1. How structured covered bonds can start an innovation in SME financing in
Spain.
Aijaz Siddique
This paper has been written under the guidance of the following individuals:
Professor Ignacio de la Torre: Partner at Arcano and Professor at IE Business School
Professor Luis Maldonado: Director del Centro del Sector Financiero de PwC e IE Business
School
Gustavo Caballero: Consultor Senior at Arcano
And I am grateful to the following individuals for listening to my ideas:
Antonio del Pino Rodriguez: Advisor in Financial Analysis at the General Secretariat of the
Treasury and Financial Policy
Eloy Garcia Gonzalez: Professor at IE Business School
IE Business School
Master in Finance Program
June 17, 2013

2. Abstract
The aim of this paper is to contribute a structure that serves the following purpose: it encourages
banks in Spain to issue loans to SMEs and use them as collateral to issue covered bonds. The
paper discusses the importance of SME sector in Spain in the current economic environment and
the various obstacles that limit the access of SMEs to funding. It explores the suitability of the
covered bond as a financial instrument and examines how and why Banco Santander can issue
these bonds. We analyze the structure of the covered bond and discuss the Spanish legal
framework regarding covered bonds. The structure of the covered bond is standard with some
additional features to improve the rating. The paper also analyzes the possible rating that the
structure will receive from Fitch and what steps to take in order to improve that rating.

3. Table of Contents
Chapter 1 Introduction
Chapter 2 SME financing in the aftermath of the financial crisis
Chapter 3 Impact of regulation on SME financing and covered bonds
Chapter 4 Banco Santander Structured Covered Bonds
Chapter 5 Analysis of Spanish legal framework with regard to the issued bond
Chapter 6 The structure of the issued bond
Chapter 7 Analysis of how the covered bond will be rated by Fitch
Chapter 8 Bibliography

4. 1. Introduction
SME sector is crucial for the revival of the Spanish economy. It contributes more than
proportionally to employment and GDP in Spain as compared to the SME sectors in other
European countries. Prior to the financial crisis this sector was expanding with the number of
SMEs showing an increasing trend. However, due to the financial crisis and the consequent
credit crunch we have observed a contraction in the number of small and medium sized
enterprises in Spain since 20071
. This has translated into a fall in work force employed in this
sector and a reduction in value added to the economy as a whole.
The major source of financing for SMEs is the banking industry in Spain. Due to high default
rate on the portfolio of loans and credit problems that banks have faced they have become quite
risk averse at lending. This combined with other financial problems have checked the growth of
the SME sector and consequently the economy which is predominantly reliant on this sector. A
covered bond issued by Banco Santander with the collateral as a portfolio of loans to SMEs
seems promising as a solution to the problem of SME financing.
The structured covered bond recently issued by Commerzbank is original in the sense that the
collateral is a pool of loans to SMEs. The bond received a long-term rating of ‘AA’ on the basis
of several criteria but predominantly because of Commerzbank’s long-term issuer default risk of
‘A+’ and the quality of the cover pool. A similar bond issued by a bank in Spain will not get the
same rating. However, the rating on the bond that results due to a poor rating of the issuer and
poor quality collateral can be improved to a certain extent by adjusting the covered bond
structure.
The second chapter focuses on SMEs and financing problems in detail. The third chapter
discusses how regulations will impact SME lending and the covered bond market in the future.
The fourth chapter focuses on why Banco Santander should issue a structured covered bond. In
the fifth chapter we discuss the salient features in the Spanish legislation with regard to the
1
EC SBA Fact Sheet 2012 page 1

5. covered bond. In the sixth chapter we propose a structure for the covered bond. In the last
chapter we discuss the rating the bond might get from Fitch.
2. SME financing in the aftermath of the financial crisis
The SME sector in Spain represents 99.9% of all Spanish firms. As of 2012 it contributed 75.6%
to the total employment in Spain as compared to the 67.4% for the EU area and its share as a
percentage of total value added was 65.7% in comparison to the 58.1% for the EU area2
. The
sector has shrunk since the financial crisis set in and this shrinking has accelerated after the
Spanish real estate crisis. The percentage of people employed has been falling since 20083
and is
expected to show a declining trend until the recession in Spain subsides.
Most of the SMEs in Spain have been predominantly reliant on bank finance before and after the
financial crisis. Following the financial crisis the banking sector suffered considerably. It has
faced high rates of default on portfolio of loans to real estate and non-real estate companies.
There has been a shortage of the interbank lending and a collapse of the securitization market
after the financial crisis. Securitizations backed by pools of mortgages were the primary cause of
the financial crisis and suffered from a decline in investor demand. (Securitizations secured by
pool of loans to SMEs have suffered similar fate due to contagion effects and poor public
perception about structured finance products in general4
.)
The financial problems have led to adoption of stringent criteria for lending. This has been a
bane for SMEs who already suffer relatively tough loan conditions due to the asymmetric nature
of their business, adverse selection and moral hazard when it comes to bank loans. Lack of
alternative sources of funding such as equity issue and venture capital in Spain has worsened the
loan conditions further. The effect of these financial problems has been observed because of the
number of SMEs who have expressed their concerns regarding a decrease in availability of bank
credit. In fact, the number of Spanish SMEs who face this issue has been rising for the last few
years and reached 37.5% in 2012, this is much higher than the figures for Germany, France or
2
SBA Fact Sheet 2012 page 1
3
SBA Fact Sheet 2010/2011 page 1
4
EIF SME Loan Securitization – An important tool to support European SME lending

6. even Italy where the SME sector contributes more to the economy than in Spain5
. Apart from the
availability of bank credit there has been a general increase in the interest and non-interest cost
of funding as reported by SMEs6
. There has been an increase in collateral requirements, a
reluctance to provide overdrafts and a limit on the amount of loans that can be issued to the
SMEs7
. Considering the importance of SMEs for Spain, these problems are worrisome.
The Bank of Spain has undertaken measures to help the banking sector. However, it is a long
way off from returning to normal pre-crisis levels. An analysis of the provisions for loan losses
for the banks over the last 5 years shows that they have been increasing and might take years to
normalize. The recent steps taken by the Bank of Spain such as restructuring, loan write-offs and
recapitalization to improve the strength of the banking sector are steps in a positive direction.
The establishment of SAREB (Sociedad de Gestión de Activos procedentes de la
Reestructuración Bancaria) to meet EU conditions for aid, aims to manage the assets of the
nationalized institutions in Spain and improve availability of credit. However, the goal of
SAREB is to get rid of all the bad loans in 15 years. The Government of Spain established FROB
(Fondo de reestructuración ordenada Bancaria) to bailout banks and avoid large-scale financial
instability. FROB targets the savings banks (Cajas) in Spain which lent funds actively before the
financial crisis, although their focus was not particularly the SMEs. A really important step was
taken recently by the Ministry of Economy and Competitiveness when it entered into an
agreement with the Spanish Banking Association and Spanish Confederation of Savings Banks
to help fund SMEs with an additional credit of € 10 billion8
. This measure would strengthen
Instituto de Credito Oficial (ICO) and increase the budget available for SME loans. Another
important initiative was the decision by European Investment Bank to provide € 0.5 billion to
ICO in order to increase the amount of credit available for SME projects9
.
3. Impact of regulation on SME financing and covered bonds
5
Spanish SMEs’ financial restrictions: The importance of bank credit page 3
6
Spanish SMEs’ financial restrictions: The importance of bank credit page 8
7
Spanish SMEs’ financial restrictions: The importance of bank credit page 8
8
www.mineco.gob.es – Signature of Collaboration Agreement for the financing of SMEs
9
www.ico.es – press release 2013

7. Apart from the problems resulting directly from the financial crisis the new regulations imposed
on the banking system penalize lending to SMEs. Under Basel III banks who lend to SMEs will
be required to comply with increased capital requirements and higher counter-cyclical buffers in
the next five years primarily due to the risk of SME loans. The risk-weight on loans to SMEs is
100%, as they are considered very risky assets. This discourages lending to SMEs as the capital
consumption is high. Risk reducing techniques such as guarantees, collateralization and balance
sheet netting can be employed to reduce the capital charge on loans to SMEs. Overall, the
negative impact of bank loans to SMEs depends on the effectiveness of these risk reducing
techniques and the profits banks generate from loans to SMEs. Banks also have the incentive to
pass on the costs to SMEs through higher rates of interest and generate higher interest revenue to
improve their capital structure.
By doing a securitization the pool of loans can be bundled together to issue bonds. However, the
cover pool remains on the balance sheet. Capital consumption decreases as a certain portion of
the capital is set aside for the cover pool of assets (in fact the Capital Requirements Directive
issued by EU to reflect the effects of Basel II in Europe puts a higher charge on cover bonds as
compared to other instruments like securitizations and promotes the issue of covered bonds).
Covered bonds sold to the investors generate liquidity and provide banks the incentive to issue
more SME loans. They are cheap sources of funding for banks. An additional advantage is that a
certain portion of covered bond funds can be pledged as collateral to the ECB for repo activities
(due to their higher quality the hair-cut on covered bonds is lower than that on other bank debt
and securitizations) if they comply with the Article 22(4) of UCITS Directive, under which
covered bonds should have specified bankruptcy protection10
. Such a protection usually exists if
the cover assets are transferred to SPE as well as registered in a special register for regulatory
reporting purposes.
Apart from the risk-based capital requirements an aspect of Basel III that might adversely affect
lending to SMEs will be the non-risk based leverage ratio. The leverage ratio under Basel III
should not fall below 3%. This will constrain the quality and quantity of assets that the banks can
10
Frequently asked questions regarding covered bonds page 5

8. have on their balance sheet and will have an impact on lending in general. Banks might reduce
loans to SMEs and pursue other profitable assets.
Basel III introduces quantitative measures of liquidity that are biased against lending to SMEs.
Under the Liquidity Coverage Ratio banks are instructed to hold high-quality and low yield
liquid assets that can be disposed of to take care of bank liquidity needs. Loans to SMEs do not
qualify as high quality assets as they have poor credit worthiness and have a high yield
(especially in the case of Spain). LCR considers covered bonds as liquid instruments (second
only to cash and sovereign debt) that are suitable for preventing cash outflows in stressed
scenarios11
. However, covered bonds cannot exceed 40% of the liquid assets. That level may
already have been breached in certain countries like Germany where covered bonds have been
issued on a large scale in the last few years. The Net Stable Funding Ratio advocates bank to
reduce reliance on short-term funding and seek stable long term funding arrangements. It assigns
weights to assets according to their stability. A weight of 85% is generally assigned to retail
loans (considerably unstable as compared to cash which is assigned a weight of 0%). SMEs loans
would either be assigned a weight of 85% or 100% if they come under the classification of other
assets. Banks might resort to other available stable funding arrangements instead of SME loans.
NSFR is biased towards covered bonds because they are considered more stable sources of long-
term funding that will improve asset-liability management due to their bullet repayment feature
instead of bond amortization. The bullet maturity feature of covered bonds also avoids
prepayment risk generally associated with standard bank bonds. Apart from Basel III, another
regulation which will have a positive impact on the covered bond market will be the Solvency II
that comes into effect on January 1, 2014. This regulation is primarily designed to ensure
consistency in the EU insurance industry and to protect the consumers. Solvency 2 puts a lower
capital charge on covered bonds due to their nature (rating and duration) compared to other
similar kinds of debt12
.
Both Basel 3 and Solvency 2 seem to favor these instruments. Covered bonds offer a dual
guarantee. This feature distinguishes covered bonds from some other securitizations and is
responsible for the higher ratings on covered bonds compared to the ratings on other debt
11
PWC. "Uncovering Covered Bonds." page 7
12
PWC. "Uncovering Covered Bonds." Page 7

9. instruments. Covered bonds have higher risk-weighting in the eligible capital requirements under
Basel III compared to certain other kinds of debt. They also benefit from lower capital charges
when it comes to counterparty exposure and market exposure to the firm.
In a covered bond, investors have a claim on the issuer as well as a pool of assets which are
isolated from the insolvency state of the issuer. Investors claim on the cover pool assets is
superior to the claims of other unsecured creditors. Several features of the covered bonds make
them suitable in the current economic environment. Specifically, overcollateralization (that total
asset value exceeds the nominal value of bonds) has to be maintained at least to a certain level
and only high quality and liquid financial assets can serve as a cover pool. Moreover, the cover
pool has to be a dynamic open pool in which assets can be replaced to maintain the quality of the
pool. Cover assets do not have any obligations to meet the cash flows to covered bond holders if
the issuer is solvent. They serve the purpose of improving the credit rating of the covered bonds
before issuer default. Bondholders have a claim on cash flows associated with the cover pool
post issuer insolvency.
An independent third party monitors the quality of pool. Investors are well informed about the
cover pool through regular disclosures made by the issuer. Unlike other kinds of unsecured debt,
covered bonds do not have many tranches. It is easier to analyze the cover pool due to its
transparency. Furthermore, the collateralized assets remain on the balance sheet of the issuer.
Due to these features, covered bonds can receive ratings that are higher than the rating of the
issuing firm. Ratings can go up to 8 notches above the rating of the issuing entity depending on
factors such as issuer risk (mainly the long-term issuer default risk), systemic risk,
overcollateralization (the ratio of the total value of the cover pool to the nominal value of
covered bonds) and discontinuity risk (the possibility that the covered bonds will not survive the
issuer default despite the fact that there is a cover pool)13
. These factors can be managed by the
issuing entity to improve the ratings on the covered bonds.
Covered bonds are either issued on a contractual basis or under specific covered bond legislation.
We have the European Covered Bond Council (ECBC) and the Canadian Mortgage and Housing
Corporation (CMHC). The ECBC brings together various covered bond stakeholders across all
13
Ratings, Fitch. "Covered Bond Rating Criteria 2012."

10. Europe. It sets a specific framework for covered bonds in every European country and represents
more than 90% of the covered bond industry. It provides several benefits in the form of
information, comparison of covered bonds issued in different jurisdictions and sets specific
legislation for guidance of covered bond issuers and investors. Introduction of covered bond
legislation in Australia in 2011 was followed by an increase in issue of covered bonds. We can
observe similar patterns in New Zealand. Specific covered bond regulation dictates the
insolvency procedures, claims on the cover assets (bankruptcy remoteness of the cover assets)
and maintenance of the cover pool. It makes covered bonds more attractive instruments
compared to other unsecured senior debt.
The need for alternative sources of funding propelled the demand for covered bonds. The market
for asset-backed securities suffered post-financial crisis. Loans were not held on the balance
sheets and the financial entities had no reason to maintain the credit quality of these loans which
were eventually divided into tranches and sold off to investors. There was a conflict of interest
between the issuer and the investor in the case of asset-backed securities. Covered bonds require
banks to keep 100% of the cover pool on the balance sheet. They have not suffered a fate similar
to the ABS market after the financial crisis and the Spanish real estate crisis.
Cover pools are usually comprised of mortgages and public-sector debt. However, recently with
the increased focus on SME financing to restore growth in Europe, we have seen innovation in
the form of loans to SMEs serving as collateral to covered bonds.
4. Banco Santander Structured Covered Bonds
Banco Santander has a very resilient business model due to its geographical diversification and
its focus on robust capital and liquidity. Its commercial banking activities in Latin America,
Europe and United States of America diversify its exposure to the struggling Spanish economy.
Its net profit fell down by 58.8% to € 2,205 million, primarily due to the provisions for real
estate loans in Spain in 201214
. However, Banco Santander SA has reduced its exposure to the
troubled assets in Spain by almost half and set aside provisions to cover remaining such assets.
14
Annual report Banco Santander – page 8

11. The bank’s core-capital stands at 10.33% under Basel II against the required 9% and it
successfully passed the stress-tests conducted by the European Banking Authority in 201215
. The
recent efforts by the Spanish authorities such as restructuring and recapitalization would start to
show results in the not so distant future and strengthen the banks position and its credit rating.
The bank has a structure with a cost-to-income ratio of 46.1%, which makes it one of the most
efficient international banks16
. It has a strong commercial banking model that serves more than
100 million individual customers, SMEs and companies17
. The recent merger of the Banesto,
Banif and Santander into the Santander brand would strengthen the position of the bank in these
segments. The Santander brand stands to gain a good share of the SME loan market in Spain
primarily because Banesto has been the market leader in SME loans.
The bank has been very active in the sphere of SME lending. In 2012, it launched the Credit
Activacion and Plan Exporta programs in Spain. The programs provided € 944 million euros of
funds to 7952 SMEs18
. The total amount reserved for SMEs under these programs is € 4 billion
and the purpose of the programs is to boost credit availability by providing credit lines to SMEs
so that can expand both domestically and internationally. These credit lines are offered at
reasonable rates of Euribor plus 3.20%. The minimum credit line is € 30000 and the maximum is
€ 5 million19
.
Just like Banco Santander, other Spanish banks like BBVA have SME focused programs. These
programs can be utilized to issue covered bonds. Banks will incur additional costs such as
monitoring of the collateral, reporting the data to the regulatory authorities and maintaining the
quality cover pool. However, as mentioned earlier there are several benefits of issuing covered
bonds that outweigh the costs involved.
5. Analysis of Spanish legal framework with regard to the issued bond.
15
Annual report Banco Santander – page 7
16
Annual report Banco Santander – page 30
17
Annual report Banco Santander – page 9
18
Annual report Banco Santander – page 33
19
Santander press – release – page 1

12. The Spanish legislation “Cedulas Hipotecarias” covers mortgage covered bonds. A discussion of
the salient features of the legislation would help us determine what components of the legislation
would have to be adjusted in order to issue structured covered bonds backed by a pool of loans to
SMEs.
Under the Spanish legislation for Cedulas Hipotecarias, the originator of mortgage loan book has
to issue the covered bonds without involving a special purpose vehicle. However, it does require
a special register for cover assets and has laid down articles specifying privileges to the covered
bondholders20
. Usually Banco Santander issues covered bonds directly without using a special
purpose vehicle. In such cases cover assets might not be completely insolvency remote despite
being registered in a special cover register. In order to ensure that the cover assets are completely
insolvency remote a new SPV will have to be created by Banco Santander. The SPV can issue
the bonds and use the proceeds to purchase the loans from Banco Santander or Banco Santander
can issue the bonds directly. In any case there would not be much of an impact on rating.
A loan guarantee will improve the quality of the loan portfolio. An institution that can provide a
loan guarantee on pool of loans to SMEs would be the European Investment Bank (EIB). EIB
has a better rating than Spanish financial institutions as it has not been affected by the Spanish
sovereign debt crisis. It would be better to divide the pool of loans into two tranches depending
on loan quality. For the tranche that contains poor quality loans Banco Santander can enter into a
guaranteed investment contract (GIC) with EIB. This would improve recovery if the loans
default and will have a positive impact on the rating.
The Spanish Law does not require a cover pool monitor that is independent from the issuer. Bank
of Spain is responsible for supervision and ensuring compliance with the legal framework. There
is also a lack of an independent trustee that can take care of investor interests by holding the
cover assets and any substitute assets to protect the claims of the investors in the case of issuer
insolvency. Post issuer insolvency the Bank of Spain will suffer from conflict of interest as it
will have to look after the interests of both bondholders and depositors. In the case of
Commerzbank Structured Covered Bond the trustee is responsible for disposal of assets in order
to ensure the claims of bondholders are met in case of issuer and guarantor event of default
20
Spanish Covered Bond Framework – ECBC

13. (when the SPV fails to comply with some requirements). Such a trustee can be appointed by the
Comison Nacional de Mercado de Valores (CNMV), the Spanish commission of securities. The
appointed trustee will be responsible for administering the assets after insolvency until the bonds
become due.
Under Spanish legislation, loans to SMEs are not eligible cover pool assets. Therefore, Banco
Santander will have to issue the bonds on a contractual basis. The assets that can serve as cover
assets are mortgage loans. The eligibility criteria is a loan-to-value calculated using mortgage
lending value. This dictates the level of overcollateralization. The minimum level of
overcollateralization is 25% in case of residential mortgage loans. Such a methodology is
inconsistent with SME loans due to the nature of these loans. In the case of Commerzbank bond
SME loans are rated according to an internal rating methodology and the loan book has an
average rating of 3.021
. Loans are rated annually and loans are removed from the pool if their
rating falls below 1.0. A similar methodology can be employed at Banco Santander. If Banco
Santander does not have an internal rating methodology ratings can be acquired from Axesor or
from one of the big ratings agencies (Fitch, S & P, and Moody’s). The loans will be rated on a
certain score and the rating will establish the eligibility criteria for loans to be included in the
cover pool. As the cover pool is dynamic, loans will be excluded if their quality deteriorates and
Banco Santander will have to replenish the pool with better quality loans.
A hedge protection to minimize liquidity risk is mandatory under Spanish legislation22
. Spanish
legislation does not require covered bond originators to have a hedge protection to account for
the interest rate risk, exchange rate risk or any related market risk. A hedge protection would be
unnecessary as far as the exchange rate is concerned, as the cover pool and bonds would be
denominated in the same currency. If the covered bonds are paid a fixed rate of interest a hedge
protection would not be needed to mitigate the interest rate risk arising from the interest rate
payments to covered bondholders. However, a hedge protection would be needed to avoid
extension risk (deceleration of bonds principle payments leading to an extension in maturity).
External swaps provided by counterparties unrelated to the issuer would be very effective in
handling such extension risks.
21
Commerzbank SME Structured Covered Bond Programme Base Prospectus
22
Spanish Covered Bond Framework – ECBC

14. 6. The Structure of the issued bond
Principal and interest due and payable
on the bonds by Banco Santander
Banco Santander
Originator
Loans to SMEs
Tranche 1
Tranche 2
Loans are divided into
two tranches. One
tranche has better
quality loans then the
other.
Tranche 1 guaranteed
by the European
Investment Fund
SME Structured
Covered Bond Program
Issue 1
Issue 2
Issue 3
Issue 4
Issue n
SPV
A new SPV created by Banco
Santander.
SPV provides guarantee to the
covered bond issue
Covered bonds issued by the parent
Loans are transferred from
the issuer to the SPV.

15. 7. Analysis of how the covered bond will be rated by Fitch
The factors that Fitch considers when rating the bonds are the credit rating of the issuing entity,
the discontinuity risk, systemic risk and the level of overcollateralization. It assesses probability
of covered bond default (primarily driven by discontinuity risk) and recovery given default
(dependent on overcollateralization and any relevant covered bond features).
As far as the credit rating of the issuer is concerned Fitch takes into account the long-term issuer
default rating. Banco Santander has a long term issuer default rating (IDR) of BBB+ which is
higher than the Spanish sovereign issuer default risk (IDR) of BBB. In case the rating of Banco
Santander had been below BBB, the covered bond rating would be only a few notches above that
of the issuer. However, in this case the covered bond can get a better rating notch uplift.
1. Probability of default on discontinuity basis:
Discontinuity risk depends on: Asset segregation, liquidity gap and systemic risk, alternative
management and privileged derivatives. The discontinuity risk determines the maximum rating
uplift on probability of default basis. Discontinuity risk is classified by D-caps. A D-cap of one
means the rating of covered bond will be one notch above the rating of the issuer. If Banco
Santander had been rated at or below the sovereign debt rating of BBB it would have received a
maximum D-cap of one. A full discontinuity risk means that the rating of the covered bond on
discontinuity risk basis will be same as the rating of the bank (without taking into account the
recovery given default).
Asset segregation: As the covered assets are properly segregated due to an SPV (low risk of
commingling the cover assets with other balance sheet assets), asset segregation will get ‘very
low risk assessment’ (‘low risk assessment’ is assigned to CH but the assets are not explicitly
segregated). Furthermore, any overcollateralization will be safe from the claims of other
creditors and it will further enhance asset segregation. Risks such as claw-back of the cover
assets from the SPV by the issuer will be defined by contractual agreement and would further
influence the risk assessment of asset segregation.
Liquidity gap and systemic risk: Usually full discontinuity liquidity gap and high systemic risk is
assigned to CH. That is based on lack of proper protection and a belief that only an intervention

16. by Bank of Spain would save the covered bond holders. However, a full discontinuity liquidity
gap would not be assigned to the structured covered bond because we have
 SPV that holds the assets separately from the issuer (the assets are properly ring-fenced)
 Level of overcollateralization
The ability of the cover pool to take care of interest and principle payments post issuer default
would further determine the assessment of liquidity gap. Fitch also takes into account the ease
with which the assets can be liquidated. Unlike public sector loans SME loans might be more
illiquid. This downside will have to be compensated in other ways.
Systemic and cover pool specific alternative management: Due to the presence of a trustee
(appointed by CNMV) that ensures that that bond obligations are properly met on continuing
basis post issuer insolvency, the risk associated with alternative management would not be
‘moderate high’ (which is usually the case with CH which lack a dedicated administrator).
Furthermore, due to the geographical diversification of Banco Santander and its robust structure,
the alternative management risk can even be as low as ‘moderate low’.
Privileged Derivatives: Derivative instruments with external counterparties unrelated to the
issuer would reduce the risk assigned to this component. However, derivative contracts with
issuer related counterparties can also provide some protection to covered bondholders.
The rating of the bond can go up by 4 or more notches depending on the discontinuity risk
assessment.
2. Stress Testing Over-Collateralization
The effectiveness of overcollateralization would depend on the extent to which it provides timely
payments to bondholders while withstanding interest rate risk, currency risk, loan counterparty
default and other related market risks. The robustness of the cover pool depends on the quality of
loan portfolio, geographical location of underlying assets and the amortization of cover pool
assets. Another factor that will have a strong impact on the level of OC is the asset encumbrance
limit. A higher asset encumbrance limit implies a higher level of overcollateralization and would
benefit the covered bond holders.

17. In the case of Spanish covered bonds, Fitch applies haircuts to the initial level of OC and these
haircuts increase as the issuer’s IDR decreases. The reasoning behind this is that post issuer
default the covered bond holders might not be able to completely benefit from OC because of
claw-back and comingling of cover assets and other factors that reduce the effective OC.
3. Recovery form cover pool given covered bonds default.
The recovery of bonds given default depends upon overcollateralization and those features in the
structured covered bond that help in recovery if the issuer defaults.
Overcollateralization: Depending on the quality of SME loans the level of overcollateralization
can go up to 75% or more.
Loan Guarantee by EIF: Another factor that would improve recovery of the loans given issuer
default would be the guaranteed investment contract with European Investment Fund.
Considering both overcollateralization and the guaranteed investment contract the rating can
further go up by a few more notches.
The rating of the bond can be 3 to 6 notches above the rating of Banco Santander if we take into
account the discontinuity risk assessment and extent to which recovery is possible if bonds
default. Considering Banco Santander’s current long-term IDR of BBB+, a rating uplift of 4
notches would rate the bond at AA-. According to Fitch AA- ratings indicate a very low
probability of default23
, a high probability of meeting the payment obligations and a low
vulnerability to expected credit events.
8. Bibliography
Commission, European Commission. SBA Fact Sheet 2012, Spain. Rep. N.p., n.d. Web. 17 June 2013.
<http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/performance-
review/files/countries-sheets/2012/spain_en.pdf>.
Commission, European Commission. SBA Fact Sheet 2010/2011 Spain. Rep. N.p., n.d. Web. 17 June
2013. <http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/performance-
review/files/countries-sheets/2010-2011/spain_en.pdf>.
23
Fitch Ratings definitions and Scales

18. Kraemer-Eis, Helmut, Markus Schaber, and Alessandro Tappi. SME Loan Securitisation An Important Tool
to Support European SME Lending. Rep. N.p., n.d. Web. 17 June 2013.
<http://www.eif.org/news_centre/publications/eif-wp_2010_007_smesec.pdf>.
Maudos, Joaquín. "Spanish SMEs’ Financial Restrictions: The Importance of Bank Credit." Spanish
Economic and Financial Outlook, Jan. 2013. Web. 17 June 2013.
Government of Spain. Ministerio De Economia Y Competitvidado. Signature of a Collaboration
Agreement for the Financing of SMEs.Http://www.mineco.gob.es/. N.p., 4 June 2013. Web. 17 June
2013.
ICO. Press Room. EIB-ICO: NEW SME FINANCING AGREEMENT. Instituto De Credito Oficial. N.p., 2013. Web.
<http://www.ico.es/web/contenidos/5/4/12392/index?abre=12395>
Pinedo, Anna T. FREQUENTLY ASKED QUESTIONS ABOUT COVERED BONDS. Rep. N.p., 2012. Web. 17
June 2013. <http://www.mofo.com/files/Uploads/Images/FAQsCoveredBonds.pdf>.
Uncovering Covered Bonds. Rep. Pricewaterhousecoopers, June 2012. Web. 17 June 2013.
<http://www.pwc.com/en_GX/gx/banking-capital-markets/assets/pwc-uncovering-covered-bonds.pdf>.
FitchRatings. Covered Bonds Rating Criteria. Rep. Fitch, May 2012. Web.
Annual Report. Rep. Banco Santander, Feb. 2013. Web.
Banco Santander. Press Room. Banco Santander Makes Available EUR 4 Billion in New Loans for SMEs to
Help Stimulate the Economy. Corporate Website. N.p., 16 Apr. 2012. Web.
Arranz, Gregario. Spain Covered Bond Framework. Rep. European Covered Bond Council, 2012. Web.
<http://www.ecbc.eu/uploads/attachements/45/64/3.27%20Spain.pdf>.
Commerzbank. SME Structured Covered Bond Programme. Rep. N.p., 5 Dec. 2012. Web.
<https://www.commerzbank.de/media/aktionaere/emissionsprogramme/sme_programme/SME_Prosp
ectus_approved_05122012.pdf>.
FitchRatings. Definitions of Ratings and Other Forms of Opinion. Rep. Fitch, May 2013. Web.
<http://www.fitchratings.com/web_content/ratings/fitch_ratings_definitions_and_scales.pdf>.