Source document: https://docs-lawep.s3.us-east-2.amazonaws.com/1697748979023.pdf (Georgia)
Covered Bonds – an introductory discussion 6 July 2021 Covered bonds – a global overview • Dual recourse instruments, subject to special public supervision • No risk transfer (in contrast with securitizations), no capital implications • Economically: • Cheapest term wholesale funding for banks, long term, fixed rate, non-prepayable • Frequently used as collateral, including for central bank liquidity operations • Most collateral globally is residential mortgages.
• Other collateral allowed includes public sector finance, commercial mortgages.

Some laws allow limited range of other assets • On-going debate about expansion to other asset classes • National differences in legal frameworks, structures to facilitate national legal and cultural specificities • $3.2tn outstanding currently Invented in, dominated by Europe.
In Europe fund circa 30% of residential mortgages • • Globally 329 banks have covered bonds outstanding • European investors still dominant: shortage of supply (most bonds have negative yields) • Non-Europe growing at c. 10% annually, currently $250bn from 9 countries* *Source: European Covered Bond Council.

At current FX rates.
Iceland and Turkey included in non-Europe 2 Globalization of covered bonds – expansion from traditional markets in distinct waves since 2003 Pre-2003 2003 – 2007 Post GFC More recently Traditional issuers • Dominated by German, Danish, French banks Growth ex-Europe • Motivated by performance in global crisis (21 issuers failed, no covered bonds defaulted)/ contrast with securitisations • Growth in Singapore, Canada, Australia, Korea, Turkey Rapid expansion in Europe • UK, Italy, Holland, Norway, Finland, Portugal, Spain, others • Drivers: new technology, supply shortage, funding needs Expansion in new jurisdictions • Various motivations • CEE: Romania, Estonia, Poland, Slovakia, Latvia • Non-EU: Brazil, Japan 3 Why develop a covered bond framework?
Various benefits seen • Stability of issuers • Typically cheapest, long dated wholesale funding for most banks • Best ‘Exit strategy’ from over-dependence on central bank emergency repo funding (eurozone) • Greater resilience to funding market stress: • Systemic (first bond market to reopen after stresses), • Or idiosyncratic (market access / credit rating nexus is weak) • Facilitates rapid expansion in mortgage lending (Bulgaria, Poland) • Foreign investors • Vast appetite for well structured covered bonds from Europe (Poland, Korea, Japan) (example: KEB Hana (Korea), Jan 21: €2bn orders for €500mn 5 yr, 98% European investors, coupon 0.01%) ‘Gateway’ to other forms of investment • • Demand has negligible overlap with traditional investors in developing countries – no cannibalisation (Brazil) • Demand from Europe for ‘equivalent’ non-European covered bond regimes will significantly increase from (probably) July 2024 (deadline for third party equivalence ruling for CB prudential treatment) 4 Why develop a covered bond framework?
Various benefits seen • Domestic investors • Reducing correlation of behaviour of high quality assets (in liquidity and credit terms), for example, diversification from government bonds in bank liquidity buffers (Romania) • Development of market infrastructure (Romania, Poland, Latvia/Lithuania) • Contributes to liquidity at longer term in cash and derivative markets (Romania) • Stability of overall financial system • Reduce reliance on cross-border, intra-group funding (Estonia, Croatia) • Creates class of investors immune from systemic bank failure • Alignment of bank and investor interest in responsible origination of mortgages (contrast securitization) • Government policy • Mortgage affordability (longer dated, cheaper, increased competition) (Brazil) • Can enforce right level of risk characteristics (for example, loan to value ratios) • Can be made compatible with other policies (e.g.
subsidies for disadvantaged groups, green finance) (Korea) 5 Can covered bonds fund other asset types?

Covered bond market by underlying assets (2020) Public sector €250bn and mixed €60bn All other assets €10bn Mortgages €2.4tn Source: European Covered Bond Council • • List of assets eligible to back covered bonds has traditional basis over 200 years.

Only became enshrined in EU law in last 20 years ‘All other assets’ mainly refers to ships mortgages – relic, numerically irrelevant.
But potential precedent • Rational for restricting asset classes: • Good assets?

• • Easy to value, long term?

Important assets?

• EU law ≠ national law.
Turkish SME CB Covid-19 pandemic has re-opened an old debate on asset types • Pre-Covid: inconclusive discussion at EU level about expansion of covered bond concept to • Loans to SMEs, Project Infrastructure, Green Loans • Concerns: ‘brand dilution’, lack of commercial need, unsuitability of proposed assets • Very small number of precedents (Turkish law, non law based contractual bonds), mainly loans to SMEs • Covid-19 pandemic has resulted in an impetus to debate the use of other asset types • Need to fund SME sector better • Vast increase in collateral needs in banking sector • Need to exit central bank support mechanisms Fiscal stimulus (infrastructure spend) looks to • cooperate with private capital • Greater focus on green finance 6 How to develop a covered bond framework (1) What must governments do?
• Supervisory framework • Principle: there must be a supervisory framework designed to protect the interests of covered bond holders • Requirements typically: • Power to grant (or revoke) permission to issue covered bonds • Establish conditions: operational capacity, resources, adequate policies, including risk management • Power to supervise on an on-going basis • Ensure compliance with law • Powers to demand information • Powers to supervise, review and inspect (typically integrated with existing bank supervision) • Power to act in insolvency (can appoint ‘Special Administrator’ to act for bondholders) • Power to issue administrative measures, penalties to ensure compliance • There is a potential conflict of interests with ‘normal’ supervision • Cover pool monitor typically also used, similar role to auditors Covered bonds must balance national specificities, international best practice and commercial needs 7 How to develop a covered bond framework (2) What must governments do (cont’d)?
• Facilitating law differs according to optimal ‘model’ (‘boxes and arrows’) and existing rules regarding assets, banks, etc.
• General principles include • Define assets eligible to back covered bonds • • ‘Macro’: residential mortgages, commercial mortgages, public sector assets ‘Micro’: loan-to-value ratios, minimum credit quality, eligibility criteria • Establish investor protection standards • Over-collateralisation, liquidity, hedging rules • Allow structuring • Asset segregation in insolvency, facilitate derivatives, exemption from bail-in • Ensure ‘neutral’ tax treatment (no existing tax avoided, no new tax incurred) • Ensure appropriate consumer protection • Fair treatment rules for included assets, amendments to contracts, data privity, rights of set-off Covered bonds must balance national specificities, international best practice and commercial needs 8 How to develop a covered bond framework (3) What must governments do (cont’d)?
• Establish a prudential framework for investors • Align investor treatment with actual risk characteristics • Typical elements include • For bank investors • Lower risk weight (e.g.
‘one level better’, 20% becomes 10%, or lower LGD assumption) • Eligibility for liquidity buffers on a favourable basis • Eligibility for central bank repo rules on a favourable basis • Treatment under net stable funding ratio rules • For Insurers, asset managers, pension funds • Depends on existing rules • Principle: remove impediments to investing, encourage appropriate alignment of risk and investor treatment • Amendments to derivative clearing obligations (where implemented) Covered bonds must balance national specificities, international best practice and commercial needs 9 How to develop a covered bond framework (4) What must governments do (cont’d)?
• Commercial support (optional) • Many supervisors have applied pressure outside formal ratios to encourage banks to use covered bonds, for example, • Needs of expanding mortgage book not adequately captured by net stable funding ratio • Discourage over-reliance on retail deposits in light of technological developments • Supervisors also have encouraged investors to purchase covered bonds to limit over-concentration in bank liquidity books • Some (Slovakia, Hungary) have required specific ratios of covered bond funding to facilitate stability • Many central banks now purchase covered bonds outright (in addition to favourable treatment under repo rules) • Covered bonds must balance national specificities, international best practice and commercial needs 10 Safeguards and considerations for covered bonds – key risks to be addressed Valid concerns • No commercial need: loan to deposit ratios are favourable, mortgage growth is slow • See example from Poland, Slovakia • Subordination of other creditors • Balance of default probability / loss given default • Package of safeguards to ensure limit at optimal level of covered bond encumbrance • Consumer rights Examples of sudden expansion of mortgage market 400 300 200 100 - • Built protections into legal and supervisory Base year +1 +2 +3 +4 +5 +6 +7 +8 +9 +10 +11 measures Less valid (but common) concerns • Capital arbitrage, tax avoidance, restraint of competition, cannibalisation of foreign investor interest • Education and dialogue Ave mortgage debt per capita rebased to 100 in 2007, source: EMF Poland Slovakia • • In Poland and Slovakia banks argued that there was no need for covered bonds given the small mortgage market and favourable loan:deposit ratios In both countries GDP growth, convergence with European norms and falling interest rates caused a very rapid expansion in mortgage lending and deterioration in loan to deposit ratios 11 Covered bonds can result in lower beta / better market access in stressed conditions • During normal market conditions, covered
 bonds interest rate is significantly below bank senior bond interest rates • During the 2008/2009 financial crisis, covered bonds spread over government debt widened, but was typically 40% of the senior bond spread • Market access for covered bonds actually improved during the financial crisis • Pre-crisis: Covered bond issuance was typically around 40% of senior bank issuance • After Lehman Bank default: Covered bond issuance rose to over 60% (and most senior debt issuance was government guaranteed) • European Sovereign Credit Crisis (2009 – 2011) Cost of debt for European banks 400 300 200 100 s t i n o p i s s a B 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 CoBo Senior Graph shows yield over swaps for iboxx index of all outstanding European bank senior and covered bonds • Covered bonds initially traded at a premium to sovereign bonds in € • During crisis, covered bonds had lower yields than their government debt in Spain, Italy, Greece and France • Greek covered bonds did not default in 2011 12 Covered Bonds Case study: South Korea Why and how did South Korea support covered bonds?
Rationale for introduction of covered bonds “…there has been growing need for...covered bonds...to ensure financial institutions’ stable funding and financial markets’ stability.
Covered bonds are expected to reduce funding cost and serve as a stable funding channel in ..crisis..[and]..help improve the structure of household debt by providing ..funding ..of long-term and fixed rate loans.” Financial Services Commission Press release October 2012 "Covered bond legislation will serve as a solution to household debt problems.
It will become a useful source of foreign currency funding in times of market tension, and will be a catalyst for activating a long-term bond market," FSC Chairman Kim Seok-dong, quoted by Reuters 9 Measures to enhance use of covered bonds • 10% risk weight for covered bonds for bank investors • Exemption from 4bp fee for bonds by banks in Korea • Pro-rata reduction in contribution to Housing Finance Credit Guarantee Fund Improvement of treatment in net stable funding ratio • • Eligibility for level 2a in bank liquidity cover regulations 8 7 6 5 4 3 2 1 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Fgn Dom 13 Covered Bonds Case study: Turkey Turkish covered bonds – some success, some problems Why Turkey is different • Very small mortgage market (C. 14% of GDP 2007) • Initial focus on loans to SMEs • Support from development banks • Initial investors include IFC, EBRD, EIB/EIF, FMO • Not eligible for preferential treatment for EU investors • No reason to follow EU rules if contrary to commercial objectives • Problematic swap market • Very high political / market volatility Turkey Covered Bond Market Issuance – Slow market development 3 2 1 0 2015 2016 2017 2018 2019 2020 Fgn Dom Sources: European Covered Bond Council, GlobalCapital Timeline • 2007 Legislation in Housing Law (5582, March 2007), also allowed SMEs • Subsequent regulations from capital markets board (111.33 August 2007) • 2011 First deal (by Sekerbank), backed by SMEs • Private placement to 3 investors (2 development banks, 1 private sector) • 11 trades subsequently, all private placements • 2016 First public deal, Vakif €500mn, mortgages • 2018 First green deal, Yapi Kredi (private, to EBRD and Clean Technology Fund) 14 Covered Bonds Case study: Romania Investment grade term funding despite challenges Alpha Bank opened covered bond market • May 2019, Alpha Bank issued €200mn 5 year covered bonds • • Romanian government is rated Baa3 (negative outlook) • Moody’s: covered bond improved Alpha Bank’s funding diversification and maturity
 mismatches Initially rated Baa2 (3 notches over Alpha Bank’s rating), subsequently upgraded to A3 on legal clarifications Difficult backdrop • Mortgage market heavily euro denominated • Lack of liquid EUR/LEU swap market was a major rating constraint • Alpha bank’s cover pool was 50/50 LEU/EUR • Alpha Bank Romania had never issued a public bond before • Government introduced new mortgage law limiting recourse to borrowers EBRD support • Technical cooperation project initiated during introduction of new law • Several upgrades proposed and accepted • Invested €40mn in first transaction 15 Covered Bond Reform and Investments Context • While covered bonds are frequently used in mature markets, their proliferation in the EBRD regions is still relatively new, including both in the EU Member States and non-EU Member states.
In December 2015, the outstanding volume of covered bonds reached €2.5 trillion globally, of which €2.1 trillion was issued by EU- based institutions.
In comparison the size of the covered bond markets in CEE and SEE is small, with only 3 countries in CEE having any meaningful number of bonds outstanding (CEE represents <1% of the total covered bond market); often there is no legal framework for covered bonds or existing legal frameworks might be inconsistent with best practice and international market standards or not applicable.
• EBRD Engagement & Impact • The aim of the EBRD’s work on covered bond legal and regulatory reforms is to (1) align the applicable frameworks with widely accepted standards, (2) render them more transparent, efficient and understandable to investors including foreign investors and to rating agencies and (3) remove barriers hindering the use of covered bonds for finance.
EBRD together with the European Commission, supported legislative reform on covered bond frameworks in the Baltic states with the introduction of a pan-Baltic covered bond framework, contributing towards well-functioning and deeper capital markets in the region, opening up long-term funding options for banks and increasing the level of lending to the real economy.

The EBRD also provided input into the EU Covered Bond Directive (adopted in March 2019).
EBRD raised awareness among potential investors and policy-makers through hosting the ECBC international covered bonds conference for the first time in an emerging covered bond jurisdiction (Latvia).

€788m has been invested in Covered Bond issuances across the CEB region to date, including first ever covered bond in Romania and the first green covered bond coming out of Poland.
• • • • Support for Covered Bond Reform Estonia Poland Bulgaria Croatia Romania Lithuania Slovakia Pan-Baltic Latvia Georgia Reforms completed New EBRD promotes covered bond legislation reform and issuance to support capital market development and diversification of funding of financial institutions Investment: €788m in Covered Bond issuances Greece Hungary Poland Estonia Romania Slovak Republic Turkey 16 Case Study: Poland - A Success Story Starting Point Poland did not have a developed CB market despite favourable market conditions.
This was due to an out dated legal framework that lacked important structural features for investors’ protection.

Only mortgage banks can issue covered bonds despite the fact that 95% of mortgages are granted by universal banks.

TC New Legal Framework – What Has Changed?

The EBRD has provided Technical Assistance to the Ministry of Finance to develop a new covered bond legislation that updated the Act on Mortgage Bonds and Mortgage Banks 1997 and aligned it with international standards.
The changes came into effect on 1 January 2016 and have already contributed to an increase in issuance of Covered Bonds by Polish issuers.

Investment EBRD has invested a total of EUR 115m in Polish covered bonds, denominated in Polish Zloty and Euros.
17 0%20%40%60%80%100%120% - 200 400 600 800 1,000 1,200 1,400201020112012201320142015Poland -Covered Bonds (EUR mio) Total Issuance Total Outstanding LCY Issuance (% Total Issuance) Contact Information Jacek Kubas Associate Director – Capital Markets Development kubasj@ebrd.com Richard Kemmish Consultant richardkemmish@outlook.com Rada Tomova Principal II – Capital Markets Development tomovar@ebrd.com Polyxeni Pentidou Associate – Capital Markets Development pentidop@ebrd.com Nika Chkheidze Analyst – SME Finance & Development chkheidn@ebrd.com Claudius Kirchhoff Associate Banker – EU Banks & Structured Finance kirchhoc@ebrd.com 18 Disclaimer This information is provided for discussion purposes only, may not be reproduced or redistributed and does not constitute an invitation or offer to subscribe for or purchase any securities, products or services.
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