A New Legislative Regime for U.K. Covered Bonds
In March of this year the U.K.'s Regulated Covered Bond Regulations 2008 came into force. Under the new regulations, U.K. credit institutions will be able to issue covered bonds complying with the UCITS Directive, in line with their European Union (EU) counterparts, benefiting from increased exposure limits and preferential risk weighting for investors.
In most European countries, the issuance of covered bonds is regulated by specific covered bond legislation. However, in some countries like the U.K. and the Netherlands, covered bonds have been issued prior to the introduction of legislation and therefore the structural features of the transactions are effected on the basis of private contractual arrangements. However, what all covered bonds have in common is that they are simply debt securities issued by banks and credit institutions, the repayment of which is backed and secured by a ring-fenced pool of the bank's or credit institution's financial assets such as residential mortgages.
In terms of EU regulation, the special character of covered bonds has been enshrined in the 1988 Directive on Undertaking for Collective Investments in Transferable Securities (UCITS). Several EU member states have implemented the UCITS Directive into national law. The U.K., however, started as a structured covered bond market in 2003 when HBOS launched its residential mortgage backed covered bond program and became the first U.K. bank to issue a structured covered bond. Subsequently, around eight U.K. banks and building societies followed HBOS' lead in setting up structured covered bond programs. All of these were backed by U.K. residential mortgages apart from two programs which were backed by commercial property loans and social housing loans.
Regulatory Harmonization
Despite exponential growth of the market in the U.K. since 2003, the U.K. covered bond market was at a competitive disadvantage compared to its European counterparts due to the absence of the implementation of the UCITS Directive in the U.K. On March 6, the long-awaited UCITS legislative framework for U.K. covered bonds was implemented by virtue of the Regulated Covered Bond Regulations 2008.
The effect of UCITS compliance is to raise the concentration limits on bonds issued by the same entity from 5% to 25% for investment funds and 40% for insurance companies. In addition, if collateralized by certain eligible assets, preferential risk weighting may be ascribed to such covered bonds under the Capital Requirements Directive (CRD) such that credit institutions can decrease their risk weighting from 20% to 10%.
The CRD implements Basel II. The purpose of Basel II is to revise the supervisory regulations governing the capital adequacy of banks. The new RCB regulations enables covered bond investors to benefit from this if the CRD requirements are met for an issuance. This more favorable risk weighting will now apply also for CRD-compliant covered bonds issued out of the UK held by foreign banks. Hence, the benefits of UCITS and CRD compliance extend outside of the confines of just the EU.
Multi-Layered U.K. Covered Bond Market
Investors will now differentiate between U.K. structured covered bonds and U.K. regulated covered bonds:
U.K. structured covered bonds: are not UCITS 22(4) compliant and do not benefit from the higher investment limits. Such bonds cannot be CRD compliant without meeting the UCITS 22(4) requirements.
U.K. regulated covered bonds: issuances by FSA registered issuers according to the terms of an RCB compliant covered bond program. If collateralized by eligible assets under the CRD, they further benefit from preferential risk weighting.
Hence, from a legal and regulatory perspective, three types of covered bonds will co-exist in the U.K.:
* CRD and UCITS compliant regulated covered bonds;
* UCITS 22(4) compliant but non CRD compliant bonds; and
* Non CRD compliant and non UCITS 22(4) compliant bonds.
Specifics of the RCB Regulations
The aim of the FSA was to implement a regime which resulted in minimal changes to existing structures. Therefore, actual implementation of the RCB regulations does not require wholesale structural changes to the existing U.K. program so the existing contractual program template for structured covered bonds will remain in place. From the issuers' perspective, the main difference will be the supervision by the FSA of all the registered issuers.
The RCB regulations are specific in providing for the five requirements of article 24.4 of UCITS:
Issuer Type: recognized issuers must be UK credit institutions with their registered office in the UK and must be authorized to carry out the regulated activity of accepting deposits. The U.K. government indicated that it will consider extending the regime to UK branches of EEA banks in spring 2009.
Supervision: the FSA will perform the supervisory and enforcement functions for the RCB regulations. This is a new feature for U.K. covered bonds and reflects the UCITS requirement for special public supervision of covered bond regimes. The Financial Services Authority (FSA) has a framework of notification and reporting requirements and has the power to give directions, take enforcement action, levy fees, and solicit information in relation to any regulated issuance. Previously, since 2005, the only supervisory requirement in relation to covered bonds was for the issuer to notify the FSA if issuance reached 4% of total assets. This requirement will remain.
Asset Eligilibility: proceeds derived from the issue of a regulated bond must be lent by the issuer to the asset owning guarantor and must be used to the extent required to satisfy certain asset capability requirements to acquire eligible property. Eligible property is defined to include assets set out in the CRD as well as social housing and public private partnership loans (although bonds backed by these assets which are not included in the CRD definition will not benefit from preferential risk weighting otherwise available in respect of UCITS and CRD compliant covered bonds). Exposures to RMBS and CMBS are limited to those backed by assets that the issuer or an affiliate has originated or acquired.
Asset Coverage: the asset pool must have certain sufficient collateral to cover bondholder claims throughout the whole term of the covered bond. Existing UK structured covered bonds program provide for a number of tests related to asset capability already so no additions or modifications are needed to the existing structures for compliance with this requirement.
Priority of Investors: pursuant to the specified priority of payments in the RCB regulations, the claims of the bondholders and the ancillary service providers such as swap providers and trustees must all rank pari passu upon realization of the security and the winding up of the asset owner. Specific amendments to the existing programs are required to reflect these requirements.
Hence, apart from the priority point, only minor modifications are required in order to bring the existing structures within the requirements of the RCB regulations. The fundamental structure and the vast majority of contractual arrangements remain in place.
U.K. Variations to European Structures
With respect to implementation of UCITS in the UK, the most important feature which the regulations did not provide for is the so called "integrated model" that was contemplated by the July 2007 consultation document. In existing U.K. structured covered bonds, ring-fencing of the collateral from the insolvency estate of the issuer is achieved by English common law arrangements via a "true sale", securitization style transfer of the assets out of the insolvency estate of the issuer to a bankruptcy remote special purpose vehicle. It is then this asset owning SPV which guarantees the issuer's covered bond obligations.
This is the main differentiation from the continental European model (such as Germany and France)* which instead of transferring the assets as described above instead involves setting up a legislative ring-fence around the asset pool which remains on the issuing bank's balance sheet. As market participants questioned whether this model was workable given existing U.K. insolvency law, the Treasury decided not to include the legislative ring-fencing protection model in the regulations at this stage. This position will be reconsidered when the regulations are reviewed one year after implementation.
Long-Term Benefits For Issuers and Investors
From an issuer's perspective, U.K. banks have now the same opportunities as their European peers to fund loans through the issuance of UCITS compliant and/or CRD compliant covered bonds. In addition, the principles based approach adopted in the current legislation provides issuer flexibility and allows for further structural innovation and development. Potentially deeper markets in the U.K. and continental Europe may make covered bonds less vulnerable to temporary liquidity squeezes and imply a more stable source of residential mortgage funding for UK banks and ultimately consumers.
* It should be noted that Italian, Greek and Dutch covered bond laws do allow for the transfer of assets away from the originator to a special purpose vehicle.
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