- 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:
- Establishing and maintaining a register of assets held in the cover pool;
- Ensuring compliance under the Covered Bond Act & meeting regulatory and prudential standards;
- Determining the value of assets and liabilities; and
- Cover pool assets to include:
- Government debt instruments (no greater than 20% of the value of all assets in the cover pool);
- Derivatives relating to the covered bond issuance such as currency and interest rate swaps; and
- 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.
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 interest.co.nz):
“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?