250 years of covered bonds

By Jacek Kubas

Map of Europe

EBRD leads effort to create covered bonds market in central and eastern Europe

Financial innovation is as old as the financial sector itself. But sometimes we can move forward by dusting off instruments that have been in our tool box for a long time, adapting them to modern usage and applying them, in order to address contemporary challenges. Such is the case with covered bonds.

First introduced by Frederick II of Prussia exactly 250 years ago, covered bonds have now become a major building block in efforts to build safe and efficient capital markets in many central and eastern European countries.

And perhaps it is not accidental that the forerunner of the modern covered bond framework was initiated in Breslau. Today, the city is called Wrocław and belongs to Poland – one of the countries where the EBRD has played a major role in developing the capital market as the “engine room of a modern economy”.

While the economies in this region have been growing strongly over the past 30 years, the development of capital markets was not able to fully keep up with this pace. Whereas the central and eastern European countries currently account for 8 per cent of the EU’s total GDP, their capital markets represent only 3 per cent of all listed shares and debt.

Yet, capital markets are essential for the functioning of a modern economy. In the case of central and eastern Europe, we still see an overdependence on bank finance, with associated problems such as access to finance and a persistent gap between demand and supply.

It demonstrates that capital market development is one of the key pressing challenges for these countries to secure their advances and lay the groundwork for further progress. It is here that covered bonds, as a long-term funding tool, come in.

Covered bonds are debt securities issued by banks and backed by a portfolio of mortgages. They are not a panacea, but they are an important and efficient source of long-term, low-risk funding. They can benefit issuers, investors, market participants and the public by stimulating the real economy with their vitalising impact on the housing market.

While covered bonds are a well-established instrument in advanced markets, the EBRD has had a pioneering role in introducing them in its countries of operations. The Bank did this in its typical fashion of combining policy engagement to create the legal and regulatory framework for a roll-out with significant investment. The EU Structural Reform Support Service provided financial support as well as the essential institutional anchor.

Legal reform support by the EBRD included the development of a new covered bond legal framework in Poland and Romania. In the Slovak Republic, the Bank worked with the authorities on updating the relevant regulatory regime. Meanwhile, in the Baltic states, the EBRD is actively involved in efforts to create a regional capital markets union, of which a pan-Baltic covered bond framework will be a centrepiece. Work is also ongoing in Croatia.

As a financial actor, to date the EBRD has invested a total of €650 million in covered bonds across its regions, including Greece, Hungary, Poland, Romania, the Slovak Republic and Turkey. The largest engagement financially so far has been the €385 million Covered Bond Framework in the Slovak Republic. It aims to help mobilise some €1.6 billion of private sector investments by Slovak banks.

An article highlighting the EBRD’s engagement in covered bonds appears in a recently published book, that celebrates the history and success of covered bonds. Today, 12 September, covered bonds experts and bank representatives will gather at the European Covered Bond Council in Munich to attend the industry’s annual showpiece event, which the EBRD will also attend.