameworks are:

• Fully aligned with the dual-recourse requirements;
• Almost fully aligned with the bankruptcy remoteness and asset segregation requirements; and
• Partially meet the CBD requirements on asset eligibility criteria

Other requirements under the CBD--such as the minimum nominal overcollateralization level of 5%; the 180-day liquidity rule; or the use of objective triggers for extendible maturity structures--are rarely included in global frameworks. However, issuers often meet these requirements on a contractual level.

The main area in which the CBD and global frameworks often differ significantly relates to reporting requirements and supervision provisions. These are often less detailed than the stipulations in the CBD.

In our view, it will be difficult to strike the right balance between retaining the safety features of product components and allowing third countries the flexibility necessary to maintain their market traditions. Given that the CBD itself takes a principles-based approach, we consider that the EU would benefit from taking a similar approach to setting technical specifications for assessing third-country alignment.

Most local regulators would prefer to use the definition of covered bonds and the specific requirements set out in the Basel III framework as a starting point. Although they are not obliged to follow the EU's provisions, they are likely to implement the Basel III requirements.

Extendible Maturities Can Ease Liquidity Risk

Under the CBD, issuers are required to maintain sufficient liquidity to cover net liquidity outflows for 180 calendar days. National legislators can stipulate that liquidity risk is addressed by keeping liquid assets, or allow extendible maturity structures.

Each jurisdiction was required to define objective triggers for maturity extensions--the issuer cannot choose when to extend a maturity date. Extension may not affect the ranking of covered bond investors or change the maturity schedule. Information about maturity extension triggers is disclosed to investors so that the consequences of insolvency are clear, including how resolution of the issuer could affect the covered bond maturity structure.

Soft-bullet maturities, already relatively common, now comprise the largest share of covered bonds. For example, German Pfandbriefe switched to soft from hard bullet structures in 2021. The other alternative, conditional pass-through structures, received less-favorable treatment from the ECB, causing their popularity to wane (see "Covered Bonds Primer," published on March 19, 2024 for a detailed description of these structures). In our view, either option for extending maturities is credit positive--both prevent bonds from being exposed to payment disruption while the issuer accesses the market to raise funds against cover assets.

Chart 6

Each covered bond market has maintained its own character

European authorities adopted a principles-based approach when drafting the harmonization package. Differences in how each country transposed the CBS enable local markets to retain their own characteristics. For example, what constitutes an objective trigger is governed by national laws. Therefore, the conditions for extendible maturity programs have tended to converge within each local market, but not at the European level.

Similarly, some national legislators allow issuers to calculate liquidity buffers based on the extended maturity date for principal payments; others, such as Germany, require issuers of covered bonds with extendable maturities to use the scheduled maturity date.

Although there is always scope for further harmonization, we consider that transposition has not created market disruption. Therefore, we see limited need for further change.

Preparing For Future Initiatives

Reservations delayed action on European secured notes

ESNs were not included in the 2019 package approved by the European Parliament because inclusion would have added to the complexity of the harmonization process. In addition, some countries had reservations about the idea and wanted to address it in a separate initiative.

Considering how important SMEs are to the European economy, we consider that a reasonable business case could be made for introducing a new instrument.

The main impediment to adoption is that regulators would prefer to see how the product performs before introducing a dedicated framework. Market participants, by contrast, would prefer to have a dedicated regulatory framework first. In particular, they seek clarity on the regulatory treatment ESNs might receive, including:

• Whether they would be excluded from bail-in requirements;
• If they would be eligible under the ECB's collateral framework; and
• What standard of eligibility would apply under the liquidity coverage requirement rules.

In our view, issuers may find it more efficient to issue covered bonds backed by mortgages, rather than SME loans. We discussed our rating approach in "Credit FAQ: Understanding The Role Of European Secured Notes In Funding SME And Infrastructure Lending," published on May 21, 2019.

Market interest in green covered bonds has surged

Issuance of green covered bonds has grown significantly over the past few years, supported by strong investor demand (see "Covered Bonds Outlook 2024: Stability Amid Turbulence," Dec. 11, 2023.) The CBD does not explicitly address green covered bonds. Nonetheless, the Commission's call for advice asked the EBA to provide an overview of the current state of the market and assess possible future developments.

For example, introducing a requirement to disclose environmental, social, and governance (ESG) risks in cover pools would provide greater clarity for market participants, in our view. Issuers may welcome the addition burden of making ESG disclosures if it spurs market interest in further green covered bond issuance.

Chart 7

Related Research

• Covered Bonds Primer, March 19, 2024
• Covered Bonds In New Markets: Issuance Holds Up In 2024, April 29, 2024
• Covered Bonds Outlook 2024: Stability Amid Turbulence, Dec. 11, 2023
• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022
• Credit FAQ: Understanding The Role Of European Secured Notes In Funding SME And Infrastructure Lending, May 21, 2019