Regulated Covered Bonds, Contributed by Adrian Brown and Sam Robinson, Nabarro LLP

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The Financial Services Authority's (FSA) finalised guidance on covered bond programmes,1 published on 1 November, establishes minimum expectations and some additional "good practice" points for issuers to consider. To supplement this guidance, the FSA's policy statement,2 published on 9 December, explains the changes to the FSA's Regulated Covered Bonds sourcebook (RCB) and provides an overview of how the Regulated Covered Bond Regulations 20083 (2008 Regulations) have been amended. The culmination of the review is that the Regulated Covered Bonds (Amendment) Regulations 2011 (2011 Regulations),4 which were laid before Parliament on 29 November, are expected to enter into force on 1 January 2013. This article summarises these documents as well as the FSA's minimum standards and the best practice compliance tips for issuers of regulated covered bonds.

Covered Bonds

A covered bond is a form of debt security, issued by deposit-takers with headquarters in the UK. The covered bond is distinct from other forms of debt security as the repayment of the initial capital sum is "covered" (guaranteed) by certain assets (mortgages/loans) which in turn are ring-fenced from other assets owned by the issuer. The assets backing the bond are transferred to a special purpose vehicle (SPV) to ring-fence them as collateral for the bond. This enhances the protection of the bondholders as they have extra security over the investment thanks to the ring-fenced assets. Covered bonds are distinct from bonds issued under securitisations as the covered bond holder, if necessary, has dual recourse. If the issuer of the covered bond defaults, then the SPV becomes responsible for administering the pool of assets. If there are insufficient assets in the pool to meet the issuer's liability, then the covered bond holder ranks as an unsecured creditor of the failed issuer. In contrast, the holder of a securitised bond is only protected by the value of the securitised assets and may not have recourse to the issuer of the bond. Unlike standard securitised bonds, covered bonds are repaid on the "bullet" repayment basis by which, even if there is a prepayment of an asset, the underlying value of covered assets must be maintained so that the value of the assets on maturity is sufficient to cover the value of the bond in full. The pool of assets is therefore "dynamic" as, for example, mortgages that are refinanced or fall into arrears can be replaced in the pool with alternative assets.

FSA Policy Statement

— Regulated Covered Bonds Sourcebook

The FSA's recent Policy Statement was broadly supported by respondents to the joint FSA/HM Treasury (together, the Authorities) consultation launched in April.5 The amendments to RCB are largely in line with the initial proposals as set out in the Authorities' Consultation Paper, but the FSA has attempted to incorporate some of the feedback received. In summary, the changes to RCB relate to three key areas. First, RCB will be amended to include consistent standards of investor reporting to ensure that issuers provide adequate information at loan level on assets. In addition, issuers will have to publish a report giving information about the assets of the pool on a monthly basis. Also, transaction documentation will have to be made available by issuers. Secondly, the Asset Pool Monitor will have a more clearly defined role and will have to provide a report on the contents of the asset pool. Finally, the regulatory reporting requirements have been updated to better reflect modern supervisory practices.

— Amending Regulation

In addition to amending RCB, the consultation encouraged HM Treasury to make certain amendments to the 2008 Regulations. Asset pools must be designated by whether they contain a single asset class or a mixture of asset classes. Designations cannot subsequently be altered. The asset designation should be published on the FSA register of regulated covered bonds. Issuers of regulated covered bonds must advise the FSA by 1 September 2012, by letter, how they wish their existing programme to be categorised in the covered bonds register. The issuer should state whether the existing programme should be categorised as public sector/liquid assets or residential mortgages/liquid assets. Under the new 2011 Regulations, securitisations will not constitute eligible collateral for covered bonds. This exclusion is designed to increase confidence and certainty amongst investors in an area where the precise distinction between covered bonds and securitisations can otherwise become blurred. There will also be a statutory minimum overcollateralisation (OC) requirement imposed upon issuers. Taking into account the views of relevant stakeholders, the Government has opted to set the OC at 8 percent. This statutory OC requirement exists alongside the FSA's OC requirement, which is calculated on a case-by-case basis.

FSA Finalised Guidance

The FSA's finalised guidance, which ought to be read alongside the Policy Statement and the 2011 Regulations, is based upon the results of the recent FSA review of Regulated Covered Bond programmes. Following this review of the covered bond programmes and compliance systems already established, the guidance is intended to clarify the minimum oversight required by the FSA to ensure that issuers of covered bonds have appropriate systems and controls in place to ensure that covered bonds are sold appropriately. This process is known as the "second line oversight" process. Although there are idiosyncrasies with different issuers relating to how the second line oversight will be performed and who will perform the compliance function, these rules are designed to be of general application to the issuers of covered bonds. The FSA's guidance explains that the relationship between the programme and the issuer needs to be established with a clear mandate and terms of reference setting out the regular formalised interaction between the programme and the issuer’s second line oversight compliance team. In the FSA's view, there needs to be ongoing monitoring to ensure that reporting to investors is regular and accurate. According to the FSA, those administering second line compliance should be familiar with the FSA's RCB requirements and should have a wider understanding of the changing UK and EU regulatory landscape. They should also have the relevant knowledge and skills to advise internally in depth on covered bonds. Also, compliance officers should have the ability to challenge senior management in respect of compliance issues relating to covered bonds. Evidence of this ability should also be in place. Coupled to this is the need for a clearly established escalation policy that allows compliance concerns to be discussed with the independent risk oversight committee. These minimum requirements, as set out in the FSA's finalised guidance, are intended to ensure effective regulation and consumer protection in the covered bond market.

Compliance Tips

In addition to the minimum compliance expectations required by the FSA, the finalised guidance sets out some useful observations on best practice, which issuers should do their best to comply with when assessing their compliance systems and processes. Rather than selecting impractical, hypothetically desirable best practice guidelines, the FSA has drawn on the procedures issuers already have in place to formulate a best practice guide for all issuers to consider and, as far as possible, implement. The FSA has set out in its finalised guidance compliance tips, which are summarised below:

  • The compliance team ought to be represented by a voting member on covered bond management committees and steering groups. This will help ensure that compliance is at the heart of decision-making.
  • Members of the compliance team should have full access to information about the covered bonds and have a full understanding of the issuing process so as to be able to challenge the issuer.
  • There should be regular reviews of the covered bond programme to ensure compliance with the FSA finalised guidance and all regulatory requirements. An appropriate escalation process ought to be established to enable compliance issues to be raised.
  • Attention should be paid to the changing regulatory landscape to ensure that the issuers of covered bonds are fully aware of regulatory changes.
  • Compliance departments ought to be empowered to sign off applications for regulatory status and material change proposals.

The FSA is open to discussing how authorised issuers can improve their compliance systems and process for covered bonds. The finalised guidance encourages readers to contact the covered bonds team at the FSA should they wish to discuss these issues further. 

Adrian Brown is a partner and head of the financial services regulatory practice at Nabarro LLP. He advises investment banks, broker dealers, fund managers and corporate finance houses on all aspects of financial services regulation. Telephone: +44 (0) 20 7524 6400; E-mail: Sam Robinson is a senior associate in the financial services regulatory practice at Nabarro LLP. Sam has advised a number of clients including banks, stockbrokers, fund managers and investment advisers on all aspects of financial services regulation. Prior to working in private practice Sam worked for seven years at the FSA, the majority of that time in the FSA's General Counsel's Division. Telephone: +44 (0) 20 7524 6836; E-mail:

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