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EBA Report on European Secured Notes (ESNs) Summary

Core Content

The European Banking Authority (EBA) conducted a comprehensive assessment on the potential of European Secured Notes (ESNs) as a new funding instrument for SMEs and infrastructure projects, as requested by the European Commission in its Call for Advice (CfA) of October 2017. The report evaluates the business case for ESNs, their impact on asset encumbrance, asset performance, eligibility criteria, and regulatory treatment. It also provides recommendations for the European Commission on how to proceed with the legislative framework for ESNs.

Main Viewpoints

Business Case for ESNs

• Funding for SMEs and infrastructure: ESNs could offer a useful alternative to traditional funding methods for SMEs and infrastructure projects, especially for smaller institutions with limited access to securitisation or unsecured long-term debt markets.
• Potential market size: Based on a comparison with mortgage-backed covered bonds, the potential size of the ESN market for SMEs is estimated between EUR 310 billion and EUR 930 billion, and for infrastructure between EUR 80 billion and EUR 170 billion.
• Challenges for infrastructure ESNs: Infrastructure ESNs face more significant challenges due to their long-term maturity, large exposure amounts, and the rules on provisioning. A dual-recourse structure may not be suitable for infrastructure exposures.
• Investor interest: Investors are likely to be influenced by the risk-return profile and the regulatory treatment of ESNs, particularly under the LCR and ECB collateral frameworks.

Impact on Asset Encumbrance

• Higher over-collateralisation: ESNs may require higher over-collateralisation compared to CRR-compliant covered bonds.
• Moderate increase in encumbrance: Despite the higher collateral requirements, the overall potential increase in asset encumbrance levels is considered moderate.
• Key factors: The impact on asset encumbrance depends on the structure of the cover pool, the dynamic nature of assets, and the potential effects on bail-inable debt and recovery value during resolution.

Asset Performance and Eligibility Criteria

• SME ESNs: SME loans are riskier than real estate and other corporate exposures. The performance of SME portfolios is more heterogeneous and pro-cyclical.
• Eligibility criteria: The EBA recommends strict eligibility criteria at both the loan and pool levels, including minimum over-collateralisation of at least 30%, quality standards, and concentration limits.
• Infrastructure ESNs: Project finance exposures tend to improve in credit quality over time, especially as projects move into the operational phase. The EBA suggests excluding construction-phase exposures and using a standardised framework for infrastructure bonds.

Key Information

Structure and Features of ESNs

• SME ESNs: The EBA suggests that SME ESNs could be structured as dual-recourse instruments, applying many of the 2016 covered bond best practices. However, some adjustments are needed for SME-specific characteristics.
• Infrastructure ESNs: A dual-recourse structure is not appropriate for infrastructure projects. Instead, the EBA proposes a standardised infrastructure bond secured by segregated infrastructure loans, potentially offering capital relief through risk transfer.
• Best practices: The report outlines several best practices, including dual recourse, segregation of cover assets, bankruptcy remoteness, liquidity buffer, stress testing, and the role of the cover pool monitor and national authority.

Regulatory Treatment

• SME ESNs: The EBA does not recommend preferential capital treatment for SME ESNs based solely on asset performance. However, a differentiated risk weight could be considered if certain conditions are met, such as dual recourse and structural credit enhancement.
• Infrastructure ESNs: The regulatory treatment of infrastructure bonds depends on their classification under CRR exposure classes. The EBA suggests they could be standardised and subject to public supervision.
• Regulatory frameworks: The report discusses the regulatory implications of ESNs under various frameworks, including UCITS, Solvency II, EMIR, and LCR. However, the eligibility of ESNs under ECB collateral frameworks is not assessed by the EBA.

EBA Recommendations

1. Eligibility criteria: Strict eligibility criteria for SME and infrastructure exposures should be applied, including minimum over-collateralisation of 30%.
2. Dual recourse structure: SME ESNs should be structured as dual-recourse instruments, while infrastructure ESNs may not be suitable for such a structure.
3. Regulatory consistency: The capital treatment of ESNs should be consistent with the CRR framework and avoid creating level playing field issues.
4. Standardisation and supervision: A standardised infrastructure bond framework is recommended, with public supervision and risk transfer mechanisms.
5. Further work needed: Additional work is required to define the features of ESNs and their classification under CRR exposure classes.

Conclusion

The EBA concludes that ESNs could represent a new distinct pan-European asset class, particularly for SMEs, and recommends a regulatory framework that supports their development while ensuring prudential stability and consistency with existing financial regulations. The report also highlights the need for further clarification and work on the regulatory treatment of ESNs, especially for infrastructure projects.