Addressing legal and regulatory impediments to NPL resolution

In the past few years, it seems that many countries have focused predominantly on addressing legal impediments contained in insolvency and enforcement frameworks (the IMF’s second pillar, for example, emphasises the importance of this). Although it is obvious that inefficiencies in insolvency frameworks include the most common and severe legal impediments to efficient NPL resolution, we should not however overlook other legal areas that might also have a detrimental effect on NPL resolution. The IMF’s research shows that the degree of concern about the overall judicial system is generally higher than the degree of concern about corporate and personal insolvency.7 This observation indicates that the problem of  legal impediments is much broader and systemic. In this respect, perhaps the second pillar of the IMF proposal could be extended to all legal areas that might include obstacles to efficient NPL resolution (with some of those legal areas being pointed to in this article).

In order to identify all legal impediments to NPL resolution in a particular jurisdiction, a detailed and comprehensive analysis of a legal system has to be conducted. Without such analysis it is possible that an important but not-so obvious impediment to NPL resolution is overlooked. Such analysis cannot be done solely via desktop analysis but must include field research, for example, interviews with banks, investors, advisory firms and other authorities.

Groups of impediments

As indicated above, NPL resolution is a complex task that requires a multidisciplinary approach  of various expertise (for example regulatory, tax, accounting, legal, finance, banking). In general,  a bank has two options for tackling NPLs:

  • dealing with NPLs internally. There are several solutions for how the banks can deal with  NPLs internally (for example, internal workout departments, outsourcing). The main characteristic of this technique is that the NPLs stay on the banks’ balance sheets.
  • transferring part of or the whole NPL portfolio to another entity. A bank transfers its distressed portfolio in order to remove bad loans from  its balance sheets (for example, selling it on the market, transferring it to a special purpose vehicle).8 This method includes any type of risk-sharing agreements.9

Many experts believe that the transfer of NPLs  is a more appropriate approach for banks as  they should focus on their primary activity and  not be distracted by NPLs. Considering these two possibilities, we could divide legal and regulatory impediments into two groups:

  • impediments to NPL resolution per se. This (first) group contains those legal and regulatory impediments that have a detrimental effect on the resolution of NPLs irrespective of which entity (bank, investor, asset management company) is resolving the NPLs.
  • impediments affecting a transfer of NPLs from one bank to another entity. This (second) group refers to those legal and regulatory impediments that obstruct a transaction for transferring NPLs from a bank to another entity and impediments that hinder the functioning of the entity that took over the NPLs.

Impediments to NPL resolution per se

This group of impediments affects all entities  that are dealing with NPL resolution. In general, legal impediments for this group are usually  found in insolvency and enforcement frameworks  (for example, cramdown, a lack of fast-track bankruptcy procedures, deficiencies in insolvency administrator frameworks). In past years authorities in different European countries were  more focused on these types of impediments,10  which is quite understandable as improving the insolvency legislation is almost a pre-condition for efficient tackling of NPLs.

Impediments affecting transfer of an NPL

This type of impediment is rarely contained  in insolvency and enforcement frameworks.  Usually most of these impediments are of  a regulatory nature (for example, data privacy, licensing requirements). However, other legal  areas (for example, civil procedure, laws  regulating contracts) may include provisions  that impede transfer of NPLs.

Many experts believe that the transfer of NPLs is a more appropriate approach for banks as they should focus on their primary activity

Development of distressed debt markets and legal impediments

In many European countries (especially in south-eastern Europe) a distressed debt market is illiquid and almost non-existent. There are many different obstacles (legal, regulatory, tax, accounting, price gaps) that discourage investors from entering those markets.

Legal impediments do not solely affect NPL resolution as such, but also hinder the development of distressed debt markets. An underdeveloped legal system does not only impede a resolution of NPLs in terms of slow and inefficient enforcement and insolvency frameworks, but an aggregate of both types of legal impediments may prevent the development of a distressed debt market. Therefore, both types of legal and regulatory impediments have to be addressed in order to facilitate the development of distressed debt markets. Namely, an investor  in NPLs will analyse both groups of impediments  in a particular legal system and on the basis of  such analysis decide whether to enter a particular market and what price he is willing to pay for  a particular distressed loan/portfolio. Basic analysis would seem to suggest that the former group of impediments affects the price of a loan more than the latter, while the latter affects the investor’s decision whether to enter the market or not.

Asset management companies are widely recognised as an effective solution for tackling NPLs and also investors will most likely enter the market through some type of asset management company. There are also different impediments that prevent the functioning of such companies. This type of impediment may be seen as a sub-type of impediment that affects a transfer of NPLs or  it might even be categorised as a separate (third) group of impediment.11

In many European countries (especially in south-eastern Europe) a distressed debt market is illiquid and almost non-existent.

Prohibition of retroactivity

In my view, prohibition of retroactivity is an additional challenge for addressing legal impediments. In general, ex post facto laws are prohibited (also in civil frameworks), which means that some changes in the legal frameworks (especially changes to contract laws) will have an insignificant effect on the existing NPL levels. Namely, in some cases a legislator may have difficulties introducing changes that would affect the existing relationship between a lender and  a borrower, since some legislative amendments  may only affect future legal relationship.

The EBRD’s studies

Considering the complexity of NPL resolution, different departments of the EBRD are actively involved in questions related to this topic. The EBRD’s Legal Transition team plays an important role in these tasks and deals with different  aspects of NPL resolution. Recently, the EBRD prepared two detailed analyses of impediments related to NPLs, in collaboration with external international and local experts:

  • in Hungary, an extensive report has been prepared that covers all impediments to  NPL resolution
  • in Serbia, the analysis was focused on impediments to the sale/transfer of NPLs.

The EBRD’s analyses reveal some interesting examples of impediments that could be categorised within the second group of impediments:


Some jurisdictions contain provisions that allow  a transfer of a loan only to certain entities that have a licence for providing financial services (for example, Hungary). A potential purchaser of a loan would have to apply for such a licence before the transaction. Obtaining such a licence can take several months (in Hungary, up to 180 days).

In Serbia, for example,12 retail loans can only  be assigned to another entity that is a Serbian licensed bank. As the investors in distressed debts are not usually banks, this provision may obstruct development of a market for distressed loans.

Civil procedure

According to the Serbian Civil Procedure Law  the defendant has to give its consent in case the plaintiff changes during the litigation. The Serbian Commercial Court of Appeal has taken the position that the existing litigation has to be finished before an NPL is sold. If the NPL is sold during the litigation procedure, the buyer of such a loan will eventually lose in the litigation.

Contract law

A provision that might have an adverse effect on the development of the NPL market in Serbia can be found in the Serbian Code of Obligations, according to which capitalisation of due interests  is only allowed for banks in case of a loan transfer; the purchasing entity (other than the bank) would not be able to charge interest on capitalised interests. This impediment would most likely not affect the investor’s decision to enter the market  or to buy a particular loan, but it would affect  the price of the loan and it represents a counter-incentive for distressed debt market development.

Data protection

Obstacles related to data protection have been raised in several countries (for example in Austria).13 In many countries (for example, Serbia) frameworks regulating data protection do not clearly exempt an NPL transaction from the data privacy obligations. These provisions severely impede development of the distressed debt market as an investor cannot perform an appropriate due diligence allowing the evaluation of a potential investment.


A high level of NPLs has a negative impact on economic growth. Efficient tackling of NPLs requires the concerted approach of governments, international financial institutions and the private sector. It is important that each country performs  a comprehensive analysis of its legal and regulatory frameworks in order to determine all relevant obstacles that impede effective NPL resolution. Countries must not overlook legal and regulatory impediments that prevent a transfer of NPLs and that discourage the development of a market  for distressed loans, in particular.

Defining a covered bond

A covered bond is primarily an on-balance sheet debt security issued by a bank. A covered bond’s defining feature is the dual nature of protection (dual recourse) offered to investors with a special pool of assets used as collateral for the repayment of bonds. Assets that can be pooled to form collateral are defined in national law (definitions typically follow a list of eligible assets in the Capital Requirements Regulation specifying covered bonds that are eligible for preferential capital weightings for EU banks) and subject to direct and specific supervision to protect the interests of covered bonds bondholders. The assets that typically serve as cover include mortgages and public sector loans. Other assets have been considered for inclusion, for example: Turkish legislation provides for covered bonds being backed by small and medium-sized enterprise (SME) loans. However, the European Banking Authority (EBA) and the European Covered Bond Council believe that covered bonds are to be backed by either mortgages or public sector loans so as not to degrade the value of the covered bond brand. This is to be either confirmed, or revisited, in the course of work on the EU Capital Markets Union.15

It is worth emphasising that covered bonds are far from being an exotic financial instrument, and, in the normal course of business, from the bondholder’s point of view, are not significantly different from any other secured or unsecured bond issued by a credit institution. The issuer pays interest and principal to the bondholders in the same manner as for other secured or unsecured bonds.

A common misunderstanding, typical for jurisdictions where a covered bonds legislation or market has not yet been developed, is confusing covered bonds with various other securitisation structures. While the structure of both types of instruments can in certain cases be quite similar (for example if a special purpose vehicle or SPV  is used to create and segregate a cover pool of,  for example, mortgage loans and to issue bonds) the similarity stops at the structure level and differences start appearing when analysing the rights and duties of issuers and investors.

Unlike a securitised bond a covered bond is an on-balance sheet obligation of the issuer enhanced by a specific collateral (cover pool) created in favour of the bondholders. In a covered bond structure, the creation of a pool of assets and its segregation from the insolvent estate of the issuer is for the sole purpose of providing security to the investors in case of issuer insolvency; while in a securitisation structure it is to transfer risk away from the issuer (by removing it permanently from the issuer’s balance sheet). Covered bonds are also “full recourse” instruments meaning that  if after the activation of the collateral cover pool  (in the case of issuer’s bankruptcy) the pool gets depleted before the bonds are fully repaid, the bondholders, for the residual (remaining) value, come in pari passu status with other general creditors of the bankrupt issuer, while in a typical securitisation that would not be the case as no recourse to the originator would be possible in such a case.

Unlike a securitised bond a covered bond is an on-balance sheet obligation of the issuer enhanced by a specific collateral (cover pool) created in favour of the bondholders.

Advantages covered bonds  bring to a transition economy

Covered bonds can potentially provide several key benefits to a transition economy. By allowing banks to fund longer-term assets in a way which is cost effective, more accurately matched to the term of those assets (thus removing balance sheet gap risks), and relatively delinked from their own credit rating (which allows market access at times of systemic stress), covered bonds contribute to the stability of the banking system. This is particularly the case in the EBRD region where banks so often rely on funding from a parent, either an Italian or German bank. The Vienna II Initiative advocates for such reliance to be decreased, and local funding sources explored.

Due to the fact that covered bonds can be secured on a portfolio of high-quality mortgage assets, usually with an 80 per cent loan-to-value (LTV) ratio, and subject to strict quality controls, they can contribute to an improvement in loan origination processes. They do not allow the originator to pass on any credit risk to a third party and therefore encourage sustainable, responsible lending practices. Many domestic classes of investors such as insurance companies and pension funds can sometimes be heavily exposed to a relatively narrow set of fixed-income assets, and covered bonds can offer them a viable, stable, liquid and long-term alternative for the diversification of both their credit and liquidity risks.

Covered bonds can also be a cost-effective source of foreign investment by allowing local banks to attract foreign investment at a lower cost and potentially in higher quantities than any other form of fund raising. In addition to the facilitation of foreign investment, when local banks fund domestically they inevitably facilitate the development of a liquid and high-quality, local capital market.


Legal framework for covered bonds in Europe

Covered bonds are structured according to national laws. EU law does not provide for a comprehensive framework for the issuance of covered bonds. Instead, the EU law sets certain criteria (primarily in the Capital Requirements Regulation – Article 129), and enables the covered bonds investors to benefit from preferential capital treatment when investing in cover bonds that satisfy those criteria.16

In September 2015 the European Commission published a consultation paper discussing the possibility of an EU-wide covered bond law as part of the Capital Markets Union initiative. However national specificities throughout the European Union make it highly unlikely that such a law could be promulgated in the medium term, if ever.

This is because covered bonds are so variously regulated throughout the EU and costs created by legal uncertainty and changing market practices would probably outweigh the benefits of a uniform approach. In some jurisdictions issuers use contract law and other aspects of the local legal system to define and set up a particular covered bond issue, ensuring that it conforms to the minimum EU  (if relevant) or other applicable standards (to be recognised as eligible investment) as well as to meet investors’ expectations. Issuing covered bonds based on contractual arrangements and without  a specific covered bond legal framework is possible and realistic only in jurisdictions where certain specific elements usually expected in covered bond structures are well supported by existing law and there is a great body of jurisprudence confirming  the enforceability of such structures (for example,  in England and Wales).

The majority of civil law countries opt for the creation of specific legislation and regulation which would support the issuance of covered bonds. When doing so several legal and regulatory steps are usually required for the development of a covered bond framework. Primary legislation usually defines covered bonds within a jurisdiction by setting rights and duties of parties to an issue; determines a model of structure; establishes supervisory and regulatory roles empowering the regulator to pass relevant regulations and removes any existing impediments to the creation of a chosen structure. Secondary regulations usually contain criteria which when met ensure that covered bonds conform to desirable market standards that will attract investors, such as a “best practice”, as defined by the EBA in the European Union. In addition to eligibility criteria, regulations also usually introduce prudential rules of protection of all stakeholders and the financial system in general. And lastly, the legislator should ensure that various investor laws and regulations (for example, pension fund laws) correctly treat covered bonds, that is, place them in an asset class that adequately reflects its low risk and liquidity characteristics.

What covered bond models do the EBRD’s countries of operations choose?

Generally speaking there are four models of covered bonds structures currently used in Europe. Depending on the chosen model various aspects of local laws need to be reviewed and potentially modified in order to make the structures work. These include issues such as transferability of loan agreements, enforceability of transferred mortgages, segregation of cover pools in case of issuer insolvency, recognition of trust or similar agency structures, priorities and potential set-off rules of various stakeholders, and so on.

In an “on balance-sheet model” banks issue bonds which are secured on a pool of assets retained on balance sheet but “ring fenced” from other creditors in the event of insolvency. Typically the pool of assets is recorded in a “cover register”. Normal insolvency law is amended to recognise the special rights of covered bond creditors in insolvency, for example, the appointment of a party to protect their interests and/or specific amendments to normal insolvency procedures. In some jurisdictions the cover pool acquires legal personality in insolvency. This model is frequently used when the insolvency law can be adequately modified to accommodate a clear segregation of assets and derogation from normal insolvency procedures. This structure is used, for example, in Germany and Spain.

In a “special bank model” a special bank which is incorporated and wholly owned by the normal commercial bank issues the bonds. This bank is regulated and capitalised as a normal bank but has activities highly restricted to the origination of qualifying assets (or their purchase from their parent) and the funding thereof by the issue of covered bonds. Typically over-collateralisation (OC) is funded by both the capital of and a subordinated loan from their parent. This model is more onerous to set up but provides greater legal certainty of asset ownership in cases where insolvency law is difficult to modify.

In a typical SPV model a bank issues an unsecured bond. At the same time it segregates a pool of assets in a bankruptcy-remote SPV which issues a guarantee of the payments due under that bond. The pool of assets on which the guarantee is based is structured on a revolving basis. Payments are only ever made by the SPV if the bond issued by the bank defaults. This model is typically used where the legal technology exists to easily transfer the beneficial ownership of assets to an SPV.

In an agency model a group of banks collectively owns an entity which extends them loans (or buys their bonds) secured on a pool of assets and funds this purchase in the bond market. Several variations on this basic model exist but none is widely used.

A model’s selection in a jurisdiction ultimately depends on a combination of various factors such as legal heritage, compatibility with existing rules in a jurisdiction, the heaviness of necessary legal and regulatory changes and the policy views of regulators. In some jurisdictions, for example, Greece, it is even possible to choose between several models.

As already mentioned, apart from choosing  a structure model and re-shaping legal rules to  fit it, a legislator and/or a regulator also needs  to draft a set of regulations that would determine bank assets that are allowed to be pooled in  cover pools (for example, mortgages, small and medium-sized enterprise loans, and so on). Those regulations also need to determine the so-called eligibility criteria which prescribe minimum LTV ratio limits,17 the calculation method of the assets’ value in the pool,18 revaluation frequency and methodology, treatment of impaired assets, and  so on. Other aspects to be regulated include measures of credit risk mitigation,19 requirements for mitigating market risk by entering into swap contracts, availability and determination of substitute assets, various reporting rules to  the regulator and investors, authorisation requirements and monitoring rules.

In any event the ultimate goal of any legislator introducing or modifying a legal framework for covered bonds should be to create a framework that would ensure that covered bonds issued in accordance with those rules satisfy investors’ demands both from the market (liquidity, stability, transparency) and regulatory capital standpoint (preferential treatment).

EBRD support of  covered bonds reforms

The EBRD actively engages in the development  of covered bonds markets in its countries of operations. The Bank supports this through all available tools: (i) policy dialogue; (ii) technical cooperation; and (iii) investments. From the transition perspective, the EBRD considers the benefits of development of covered bonds markets to be two-fold, it supports the development of local capital markets by increasing available methods  of capital markets financing, and, supports stable and responsible housing finance.

In the following section we examine developments in the area of covered bond law in the EBRD’s countries of operations profiling three EBRD jurisdictions that have relatively recently undertaken, or are undertaking, covered bond legal reforms  and where the EBRD has played an advisory role, namely Poland, Romania and Croatia.


Due to various factors, the Polish covered bonds market has never developed, although the favourable market conditions exist. This was mostly due to two factors: (i) an outdated legal framework (the Act on Mortgage Bonds and Mortgage Banks from 1997) and; (ii) the covered bonds structure model whereby only mortgage banks were/are allowed to issue covered bonds, while over 95 per cent of mortgages were granted by universal and not mortgage banks. The existing framework required updating and alignment with international standards. The levels of outstanding covered bonds in Poland were lower than in Hungary, or the neighboring Slovak Republic or the Czech Republic. In order to create the market, participants, the Ministry of Finance and the EBRD worked together to create a new legal and regulatory framework for covered bonds in Poland.

Such work resulted in a new covered bond legislation. On 24 July 2015 the Polish parliament approved an amendment to the existing covered bond framework, the Act on Mortgage Bonds and Mortgage Banks. Amendments were also introduced to the Polish bankruptcy law. The changes came into effect on  1 January 2016 and are likely to lead to a significant increase in issuance of Polish covered bonds as they become a more attractive way for banks to increase their long-term funding base. The amendments are also the first in Europe providing for a pass-through structure (which will be explained in more detail later).

As already indicated, Polish covered bonds can only be issued by specialised mortgage banks (currently only three have such a licence), of which only two are active issuers of covered bonds (Pekao Bank Hipoteczny SA and mBank Hipoteczny SA). PKO Bank Hipoteczny is the newest mortgage bank, but it is expected to issue its first covered bond at the beginning of 2016.

In 2016 the Polish covered bonds’ landscape  is expected to change with new Polish zloty- and euro-denominated benchmark issuances and  new mortgage banks applying for the licence.

The revised Polish covered bonds law remains fairly traditional. Inspired by German legislation, Polish covered bonds can be secured by mortgage loans  or by public sector debt. Residential mortgage loans can be used as collateral for covered bonds up to  a maximum 80 per cent of the value of the underlying property (LTV ratio). For non-residential mortgage loans the LTV ratio is 60 per cent. Mortgage banks are not allowed to originate or acquire mortgage loans with a LTV ratio higher than 100 per cent. The collateral for public sector covered bonds can consist of debt issued or guaranteed by central governments or central within the European Union or the Organisation for Economic Co-operation and Development (OECD), except for states that are currently in the process of restructuring or have restructured their foreign debt within the last five years. Substitution assets, which can consist of cash, central bank deposits or public sector debt eligible as ordinary collateral, are limited to a maximum of 15 per cent of the volume of collateral required to cover the outstanding covered bonds. Derivatives used for hedging purposes can also  be included in the cover pool.

An independent cover pool monitor needs to be appointed for each covered bond issuer by the Polish Financial Supervisory Authority (KNF). The main task of the cover pool monitor is to ensure that the issuer complies with the coverage requirements set out by the covered bond framework. The framework now also requires a nominal minimum OC of 10 per cent. This limit is a minimum, and banks, hoping for a higher rating uplift, will have to comply with the expectation of rating agencies that may ask for a 20 to 30 per cent level of OC. The total nominal amount of outstanding covered bonds may not exceed 40 times the issuer’s own capital.

What happens if the mortgage bank enters into bankruptcy and what is the so-called “pass through structure”?

In case of bankruptcy, the cover pools and covered bonds are split from the issuer’s balance sheet and an administrator, who represents the rights of the covered bondholders, will be appointed by the bankruptcy court. The maturity dates of all outstanding covered bonds will automatically be extended by 12 months. Interest payments on outstanding covered bonds will continue to be made as specified in the terms and conditions of the bond in question.

Within three months of the date of announced bankruptcy of the issuer, the insolvency administrator will perform a coverage balance test, which examines whether the cover pool is sufficient to satisfy all claims arising from the outstanding covered bonds.  If this test is passed, a liquidity test will be conducted, which examines whether the cover pool is sufficient to satisfy all claims arising from the outstanding covered bonds at their extended maturity date.  If the liquidity test is also passed, the covered bondholders’ claims are satisfied in accordance with the terms and conditions, taking into account the automatic maturity extension by 12 months. Subsequent liquidity tests will be performed every three months and subsequent coverage balance tests every six months.

In the event of a failed liquidity test, maturity dates  of all outstanding covered bonds will be extended to three years after the due date of the last maturing cover asset. Covered bondholders will be repaid pro rata on a pass-through basis. The same applies  if a coverage balance test is failed. A bondholder meeting can be called to decide, with a two-thirds majority, whether the cover pool should be liquidated and the proceeds distributed among the covered bondholders instead of a pass-through repayment.

In addition, Polish covered bonds meet the requirements of Article 52(4) of the Undertakings for Collective Investment in Transferable Securities (UCIT) Directive and those set out in Article 129  of the Capital Requirements Regulation (CRR). Therefore, Polish covered bonds could qualify for  a preferential risk weighting under the CRR.

In terms of a rating uplift, the major rating agencies specified that the new legal and regulatory framework would allow for a higher maximum rating uplift than the current maximum of two to three notches. 2016 may be the year of Polish covered bonds.

The EBRD actively engages in the development of covered bonds markets in its countries of operations. The Bank supports this through all available tools: policy dialogue, technical cooperation and investments.


To establish a legislative framework in line with best practices, the Romanian parliament adopted a new covered bond law in September 2015. The new law replaces Law no. 32/2006 that had many deficiencies and has never been used. The new law conforms to: (i) the definition of covered bonds as per EU legislation including the Capital Requirements Directive and the UCITS Directive; and (ii) the “Best Practice” supervisory guidelines as published by the European Banking Authority. It is expected that the Romanian covered bonds will be exempted from bail-in application20 of the Bank Recovery and Resolution Directive (BRRD) similar to other countries in the European Union.

According to the new law, commercial banks in Romania can issue covered bonds that are backed by a pool of commercial and residential mortgage loans that are ring-fenced from the bank’s balance sheet in a bankruptcy situation. This structure would offer a double layer of protection to investors: first they will have recourse to the issuer and if the issuer is not able to honour the obligations under the covered bond programme they will have access to the cash flows of mortgage loans. The National Bank of Romania is responsible for the regulation and supervision of covered bonds, including post-issuer default, and for drafting the secondary legislation.

The new law includes specific provisions to reduce the collateral and refinancing risk, while depending on the hedging arrangements, covered bonds investors can still be subject to foreign exchange risks.

While the maximum LTV ratio for residential mortgage loans is maintained at 80 per cent (60 per cent for commercial real estate)21 in the calculation of the cover, only 60 per cent of the property market value securing the mortgage loan will be considered. This additional requirement offers extra protection to investors as it secures against a decrease in the real estate market value. In this situation, issuers will need to add more mortgage loans to the pool to be able to satisfy the cover tests. Another provision to reduce the collateral risk is the requirement for the issuer to include and maintain in the cover pool performing loans only (maximum 15 days overdue)22 which represents a significant improvement compared with the previous law (which referred to overdues over 60 days) and offers additional protection to investors against a deterioration of the macroeconomic environment. The new law introduces provisions  to protect investors against the liquidity risk. Legal minimum OC is set at 2 per cent on a net present value basis, however higher OC can be committed through the covered bond programme.23 The issuers will have to demonstrate that they will be able to comply with this requirement in a crisis situation. In addition to the minimum OC, issuers will have to pass a maturity test. Issuers will have to ensure  that for the next 180 days the difference between the incoming and outgoing cash flows on a daily basis is covered by liquid assets.24 To further protect against the liquidity risk the law allows for the covered bonds to be structured as a conditional pass-through or soft-bullet eliminating the automatic acceleration on the insolvency of the issuer.

The law does not envisage any minimum requirements with regards to foreign exchange risks which might expose investors to currency risks. The issuers are allowed to use derivatives as part of the covered pool but it is up to the issuer to choose the most effective structure.


Covered bonds are currently not specifically regulated in Croatia which creates an insurmountable hurdle for potential issuers since elements typically expected, such as segregation and transfer of cover pool assets or insolvency ring-fencing, are not supported under the current legal framework. As a consequence of the transposition of EU law, some pieces of Croatian legislation do mention or refer to covered bonds25 but without defining them and without providing an overreaching legal structure. At the same time it seems that market players have started paying attention and are looking into the possibility of issuing and/or investing in locally issued covered bonds.

This is the reason why the Croatian government decided to introduce a covered bond law which would address the existing bottlenecks and introduce regulations setting minimum standards in conformity with the eligibility criteria established in the Capital Requirements Regulation.

According to the initial plans of the government Croatian covered bonds will be debt securities issued by regular commercial banks and secured on a pool of loans where loans are secured with hypothecations or fiduciary transfer of ownership on the real property of the borrower (mortgages).

It seems that the on-balance-sheet model of structuring covered bonds would be preferred in  the Croatian case as this model reduces the need for formal transfers of loans which in local circumstances would be a rather complicated process. The need for transfer would only arise  if the issuing bank defaults (or is likely to default), which is the case only in exceptional circumstances. From that point of view, it is the simplest model to implement, requiring the fewest number of steps.  In addition, from the investors’ perspective, this model makes it quite clear that the issuing bank  is fully liable for the performance of the bonds, a fact not to be neglected in the developing covered  bond jurisdiction. However, even in this relatively straightforward structure several issues were identified as major or potential stumbling blocks, which will have to be addressed in order to create an efficient legal environment for issuing covered bonds in Croatia.

As it currently stands certain claims of a bankrupt bank’s employees, the central bank’s claims, secured deposits and claims of the deposit guarantee agency would have priority over the claims of the bondholders in case of insolvency. A new legal framework would therefore have to create clear and certain rules that would provide for ring-fencing of cover pool assets from the rest of the issuer’s insolvency estate to avoid competing claims from those types of creditors. In particular, the new regime should follow the “Best Practice” supervisory guidelines of the EBA, as well as requirements laid down in Article 52(4) of the UCITS directive, which requires that in the event of the issuer’s failure, the cover assets are to be used on a priority basis for the reimbursement of the principal and payment of the accrued interest.

In order to allow for the cover pool to survive and  to continue to service the bonds after the issuer’s insolvency, any new legislation should remedy current legal hurdles by introducing a simple and straightforward method of assets transfer from the cover pool to an administrator which would have legal and effective protection against the challenges of other unsecured creditors, as well as the possibility to enforce collateral in the case of default of the borrowers in the cover pool.

In addition, under the current legislative regime, there seems to be a risk of delays to payments on covered bonds in insolvency (a stay-on payment or similar), including under the bank resolution regime where a deposit guarantee agency is authorised, for the purpose of protection of secured deposits, to transfer secured deposits which are collateral in the covering portfolio without transferring other assets, rights and obligations; or transfer, convert cash assets, rights and obligations without transferring deposits. The new legislation should clarify that measures undertaken within the bank resolution regime shall not prevent payments to the bondholders from the pool of cover assets. Apart from resolving priority issues over the cover pool the new legislation should also limit or prohibit set-off possibility which currently borrowers under loans in the cover pool enjoy in respect of their claims against the issuer. Alternatively, the new legislation should introduce an over-collateralisation model which will adequately account for this set-off risk.

In addition to the rules that would facilitate the creation of covered bonds and the legal protection of bondholders’ rights in Croatia it will also be necessary to define the rights and obligations  of cover pool administrators, prescribe reporting standards and eligibility criteria in accordance  with the CRR as mentioned above and introduce  a supervisory regime.

The Croatian National Bank should be granted  the supervisory powers in order to run a dedicated supervisory regime for covered bonds. This, if done in alignment with the EBA Best Practices, assumes that the competent authority approves the establishment, by a given issuer, of a covered bond programme in accordance with a clear  and sufficiently detailed set of criteria for approval and, in general, an explanation of duties and powers of the competent authority. The year ahead promises to be an exciting one in terms of the development of Croatian covered bonds and the capital market in general.


It appears that covered bonds are becoming more and more popular in the EBRD region and this has been reflected in the increased legislative activity in various EBRD countries of operations. There  are many benefits of developing a covered bonds market and these can generally be grouped into three main categories depending on the issuers, investors and/or the systemic perspective.

For the financial institutions they are an effective way of attracting long-term funding at reasonable cost and this can be translated into cheaper mortgage lending to retail customers. In the medium and long term the covered bonds influence the development of the primary mortgage market as  the underwriting criteria will have to be aligned with the best international standards benefiting retail customers. The ultimate effect will be a more sustainable primary mortgage market.

For investors, these instruments offer the best protection as they are subject to controls from the regulator as well as rating agencies. Many domestic investors who are currently heavily exposed to a relatively narrow set of fixed income assets will therefore find a valuable tool for the diversification of both their credit and liquidity risks. It is expected that covered bonds are to be highly rated, liquid, long-term instruments suitable for local pension funds and insurance companies.

Covered bonds can also contribute to the development of the local capital market as these instruments will be listed on the local stock exchange and will facilitate the establishment  of a liquid, high-quality bond market.

All of these features, coupled with beneficial market conditions for the development of covered bonds markets, indicate that the probable answer  to the question posed at the beginning of this article is: yes, definitely “to bond”.

Renewable energy: a sustainable solution in Egypt

Thermal (oil and gas) power plants largely dominate the Egyptian power generation scene, representing about 89 per cent of the overall energy production.

Sun is widely available in Egypt and the Gulf of Suez (especially the Gulf of Zeit) features some of the best wind resources in the world. Harnessing the abundant wind and sun resources can contribute to increasing the generation capacity and lowering the country’s dependency on natural gas imports (necessary for the generation of conventional electricity). In addition to decreasing the country’s reliance on hydrocarbons, renewable energy insulates Egypt from commodity price volatility. Wind and solar energies offer some diversification as, currently, about 89 per cent of Egypt’s electricity is fossil fuel based and mostly produced in gas-fired plants. Wind and sun also constitute clean sources of power with low or virtually zero greenhouse gas emissions and limited or no environmental impact. Importantly for a water-stressed country such as Egypt, wind and solar plants also use little or no water in their operation. Such plants are easy to build and low-risk. Solar photovoltaic plants in particular can be commissioned at a much faster pace than thermal power plants. Due to some economies of scale as a result of mass production, improved wind turbine and solar panel designs as well as new technology, the cost of generating both wind and solar energy is now competitive with other forms of electricity generation. Hence, with outstanding natural resources on its doorstep and a generation cost now competitive with that of generating fossil fuel electricity, it has been a natural move for the Egyptian authorities to promote the development of wind and solar energy.

The overall national strategy for renewable energy was announced in a decision of the Supreme Energy Council in February 2008. It set out an ambitious target of 20 per cent of the electricity consumption to be generated from renewable sources by 2020 (the “Target”). It mainly refers to wind and to a lesser extent, hydroelectric power. This strategy was implemented through a series of state-owned wind farms on the one hand and the involvement of a private developer for the construction, ownership and operation of a 250 MW wind farm in the Gulf El Zeit, on the other. Due to political and economic disruption, these projects have been delayed but 600 MW of state-owned wind power has been commissioned at Zafarana on the Gulf of Suez and in November 2015 a 200 MW state-owned wind farm began operating in the Gulf of Zeit. This strategy was redesigned in 2014 and gave rise to Law No. 203 enacted by presidential decree on 21 December 2014 (the “Renewable Energy Law”). The former Ministry of Electricity was renamed the Ministry of Electricity and Renewable Energy, revealing the increased importance of renewable energy in the government’s strategy to solve the energy crisis.

The 20 per cent Target has remained unaffected by the provisions of the Renewable Energy Law. It constitutes the highest renewable energy target in the Middle East and North Africa region after Saudi Arabia.

Wind and solar energies offer some diversification as, currently, about 89 per cent of Egypt’s electricity is fossil fuel based and mostly produced in gas-fired plants.

Inviting private sector participation in renewable energy generation

To tackle the energy crisis and increase the power capacity, the government has encouraged the private sector to invest in renewable energy projects in Egypt.

As a result of a policy decision to gradually decrease state intervention in power generation, Egypt’s strategy aims to increase the role of private participants through their ownership and finance of power plants. The Egyptian authorities have sought the private sector’s involvement in the development of renewable energy projects in three different ways:

  • Build, Own and Operate type of wind and solar projects tendered by the Egyptian Electricity Transmission Company (“EETC”) acting as wholesale purchaser of electricity pursuant to a long-term power purchase agreement where the private developer builds, owns and operates the plant and sells the electricity output to EETC
  • Feed-in-Tariff Programme, where private developers are assured to sell renewable electricity at a fixed price for 25 years (solar) or 20 years (wind) pursuant to EETC’s obligation to purchase at a fixed tariff, guaranteed by the Arab Republic of Egypt acting through the Minister of Finance
  • merchant renewable energy projects owned and operated by private developers delivering the output to the grid but selling it to commercial and industrial consumers through bilateral agreements.

The EBRD’s involvement

The EBRD is a strong supporter of these initiatives which, for the reasons stated above, meet the Bank’s sustainable energy agenda as well as the Bank’s private sector agenda by introducing a large number of private sector players. The Bank has therefore invested many resources in the programme since the beginning of 2015 which took various forms.

The Bank has initiated extensive policy dialogue through workshops, conferences, meetings and informal discussions with the Egyptian authorities to shape the contractual framework and the regulations applicable to a feed-in-tariff scheme (the “Feed-in-Tariff Programme”) launched in 2014 for the generation of 4 GW of wind and solar electricity (some 4,300 MW for the first round only, that is 2,000 MW of wind and 2,300 MW of solar power).

The EBRD has also funded a short-term technical cooperation consultancy under the SEMED Resource Efficiency Policy Dialogue Framework for the drafting of the additional provisions of the high-voltage network code in order to accommodate the specifics of solar photovoltaic plants.

In addition, the EBRD is sponsoring the tender of a 200 MW solar plant in Kom Ombo through the Public-Private Partnership (“PPP”) Project Preparation in the Southern and Eastern Mediterranean (“MED 5P”), an EU advisory facility created to support public authorities in the SEMED region in the preparation, procurement and implementation of public-private partnership infrastructure projects. MED 5P is providing €1.5 million in legal, technical and financial advisory services to the Egyptian government for the preparation of the Kom Ombo PPP project.

The EBRD is also supporting the development of long-term renewable energy by providing more than €2 million of technical cooperation funds for a Strategic Environmental and Social Assessment in connection with the second phase of development of the East Nile. This region is expected to be the area of future development of renewable energy after the Gulf of El Zeyt and the Benban sites are fully utilised.

Lastly, the EBRD will provide up to US$ 500 million to finance a number of renewable solar projects under the first round of the Feed-in-Tariff Programme.

Promoting competition in the power market

The Egyptian government has not only welcomed the private sector’s participation in renewable energy, it has also undertaken various reforms in order to ensure a more private sector investment friendly environment. The efforts include setting a roadmap for a gradual opening of the power market to competition, redefining the mandate and powers of the regulator and unbundling the transmission company/single buyer of bulk electricity as well as restructuring the tariffs and the subsidy scheme.

The unified electricity Law No. 87 of 7 June 2015 enacted by presidential decree (the “Electricity Law”) establishes a broad framework for the partial deregulation of the existing power market and the introduction of some competition.


Source: Egyptian Electricity Holding Company Data 2014 Annual Report.

In the existing Egyptian single-buyer market model, with a vertically integrated supply chain through generation, transmission, distribution and supply, the first step has been to open power generation and supply to competition, while transmission and distribution will remain natural state monopolies which cannot be subject to market forces at this stage.

Two markets will co-exist in practice. The competitive market will only be accessible to eligible consumers (“Qualified Consumers”) who will have the right to purchase electricity through bilateral agreements from either: (i) the power generation company of their choice; or (ii) the authorised suppliers (traders) (“Authorised Suppliers”) of their choice. Although the term “Qualified Consumer” is not defined in the Electricity Law and will need to be so by secondary legislation, we understand that it should extend to industrial, commercial, administrative and government consumers rather than residential consumers. The latter or non-qualified consumers will have no alternative but to purchase their power on the regulated market pursuant to some standardised agreements and fixed tariffs approved by the Egyptian Electric Utility and Consumer Protection Regulatory Agency (“EgyptERA”).

Although not clearly stated, according to some experts, the government’s long-term goal is to shape a market where investors will take the risk of generating power without any power purchase agreement or related contractual power purchase undertaking guaranteed by the Ministry of Finance. The state will gradually withdraw from power generation and state-owned power plants will decrease in number following decommissioning or privatisation. As a first step, the Egyptian authorities are aiming for a market of multiple generators and suppliers, respectively, competing among themselves. It is unclear whether full-scale liberalisation of the market where competition is also introduced beyond generation and supply with a full unbundling of the supply chain is contemplated at this stage.

Redefining the mandate and powers of the state-owned utilities

The Electricity Law has clarified the role and powers of the EETC. Formerly a state owned subsidiary of the Egyptian Electricity Holding Company (“EEHC”) which was vertically integrated into the supply chain, the EETC will be unbundled and separately owned, gaining some independence from all other utilities participating in the supply chain. In its capacity as transmission system operator, the EETC still enjoys a monopoly over the power transmission activities and management of the network operations. In its capacity as single buyer, it will primarily be responsible for ensuring a power supply to non-qualified consumers as well as an interim power supply to Qualified Consumers (via six-month long agreements). The EETC will be the counterparty to the power purchase agreements to be entered into with the private sector generation companies in connection with the Feed-in-Tariff Programme and the Build-Own-Operate projects.

The Electricity Law has conferred more independence on EgyptERA, the sector regulator. To ensure general oversight and regulation of the power sector, EgyptERA grants licences and approves tariffs applicable to the sale of electricity to non-qualified consumers and tariffs applicable to all for the use of the grid and distribution networks.

The Electricity Law also anticipated a new market operator, which will be an autonomous unit within the EETC, enjoying financial and administrative independence. It will regulate the power supply and demand bids as well as being responsible for accounting and settlement operations.

The newcomers are the Authorised Suppliers which are legal entities licensed by the EgyptERA to deal with the purchase of electricity or related services in the name of and for the account of producers, distributors and consumers. Secondary legislation is expected to provide further details on the role and status of the Authorised Suppliers as well as defining their rights and obligations.

The New and Renewable Energy Authority (“NREA”) was established in 1986 as a state agency responsible for the development of renewable energy. Although it reports to the Ministry of Energy and Renewable Energy, it is independent from EEHC and the other state-owned electricity companies. It advises on the renewable energy targets, strategy and regulatory framework. In 2014, the NREA’s competencies were amended and the EgyptERA endorsed a more active role in the development of renewable energy through: (i) its involvement in renewable power projects whether managed alone or in collaboration with third parties; (ii) the sale of the electricity produced from such projects to third parties; and (iii) the setting up of joint stock companies, whether alone or in partnership with others, to develop and operate such projects. In addition, the NREA owns and acts as lessor of the public land allocated to the development of wind and solar plants in connection with the Feed-in-Tariff Programme.

A comprehensive power tariff and subsidy reform

Liberalising the energy sector and opening it to private independent power producers requires a necessary change in the tariff-setting regime, including the subsidy scheme, in order to appear attractive to private sector investors and allow proper competition to exist. Without such reform, the actual cost of generating renewable energy compared with the existing subsidised tariff charged to consumers makes merchant projects economically unattractive.

The reform is also necessary in order to relieve the financial burden on the EETC as the purchaser of renewable energy under, among others, the Feed-in-Tariff Programme, at fixed tariffs for 25 years (solar) and 20 years (wind).

The Renewable Energy Law provides for a mechanism of cost sharing with end-users or Qualified Consumers. A percentage of the cost of generating renewable energy will be borne by a category of end-users as the latter will be requested to purchase a quota of their electricity from renewable sources at the applicable tariff. The category of end-users as well as the quota will be defined yearly by the Cabinet on the recommendation of the Ministry of Electricity and Renewable Energy. This mechanism will enable sufficient funding to cover the costs to the EETC of purchasing renewable energy.

The Renewable Energy Law also provides that each MWh of renewable energy produced will give right to a certificate of origin which can be traded independently. Further regulation is required to establish this green certificate scheme. Until the mechanics of the competitive market start to operate and Qualified Consumers are able to choose their respective power supplier, end-users who are subject to the obligation to share the cost of generating renewable electricity will also be able to surrender equivalent volumes of tradeable certificates of origin as an alternative to purchasing an electricity quota from renewable sources.

The gradual liberalisation of power generation and distribution contemplated by the Energy Law will also enable parallel liberalisation of the tariffs, leaving electricity tariffs subject to market forces.

In July 2014, a comprehensive energy subsidy reform was adopted setting out a five-year programme of power tariff increases to reach a level reflecting the true cost of electricity to the consumer.

A road map to a full scale liberalised market?

The Electricity Law only establishes a broad framework for a gradual liberalisation of the power market. Secondary legislation through either Cabinet decrees or regulations issued by EgyptERA is expected to further address the already-contemplated unbundling of the power utility into multiple generators and suppliers who trade with one another or with other market participants in a competitive wholesale market. A clear implementation timeframe and milestones to achieve reform implementation and competition is therefore required.

Objective and transparent rules for the use of the transmission and distribution networks by market competitors, without any discrimination, will be necessary alongside firm pricing regulation for the use of these networks. The regulator’s independence is another key component of a well-functioning, liberated market. In the wholesale market, regulation should focus on preventing anti-competitive abuses of market power. In the retail market, regulation should ensure a balance between the interests of suppliers and consumers.

The focus of the government may shift to a policy role. This is performed with less conflict of interest when the state ceases to act as the main owner, investor and controller of the entities constituting the power supply chain, especially in wholesale generation and retail supply of electricity.