Covered Bonds in - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in

Dr. Otmar Stöcker, Managing Director Association of German Pfandbrief Banks

NBP Workshop on Recent trends in the real estate market and its analysis Zalesie Górne, 15.11.2013

(14.10.2013) 1. Asset Encumbrance 2. Covered Bonds vs. deposits 3. EU-law definitions on Covered Bonds 4. Legal structure of Covered Bonds in Europe 5. Bail-in

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 2 1. Asset Encumbrance (AE)

Since financial crisis upcoming political discussion on: How to make sure that . tax payers do not need to rescue banks? . deposit insurance is sufficient in a real bank insolvency case? → How many assets would be part of insolvency estate? → How many assets are encumbered (pledged) in favor of special creditors?

Asset Encumbrance

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 3 1. Asset Encumbrance (AE)

. ECB and EBA focus on AE including collateral for: - Central bank funding - Repos - Derivatives - Covered bonds Evidence shows:  Covered Bonds are not main drivers of AE  CB related AE = transparent, because volumes of CBs and cover pools are regularly published

. No EU-law limit for CB volumes

. A few countries set national limits (see next chart).

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 4 1. Asset Encumbrance (AE)

National regulations on asset encumbrance regarding covered bonds:

Country Limit on covered issuance

Australia 8% of total Australian assets

Belgium Maximum amount is capped at 8% of issuer total assets

Canada 4% of total assets

Greece 20% of total unencumbered assets

Italy Issuance limited to a percentage of eligible cover assets. Limits are based on capitalisation of the institution however (no limit if tier 1 >11% + tier 2 > 7%) Ratio between covered bonds to total assets has to be "healthy", DNB decides on a case by case basis New Zealand 10% issuance limit on the proportion of a New Zealand bank’s assets that may be encumbered in favour of covered bonds US According to the FDIC's Policy Statement and the US Treasury's Best Practice Guide: 4% of total liabilities

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 5 2. Covered Bonds vs. deposits

Covered bonds are exempt from deposit insurance. Positive effects of CBs for deposit insurance

During financial crisis 2 stable funding sources:

Covered Bonds deposits long-term + investors low outflows readiness to buy

CBs = long term funding source CB - eligibility criteria CBs = stable funding source → clearly → long-term asset business more → high quality of cover assets shown during financial crisis balanced → less credit risks in CB issuer’s → less liquidity risks balance sheet  . Funding and liquidity problems less probable, if credit institution disposes of CB . Less credit risks translates in higher financial stability.

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 6 2. Covered Bonds vs. deposits

Bank funding: Unsecured, covered and Pfandbrief vs. swaps *)

(bp) ECB announces 300 ECB announces Covered-Bond- 275 Covered-Bond- Purchasing Draghi 250 Purchasing Programme 2 in London: Programme 1 „whatever it 225 takes“ 200 175 150 125 100 75 50 25 0 -25 2007 2008 2009 2010 2011 2012 2013

iBoxx senior financials iBoxx all covered bonds iBoxx German Pfandbriefe

sources: iBoxx, Commerzbank Research *) comparison distorted by different durations of indices

u clear advantage of Pfandbrief funding since beginning of financial crisis

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 7 2. Covered Bonds vs. deposits

Development of Spreads (Basis points)

1000 ECB announces Spreads Covered-Bond- Draghi in London: Covered Bonds 900 Purchasing „whatever it takes“ 800 Programme 2 (in bp, average 700 maturity) 600 500 400 300 200 100 0

-100

Jul.10 Jul.11 Jul.12

Apr.10 Okt.10 Apr.11 Okt.11 Apr.12 Okt.12 Apr.13

Jan.10 Jan.11 Jan.12 Jan.13 Gesamtmarkt Covered Legal Hypothekenpfandbriefe Oeffentliche Pfandbriefe Portugal Covered Covered Single Covered

source: LBBW Pfandbrief offers cheapest and most stable funding of all Covered Bonds

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 8 2. Covered Bonds vs. deposits

Pfandbrief issuance Jan 2008 – Sep 2010 (bn €)

insolvency ECB announcing 22,0 Lehman Covered Bond 20,0 Brothers Purchase Programme 18,0 16,0 14,0 12,0 10,0 8,0 6,0 4,0 2,0 0,0

Jan. Feb. Mrz. Apr. Mai. Jun. Jul. Aug. Sep. Okt. Nov. Dez. Jan. Feb. Mrz. Apr. Mai. Jun. Jul. Aug. Sep. Okt. Nov. Dez. Jan. Feb. Mrz. Apr. Mai. Jun. Jul. Aug. Sep. 08 08 08 08 08 08 08 08 08 08 08 08 09 09 09 09 09 09 09 09 09 09 09 09 10 10 10 10 10 10 10 10 10 Jumbo-(Inhaber-)Pfandbriefe 2,9 4,5 2,3 6,0 3,5 2,4 2,7 3,0 0,0 0,0 0,0 0,0 0,0 2,0 1,3 1,0 4,0 2,7 2,1 1,3 2,5 2,5 0,0 0,0 2,5 3,5 2,0 1,0 0,0 4,4 0,5 0,5 0,1 Inhaber-Pfandbriefe 8,0 5,5 3,7 8,2 8,8 11,6 7,2 5,1 12,4 8,5 8,0 7,5 3,4 4,9 4,9 4,9 5,2 9,0 7,9 4,5 4,0 3,0 3,9 3,2 3,4 2,6 4,8 3,5 4,9 7,9 9,7 1,8 5,2 Namenspfandbriefe 1,7 1,9 1,9 3,4 1,2 7,0 1,8 3,5 1,4 3,4 2,4 1,6 3,9 2,9 4,1 4,8 3,4 3,0 2,4 1,4 2,3 1,1 1,2 1,8 1,4 2,4 1,1 1,6 1,0 1,6 1,2 0,7 2,0

sources: , HVB, vdp

• Mortgage Pfandbrief* 2009: 58 bn € 2008: 63 bn € 2007: 27 bn € ► • Public Pfandbrief 2009: 52 bn € 2008: 90 bn € 2007: 108 bn € • Pfandbrief total 2009: 110 bn € 2008: 153 bn € 2007: 135 bn € *) incl. Ship Pandbrief

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 9 2. Covered Bonds vs. deposits

Market of the European Covered Bond Countries in the European Covered Bond Market (end of 2012: 2.714 bn €)

Luxembourg Greece Czech Republic 24,86 18,05 9,06 Finland 0,92% 0,66% 0,33% 26,68 Hungary 0,98% 4,96 Portugal 0,18% 35,87 1,32% Cyprus 4,55 0,17% 42,84 1,58% 52,65 Slovakia 1,94% 3,84 0,141%

Netherlands 61,52 Belgium 2,27% 2,59 0,0954%

Switzerland Iceland 85,71 0,89 3,16% 0,033%

Poland Italy 0,77 126,71 0,03% 4,67%

Germany 524,88 19,34% Norway 110,20 4,06% Spain 440,35 16,22% For comparison: 188,99 6,96% Sweden 220,37 France 365,89 Canada: 49,12 bn. 8,12% 361,89 13,48% USA: 6,00 bn. 13,33% (source: ECBC – 30.8.2013)

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 10 2. Covered Bonds vs. deposits

Public Covered Bonds in Europe compared with Mortgage Covered Bonds (as at end of 2012, in bn. EUR)

ICE 0,893 PL 0,11 BE 2,59 P 1,30 SK 3,84 UK 2,74 CY 4,55 NOR 3,74 HU 4,96 IT 10,30 CZ 9,06 LUX AT 17,01 24,86 100% AUT 25,83 GR 18,05 CH 85,71 IRL 27,55 IRE 25,10 90% NO 107,46 ES 33,61 FIN 26,68 IT 116,41 80% PT 34,57 UK NL 61,52 185,24 F 70% F 208,30 208,30 D 60% 216,00 S 50% 220,37

40% DK 359,56 30% D 301,13 20% ES 406,74 10%

0% Mortgage Covered Bonds (2.115,25 bn) Public Covered Bonds (503,2 bn) (source: ECBC – 30.8.2013)

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 11 2. Covered Bonds vs. deposits

Core of conflict between CB’s and deposits = over-collateralisation (OC)

deposit insurance CB issuer = credit institution capital

depositors

cover pool senior unsecured creditors

cover assets clients 110 CB investors

100

10 = OC  funded via

Without OC - CB not successful, because good rating not possible !!

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 12 3. EU-law definitions on Covered Bonds

1. Art. 52 IV UCITS-directive covered bonds = - bonds, issued by credit institutions - secured via cover assets, which are insolvency protected - subject to special public supervision - covered bonds secure investors in case of insolvency of the issuer

2. Art. 129 CRR = Art. 52 IV UCITS + asset quality criteria

But so far no definitions or minimum criteria regarding - Insolvency segregation of cover assets and insolvency remoteness of covered bonds - Special banking supervision

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 13 4. Legal structure of Covered Bonds in Europe - Covered Bond legislation overview -

Geographical overview Covered Bond Legislation in Europe (year of introduction / latest substantial amendment) (as at Dec. 2012)

2008

Legislation in countries of the EU/EEA/CH 2000/ 2010 2006 2003 28 2004

2002/ 1851/2007 1998 33 2007 2008 2003 2008  Legislation in

1900/2005 other countries 2012 1998  1997 1995 2006 1996

1999/2010 1931 2005 5 1997 2006 2005 2006

2010 2006 2008 1981/2007 2000

2007 2007

 2010

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 14 4. Legal structure of Covered Bonds in Europe

Transparency of legal structure of Covered Bonds

Transparency

Covered Bond Legal structure markets of Covered Cover pools Bonds

Priority position Insolvency Insolvency Who is the Legal nature of of Covered segregation of “remoteness” of issuer? cover pool Bonds cover assets Covered Bonds

. All clearly and in detail answered by parliamentary legislation? . Contractual structures publicly disclosed? Legal opinions / legal memoranda published?

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 15 4. Legal structure of Covered Bonds in Europe - Covered Bond models -

Model 1 Covered Bond issuer is completely specialised funding institute: France, Ireland

parent  Origination and servicing of eligible assets and bank management of Covered Bond issuing institute by parent bank or other parent institution  Funding institute has no other function than holding (or mainly holds) eligible assets transfer of acquisition of eligible eligible assets  Issuer has the legal status of a credit institution assets  Issuance governed by special legal framework payment of principal and  Issuer has no or almost no staff Covered interest  Decisive = insolvency segregation of Bond investor CB issuer from parent bank Issuer purchase of Covered  CB issuer capable of acting in spite of Bonds insolvency of parent bank?

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 16 4. Legal structure of Covered Bonds in Europe - Covered Bond models -

Model 2 Covered Bond issuer is specialized credit institution by law: Denmark, Hungary, Luxemburg, Norway, Poland Covered Bond issuer

payment of non-eligible assets payment of principal and principal and interest interest borrowers investors eligible assets grants loans purchase of Covered Bonds

 Issuer originates, services and funds eligible and non-eligible business  Loan origination restricted by law to mortgages and public-sector loans  Issuer has the legal status of a credit institution  Issuance governed by special legal framework  Decisive = insolvency segregation of cover assets from insolvency estate

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 17 4. Legal structure of Covered Bonds in Europe - Covered Bond models -

Model 3 Covered Bond issuer is universal credit institution

Austria, Belgium, Bulgaria, Czech Republic, Cyprus, Finland, Germany, Greece, Iceland, Latvia, Lithuania, Portugal, Romania, Russia , Slovakia, Slovenia, Spain, Sweden

Covered Bond issuer non-eligible assets payment of payment of principal and principal interest and interest

borrowers eligible assets investors purchase grants of loans Covered Bonds

 Issuer originates, services and funds eligible and non-eligible business  Strict eligibility criteria apply to eligible cover assets  Issuance governed by special legal framework  Decisive = insolvency segregation of cover assets from insolvency estate

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 18 4. Legal structure of Covered Bonds in Europe - Covered Bond models -

Model 4 Covered Bond issuer is using SPV to achieve insolvency segregation of cover assets: Italy, Netherlands, UK

transfer of assets legally separated company Covered Bond purchase of assets issuer • Covered Bond issuer (credit institution) originates, services and funds eligible & non-eligible loans • Transfer of assets onto legally separated entity (SPV without the legal status of a credit institution) payment of principal purchase of and interest Covered Bonds • Legally separated entity guarantees payment of principal and interest • If insolvency segregation not governed by special legal framework but based on general law: investors  Special public supervision covering legal structure ?  Legal structure disclosed in detail to public?

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 19 4. Legal structure of Covered Bonds in Europe - Covered Bond models -

Covered Bond - Pooling Models Model 5 Austria (Pfandbriefstelle), France (CRH),

mortgage member banks / borrowers originators

Covered Bond investors Issuer

loans to member banks

eligible loans to clients

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 20 4. Legal structure of Covered Bonds in Europe - German Pfandbrief fundamentals -

• Pfandbrief is a bank • Cover assets remain on balance • Pfandbrief is collateralized by cover assets subject to strict quality requirements:  regional restrictions u  conservative loan appraisal in property and ship lending  only senior loan up to 60% of mortgage lending value eligible for cover  loans to public sector subject to public guarantee • Upon deterioration of cover asset quality: credit check and potential revision or substitution

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 21 4. Legal structure of Covered Bonds in Europe - German Pfandbrief fundamentals -

Segregation principle

issuer insolvency insolvency administrator creditors

 other Pfandbrief bank other assets creditors

other assets cover pool administrator

mortgage- mortgage loans Mortgage Pfandbrief loans

loans loans Public to public to public Pfandbrief Pfandbrief banks institutions instiutions with limited Ship ship ship loans business activity loans Pfandbrief

aircraft aircraft Aircraft Pfandbrief loans loans

• Pfandbrief does not accelerate • Pfandbrief and cover assets are exempt from the insolvency estate u • Bank license upheld for each Pfandbrief bank with limited business activity • Cover pool administrator

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 22 5. Bail-in

Need to harmonize CB definitions / criteria in all EU legislation ! European Banking Union

S R M S S M Treatment of Covered Bonds

- UCITS vs. CRR - exclusion from bail-in single resolution - nat. discretion for partial single supervisory mechanism write-down, if lack of mechanism nd coverage (=2 bail-in) - regulation - - special supervision - regulation -

BRRD (Bank Recovery and Resolution Directive) Resolution instruments / tool box • valuation • bail-in • minimum bail-inable liabilities

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 23 5. Bail-in

Covered Bond issuer insolvent

Cover pool

more than sufficient sufficient not sufficient (excessive OC)

transfer of part secondary / special bail-in not bail-in allowed / of OC to general insolvency procedure over necessary possible ? bank estate ? CB’s + cover pool ?

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 24 Summary

. Long-term Covered bonds are complementary instruments to shorter-term deposits . CBs proved to be a reliable funding source during financial crisis . Covered Bonds stabilize bank funding . Covered Bonds are not main drivers of Asset Encumbrance + CB related AE = transparent . Need to harmonize CB definitions / criteria in all EU legislation (CRR, BRRD, SRM, SSM etc.)

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 25 Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 26 Verband deutscher Pfandbriefbanken e.V. Association of German Pfandbrief Banks Dr. Otmar Stöcker Georgenstraße 21 10117 Berlin Phone +49 30 20915-210 Fax +49 30 20915-101 E-Mail: [email protected] Internet: http://www.pfandbrief.de / http://www.pfandbrief.org

Covered Bonds in Europe - Legal conflict between secured bonds and deposits regarding insolvency remoteness and bail-in 27