Earlier this year the Estonian parliament enacted long-awaited dedicated covered bond legislation, finally allowing local banks to enter both regional and European-wide covered bond markets and to gain access to a reasonably priced and stable source of long-term funding for their key banking businesses (most importantly for funding the issuance of mortgage loans). Additionally, under the new legislation, local covered bond issuers able to meet prudential requirements under the Capital Requirements Regulation (CRR) will be able to benefit from certain forms of preferential treatment afforded to covered bonds. For the local banking sector that, at the moment, remains dominated by Scandinavian banking groups, the new legislation also creates a viable alternative to the parent funding.
The new law, which entered into force on March 1, 2019, has been warmly welcomed by the larger players in the regional banking sector, including Luminor Bank, the third-largest bank in the Baltics (a majority stake of which was recently acquired by Blackstone), which announced its intention to launch its first covered bond programme just weeks after the law was passed. LHV Bank has also indicated its intention, eventually, to partially finance its recent acquisition of approximately EUR 470 million of Danske’s Bank’s Estonian private loan portfolio with a covered bond issuance. Likewise, the issuance of covered bonds by local credit institutions is seen as an important and positive development by regional institutional investors, including pension funds, and many hope it will help revive the local capital markets generally.
As it was prepared in parallel with early parts of the legislative process relating to the European Commission’s Covered Bond Directive, the Estonian covered bond law already, to a certain extent, includes elements of the Directive, which is expected to speed up the transposition of the Directive into Estonian law. However, the law will still need to be further aligned with the changes that were incorporated in the Directive later in the process, including the requirement to specifically define objective triggers for extending the maturity of covered bonds in the national law.
In a nutshell, Estonian law allows issuers holding a specialized authorization to issue two types of covered bonds: mortgage-covered and mixed pool-covered. Specialized authorizations for issuers able to satisfy detailed requirements set out by law demonstrating that their internal processes and procedures are secure enough to reliably keep track of and ensure the eligibility and high quality of the assets in the cover pool are issued by the Estonian FSA. In this context, it is important to note that Estonian covered bond law follows an “on-balance sheet” model, in which the issuer retains formal ownership of the cover pool securing the covered bonds until they are fully redeemed, but the eligibility and sufficiency of the cover assets is monitored by an independent cover pool monitor who is required to periodically report to the Estonian FSA. On the occurrence of bankruptcy, moratorium, and certain other events, the covered bond portfolio is segregated from the issuer’s assets and a court-appointed cover pool administrator takes over the administration thereof, although the cover assets legally remain on the issuer’s balance sheet until sold. Following this segregation, the cover pool is legally deemed to be ring-fenced and unaffected by the issuer’s bankruptcy and can only be used to satisfy the claims of the covered bondholders and to discharge liabilities under the derivative instruments included in the cover pool. Regardless of the segregation of the cover pool, the covered bondholders retain the dual-recourse in relation to claims arising from the covered bonds against the issuer and against the separated cover pool.
Given the smallness of Estonian market and the pan-Baltic operations of the largest local banks, one of the important goals of the local covered bond legislation has been to create a workable framework for issuance of covered bonds secured by a pan-Baltic cover pool, to enable Baltic banks to reach a critical volume that would be attractive enough for European investors. While the new law addresses the relevant aspects from local perspective, we are of the opinion that, in order for certain features of the legal framework (such as ring-fencing of cover pool assets in third party enforcement proceedings) to seamlessly work across all three Baltic jurisdictions, the laws of all three jurisdictions need further improvements. The need to address these pitfalls has been discussed with the Estonian Ministry of Finance and there is hope that Estonia, Latvia, and Lithuania will soon be able to agree on an approach that will create a well-functioning pan-Baltic covered bond framework.
Marina Kotkas, Partner, Cobalt Estonia