UK Regulated Covered Bond Regulations 2008 - Highlights Of The UK´s Regulated Covered Bond Regulations - Part 1 Of 4

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Keywords: FSA, covered bonds, debt securities, asset pool, UCITs Directive, Capital Requirements Directive, credit institutions, ring-fenced pool

Originally published March 2008

Foreword

The UK's "Regulated Covered Bond Regulations 2008" and the Financial Services Authority's Regulated Covered Bond Specialist Sourcebook came into force on 6 March 2008. Under the Regulations, UK credit institutions will be able to issue covered bonds complying with art. 22(4) of the UCITs Directive ("Regulated Covered Bonds"). The new framework introduced by the Regulations and the Sourcebook brings about a number of regulatory incentives for the issuance of Regulated Covered Bonds which will have an impact upon the strategy of UK credit institutions going forward.

What Is A Covered Bond?

Covered bonds are debt securities issued by banks and other credit institutions, the repayment of which is secured by a ring-fenced pool of assets backing the bond.

What Is A "Regulated Covered Bond"?

These are covered bonds that comply with a number of criteria set forth by Council Directive 85/611/EC (the "UCITs Directive"). The criteria are the following:

1. the issuer must be a credit institution with its registered office in the EU;
   
   
2. the issuance by such credit institution must be subject by law to special public supervision to protect covered bondholders;
   
   
3. sums deriving from the issue must be reinvested in eligible assets which, during the life of the bonds, are capable of covering claims attaching to the covered bonds; and
   
   
4. in the case of failure by the issuer, such sums would be used on a priority basis for repayment to the covered bondholders.
   
   

The definition of such "eligible assets" is determined in part 12, Annex VI of the Banking Consolidation Directive (2006/48/EC) (the "Capital Requirements Directive" or "CRD"). The common feature of these assets is their good quality and safety from a credit risk point of view (i.e. exposures to (i) EU Central Governments, (ii) AAA-rated banks and (iii) exposures secured by residential or commercial real estate with a maximum 80% or 60% LTV, respectively, etc.).

What Are The Benefits Of Regulated Covered Bonds?

Holders of Regulated Covered Bonds have a direct claim against the issuer credit institution secured by a first ranking claim against a pool of high quality assets. The combination of these features makes Regulated Covered Bonds a very safe debt instrument, usually with a top credit rating. Because of these features, Regulated Covered Bonds merit the following regulatory benefits which make them an attractive instrument from both issuer and investor perspectives:

1. collective investment institutions regulated by the UCITs Directive may invest up to 25% of their assets (rather than 5%) in Regulated Covered Bonds of one issuer;
   
   
2. insurance companies under the Life and Non-Life Insurance Directives (Directives 92/96/EEC and 92/49/EEC) may invest up to 40% of their assets (instead of 5%) in Regulated Covered Bonds of one issuer; and
   
   
3. credit institutions investing in Regulated Covered Bonds benefit from a reduced risk weighting compared with the senior unsecured debt of the same issuer.
   
   

More than 30 European countries have implemented some form of legislation to allow their credit institutions to issue Regulated Covered Bonds. Part 4 of this paper provides a comparison of the main features of these regulations in 5 European countries. UK, Germany, Spain, France and Italy.

What Is The Purpose And Main Features Of The UK's "Regulated Covered Bond Regulations 2008" (The "Regulations")?

The Regulations are aimed at incorporating into UK law the above UCITs Directive and CRD criteria so that UK credit institutions may issue Regulated Covered Bonds. The regulatory criteria for Regulated Covered Bonds are based on the principles that have already existed in the UK structured covered bond regime since the first issuance in 2003; as a result, almost all outstanding UK structured covered bonds should qualify as Regulated Covered Bonds, subject to certain changes and subject to registration and increased supervision.

HM Treasury has drafted the Regulations in cooperation with the FSA and with the industry through a consultation in July of 2007 (the "July 2007 consultation"). The overarching principle of the Regulations is to create a flexible framework for Regulated Covered Bonds in the UK to promote market innovation, while inserting certain "quality markers" to "help increase investor confidence and ensure the development of liquid products". To reflect this approach, the final text of the Regulations have incorporated a number of changes to the initial draft, such as:

1. a more restricted list of eligible assets compared with that provided in part 12, Annex VI of the CRD;
   
   
2. a more restricted list of countries where eligible assets may be located;
   
   
3. the limitation of eligible issuers of Regulated Covered Bonds to UK authorised credit institutions only (i.e. no UK branches of non-UK credit institutions), and the requirement that the SPV acquiring the pool of assets must have its centre of main interests in the UK to ensure that insolvency proceedings will fall under UK jurisdiction; and
   
   
4. extended supervision powers for the FSA over Regulated Covered Bonds.
   
   

More importantly, the Regulations have dropped the "integrated model" (the "integrated model") that was contemplated by the July 2007 consultation. This integrated model is used by Regulated Covered Bonds in other EU Member States such as Germany or Spain, and involves setting up a legislative ring-fence around the asset pool, which remains on the issuing bank's balance sheet (thus no need for an SPV). As market participants questioned whether this model was workable given existing UK insolvency law, HM Treasury decided not to include the integrated model in the Regulations at this stage, but this position will be reconsidered when the Regulations are reviewed one year after implementation.

Part 2 of to this paper summarises the Regulations in further detail. Part 3 of this paper summarises the Financial Services Authority's Regulated Covered Bond Specialist Sourcebook (the "Sourcebook"), which sets out the guidance, directions and rules made by the Financial Services Authority (the "FSA") under the Regulations.

A copy of the Regulations can be found on the website of the UK's Office of Public Sector Information (http://www.opsi.gov.uk/si/si2008/uksi_20080346_en_1). A copy of the Sourcebook can be retrieved from the FSA's website (http://www.fsa.gov.uk/pubs/policy/ps08_02.pdf).

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