Luxembourg opens its covered bonds market

On 7 May 2021, the Luxembourg Minister of Finance submitted draft bill no. 7822 on the issuance of covered bonds (the Bill) to parliament. The draft Bill, which is foreseen to come into force on 8 July 2022, overhauls the existing regime for covered bonds (lettres de gage), in that it will: 

• allow universal banks to issue covered bonds in Luxembourg and no longer restrict access to banks specifically authorised as covered bond banks (banques d’émission de lettres de gage); and
• implement the European covered bonds regime set out under Directive (EU) 2019/2162 (Directive 2019/2162) and Regulation (EU) 2019/2160 (together, the European Framework)¹  and establishing two new types of “European” covered bonds.

More details on some of the key features of the Bill are set out below.

Opening of the covered bonds market to all Luxembourg credit institutions 

The Bill will abandon the “specialist bank principle” (Spezialbankenprinzip), pursuant to which banks issuing covered bonds in Luxembourg must be authorised as specialised covered bond banks (banques d’émission de lettres de gage) and limit their principal business to the granting of loans (in any form) specifically secured and re-financed by covered bonds issuances. 

As a result, all credit institutions authorised in Luxembourg, whether universal or specialised in covered bond issuances, will now have the opportunity to issue covered bonds². A specific licence to be a covered bond bank is no longer required. It will however remain possible under the new framework to be licenced as specialised covered bond bank and hence limit a bank’s activity accordingly. 

Universal banks licensed in Luxembourg will be able to diversify their exposures by combining their traditional banking activities with the issue of covered bonds in Luxembourg. In order to ensure adequate protection of the bank’s creditors, the Bill provides that universal banks issuing covered bonds must ensure that the aggregate cover asset pools linked to covered bonds represent not more than 20% of the bank’s total commitments, including own funds, but deducting eligible deposits³. This limitation creates a constant interplay between the bank’s covered bonds activity and the recourse to other sources of re-financing from creditors benefitting from increased protection, and as such patrols the overall encumbrance of the bank’s assets. 

Harmonisation of the Luxembourg covered bonds regime with the European Framework - introduction of “European” covered bonds

While the European Framework aims to harmonise the covered bonds framework throughout the European Union, Directive 2019/2162 laying down the regulatory framework for “European covered bonds”, does not prohibit the maintaining of national covered bond regimes. 

Against that background, the Luxembourg legislator decided to implement the European Framework by the introduction of two new types of covered bonds, namely (i) the “European covered bonds” (obligations garanties européennes) and (ii) the “(high-quality) European covered bonds” (obligations garanties européennes (de qualité supérieure)), but also to maintain the current framework for “lettres de gage”⁴. 

The European covered bonds are considered to be an additional category of Luxembourg covered bonds (lettres de gage). In addition to the general requirements applicable to the four types of “traditional” covered bonds (lettres de gage) provided for in the existing Luxembourg legislation (i.e. mortgage, public, movable assets and renewable energy covered bonds), the “European” covered bonds” and “(high-quality) European covered bonds” are subject to specific requirements deriving from Directive 2019/2162. These additional rules apply to “European” covered bonds notably in respect of their cover asset pools and the valuation of their cover assets. Hence, both types of “European” covered bonds will qualify as Luxembourg covered bonds or lettres de gage while “traditional” covered bonds may not be labelled as “European” covered bonds or obligations garanties.

If the draft Bill is adopted, the following categories of covered bonds (lettres de gage) may be issued under the harmonised framework:

• “mortgage” covered bonds (lettres de gage hypothécaires) issued in respect of loans secured by rights in rem over real estate;
• “public” covered bonds (lettres de gage publiques) issued in respect of loans to public sector entities;
• “movable assets” covered bonds (lettres de gage mobilières) issued in respect of loans secured by rights in rem over movable property (the Bill now specifies that three different categories of “movable assets” can be foreseen, being (i) aircraft, (ii) ships and boats and (iii) railway rolling stock, whilst this is not limited in the current regime);
• “green” or “renewable energy” covered bonds (lettres de gage énergies renouvelables) issued in respect of loans secured by rights in rem or charges over assets generating renewable energy;
• “European” covered bonds (obligations garanties européennes) issued in respect of loans secured by physical assets (e.g. real estate) subject to public registration (or an assimilated type of registration) or in respect of loans granted to or secured by public sector entities; the Bill lays down the eligibility rules for such assets, in line with the criteria set out in Directive 2019/2162⁵; and
• “(high-quality) European” covered bonds (obligations garanties européennes (de qualité supérieure)) issued in respect of loans secured by high-quality “eligible assets” (including certain public sector, immovable and movable property assets) meeting the criteria set out under article 129 of the Capital Requirements Regulation (Regulation (EU) 575/2013), so as to be eligible for the preferential treatment set out in the Capital Requirements Regulation.

Covered bonds, irrespective of their type, are structured to be particularly safe by virtue of the dual recourse protection⁶ offered to bondholders in the form of:  (i) a preferential claim over the pool of cover assets related to the specific covered bond and (ii) an ordinary claim against the issuing bank’s general estate. 

Overhaul of the Luxembourg covered bonds framework

While the existing Luxembourg covered bonds framework is already largely compliant with some of the key features provided for in Directive 2019/2162, the Luxembourg framework has nevertheless received a significant overhaul. 

In line with the “product-focused” approach of the European Framework, the Bill establishes a bespoke regime by setting up a dedicated “Luxembourg law on covered bonds issuance” and extracting the covered bonds regime from the Luxembourg law of 5 April 1993 on the financial sector. 

Furthermore, to follow the market development, the Luxembourg legislator removed “co-operative” covered bonds (lettres de gage mutuelles) (i.e. covered bonds issued in respect of lending to co-operative banks) from the list of instruments available to issuing banks as they were not used in practice. A number of simplifications have also been made with respect to the eligible assets for existing categories of covered bonds (for instance, the references to exposures to certain types of eligible assets via securitisation have been removed, the possible types of movable property covered bonds have been clarified (see above) etc.).

The Bill also provides for greater transparency and investor protection as it introduces new rules on the structural characteristics of Luxembourg covered bonds (whether “European” or not), the approval of covered bonds programmes, the disclosures to be made to investors and the supervision of covered bond banks by the Commission de Surveillance du Secteur Financier. 

The Bill also specifies the insolvency regime applicable to banks issuing covered bonds by adding a detailed section dedicated to insolvency proceedings for banks issuing covered bonds in the Luxembourg law of 18 December 2015 on the failure of credit institutions and certain investment firms, as amended.

¹ Directive (EU) 2019/2162 of the European Parliament and of the Council of 27 November 2019 on the issue of covered bonds and covered bond public supervision and amending Directives 2009/65/EC and 2014/59/EU (http://data.europa.eu/eli/dir/2019/2162/oj) and Regulation (EU) 2019/2160 of the European Parliament and of the Council of 27 November 2019 amending Regulation (EU) No 575/2013 as regards exposures in the form of covered bonds (http://data.europa.eu/eli/reg/2019/2160/oj)
² Subject to such credit institutions obtaining the CSSF’s prior approval for setting up one or more covered bond programmes.
³ As defined in article 1, point 37 of the Luxembourg act dated 18 December 2015 on resolution, recovery and liquidation measures of credit institutions and certain investment firms, as amended.
⁴ The current regime for Luxembourg covered bonds (lettres de gage) is already largely aligned with the key features of Directive 2019/2162.
⁵ These eligibility rules for “European” covered bonds are, in certain respects, slightly narrower than the eligibility rules for the four categories of traditional lettres de gage set out above.
⁶ This dual recourse mechanism already applies under the current regime, though the Bill now foresees an express provision on this topic, in line with Directive 2019/2162.