Covered bonds exposure draft released

The Exposure Draft on Covered Bonds legislation has been released. Key points to note are as follows (courtesy of CBA via email):

  • Proposed maximum issuance cap of 8% of total Authorised Deposit Taking Institution (ADI) assets.
  • Segregation of cover pool assets will be achieved via establishing a special purpose vehicle (SPV).
  • The cover pool will be monitored by an independent entity to the issuing ADI that holds an Australia Financial Services Licence. Their responsibilities will include:
  1. Establishing and maintaining a register of assets held in the cover pool;
  2. Ensuring compliance under the Covered Bond Act & meeting regulatory and prudential standards;
  3. Determining the value of assets and liabilities; and
  4. Reporting.
  • Cover pool assets to include:
  1. Government debt instruments (no greater than 20% of the value of all assets in the cover pool);
  2. Derivatives relating to the covered bond issuance such as currency and interest rate swaps; and
  3. Residential loans (with maximum LTV of 80%) & commercial properties loans (with maximum LTV of 60%).
  • ADIs would be allowed to aggregate their assets to issue covered bonds (maximum issuance cap applies to each participating ADI).
  • APRA would have the power to restrict and/or impose additional requirements on ADIs with respect to covered bond issuance.
  • The Exposure Draft is open for comment. Comments must be submitted by 22 April 2011.

The RBA Financial Stability Review, released last week, provided a nice overview of covered bonds. Below are the key extracts [my emphasis]:

Covered bonds are bonds secured by a pool of high-quality assets on the issuing financial institution’s balance sheet. The main feature of covered bonds is that if the issuer can no longer service the periodic bond payments, investors have a preferential claim on this pool of assets and the associated cash flows. If the cover assets are not sufficient to meet the bond payments in full, covered bondholders also have an unsecured claim on the issuer to recover any shortfall. In that case they would stand on an equal footing with the issuer’s other unsecured creditors. This is known as dual recourse…

Because of strict regulations and the two-fold protection of investors’ interests, covered bonds are considered to be the safest form of bank debt. As a result, they typically carry a higher credit rating than that of their issuer, and allow the issuer to access cheaper and more stable long-term funding from the wholesale debt markets…

Australian ADIs are [currently] not permitted to issue covered bonds because covered bondholders would have preferential access to an ADI’s assets, thereby subordinating other unsecured creditors, like ordinary depositors. This would conflict with the Banking Act 1959, which enshrines the principle of depositor preference under which, if an ADI is wound up, all of its assets in Australia are made available to meet the ADI’s deposit liabilities in Australia in priority to other liabilities of the ADI…

The net effect of increased covered bond issuance on banks’ funding costs is uncertain. By committing bank assets to secure payments on covered bonds, unsecured senior bonds as well as more junior debt securities are effectively lowered in rank, so investors in them might demand higher returns to the extent that the impact on credit quality of those securities is perceived as material. Total wholesale funding costs therefore might not fall.

The decision to allow Australian banks to issue covered bonds up to 8% of total ADI assets has been broadly welcomed by the banking industry; although ANZ’s CEO, Mike Smith, remains cautious, instead preferring to raise funding from depositors in Asia (from

“Covered bonds are basically an enriched type of securitisation. I actually think that that’s a drug that you don’t go on unless you seriously need to…Whilst I would test the market with an issue, I wouldn’t necessarily rely on it”…

“In terms of ANZ, we’ve decided to control our own destiny in this and we have moved to raising deposits in Asia. This is where the big liquidity pools are so we are trying to reduce our reliance on that wholesale borrowing element, and so far that’s been quite successful.”

The Reserve Bank of New Zealand (RBNZ) also recently enshrined the rights of foreign covered bond investors to mortgages written by New Zealand banks ahead of local bank depositors, and gave the banks the ability to issue covered bonds worth up to 10% of their total assets. This limit was an increase from its previous guideline of 5%. The Bank of New Zealand (owned by Australia’s NAB) became the first New Zealand bank to issue covered bonds, issuing NZ$425 million worth to domestic institutional investors in June 2010. Westpac New Zealand also recently issued its first covered bonds.

I remain wary of covered bonds, mainly because the increased protections afforded to investors could come at the expense of taxpayers. That said, provided the Government resists calls to relax the 8% ceiling on their issuance, the risk to taxpayers is probably very low, particularly in light of the Financial Claims Scheme, which allows the Government to levy the banking industry to recover any taxpayer money used to pay depositor claims in the event that an ADI fails and selling its assets does not recover taxpayer funds in full.

What do you think: are covered bonds a worthy addition to the Australian banking system?

Cheers Leith

[email protected]

Leith van Onselen


  1. I think in principle at least anything that helps the banks diversify their funding base is a step in the right direction, as long as it doesn’t come at the expense of taxpayers.

    Interesting that the cap is so high though. The US is talking about 4%, and Canada has set 4% as a limit too.

    Will also be interesting to see what the ratings agencies have to say, since covered bond issuance will effectively subordinate the claims of existing senior debt holders.

  2. Questions that come to my mind:

    1) 8% of ‘assets’… is that a ‘snapshot’ 8% or an ongoing one… what happens if those assets fall? Will they fall (given the RBA loosening of what they accept on repo)?

    2) 8% is pretty generous (given it has been 0%)… what’s to stop it endlessly being increased everytime the system reaches a new limit and the easy choice is to move to 12% or 15% and so forth? I think that sort of incrementalism is very likely if things don’t go well.

  3. From the point of view of the status quo, i think it is a good move…

    But i’m not really a fan of the status quo, and don’t think it is wise, nor sustainable, the way they carry on.

    Principally speaking, i do not like the idea that a depositor does not have 100% full rights to their deposit.

    Additionally, i share the other commenter’s concerns about changing asset values.

  4. Nice post..seems the lenders have a Quantity of easements ..lets hope it works,and profits all…and a tip of a glass
    for your source….for it might-be away.
    Thanks Leith…JR

  5. rational investor

    I wonder what effect this will have on the banks existing bond and preferred share price. It effectively removes some of the existing margin of safety for the existing senior securities.

    It’s a little like changing the rules halfway through a game.

    • simple:
      CDO and RMBS- at the end bondholders will get nothing

      Covered bonds- depositors and taxpayers will get nothing, bondholders-everything.

      p.s. in case of RMBS- bondholder is also a taxpayer because AOFM is the willing liquidity provider ready for a nice haircut.

  6. I am with the Greens on this. Why do banks need taxpayer subsidy when they are “super” profitable and already enjoy an implicit taxpayer subsidy?
    “Australian depositors are expected to feel secure about covered bonds because of the Government’s Financial Claims Scheme. But this is simply asking the taxpayer to carry a risk currently borne by the banks.
    “This comes on top of what the IMF has calculated to be on average a 20 basis point subsidy given by the public to the large banks through the existing implicit ‘too big to fail’ policy”

  7. Strike me cynical but this looks awfully like putting the big moneyed interests ahead of the average citizen who cannot afford to get into the bond game but can only deposit their money in the bank and therefore have less protection. And as others have pointed out, puts the taxpayer on the hook for the loses if/when things go wrong.

  8. Crocodile Chuck

    Little Guy and Mav above nail it. Covered bonds will enshrine the Federal Government guaranteeing deposits-as now the bondholders will be at the front of the queue.

    Secondly, suspect this will further entrench the ‘Big Four’ at the expense of the Tier Two players, thus chipping away at what remains of ‘competition’ in retail banking.

    Last: bonds used to be considered ‘risk capital’. When the GFC hit, they became ‘riskless’, as all the bad paper was shifted to the (already long suffering) taxpayer.

    UPSHOT: great for the (Big) banks; the opposite for society, depositors and the taxpayer.

  9. I seem to be running out of places to put my cash. Housing is a duff investment, stock market doesn’t look too appetising, bonds high, commodities over priced, and now deposits lose their security.