Australia: An Update on Structured Covered Bonds

Key Point

• Covered bond issuance is very attractive to banks and other financial institutions because it offers potential funding advantages including access to new and wider investor bases and relatively low costs of funding.

Since HBOS completed its first structured covered bonds issue in July last year (which we reviewed in April) the UK covered bonds market has rapidly expanded. HBOS followed up its first issue with three further issues - bringing its total covered bond issuance to €8.5bn. Northern Rock and Bradford & Bingley, two other UK banks, have also established structured covered bond programmes. Northern Rock went to market with a €2bn issue in May this year. Bradford & Bingley followed soon after with a €2bn issue of its own.

Covered bonds are full recourse debt instruments secured by a particular pool of assets. In continental Europe they are issued under specific legislation eg. Pfandbriefe in Germany and Cedulas Hipotecarias in Spain. The UK has no such legislative framework for the issue of covered bonds and as such the issues by the UK banks have been "structured" using securitisation technology to replicate the economics of the continental covered bonds.

Covered bond issuance is very attractive to banks and other financial institutions because it offers potential funding advantages including access to new and wider investor bases and relatively low costs of funding.

In a letter to the British Bankers Association last month the UK Financial Services Authority (FSA) has formally responded to the development of the UK structured covered bond market. The FSA, although recognising the advantages to banks of the issue of covered bonds, is concerned about the potential additional risk to depositors posed by such issues, in particular, the ring-fencing of a bank's "good" assets involved. In this regard the FSA has stated that it is still considering its policy response to covered bonds and whether it will issue specific guidance on the issue.

In the interim the FSA indicated in its letter that it will take a case by case approach to issues of covered bonds by UK banks. The FSA will focus on "materiality" of issuance, ie. if a bank's issue of covered bonds is small enough when compared to its total assets so as to be immaterial they will not be concerned. Once a bank's issuance becomes "material" the FSA will consider whether they will require the bank to hold additional capital against its assets (by adjusting its individual capital requirements).

When is an issue likely to be "material" in the FSA's view? In considering this question the FSA will take into account the size of the covered bond issue, the size of the bank's mortgage book and the total assets of the bank. The FSA has suggested that, as a rough rule of thumb, issuance of up to 4 percent of a bank’s total assets will not be "material".

The question of whether Australia will develop a structured covered bond market similar to the UK covered bond market is one that rests with the Australian Prudential Regulation Authority (APRA).

APRA has indicated that it, like the FSA, is concerned that covered bonds are inconsistent with depositor protection principles, in particular, the granting of a first call over an ADI's assets to covered bond holders in priority to depositors.

The Australian Securitisation Forum has set up a sub-committee which is putting together a submission to APRA on the issuance of covered bonds by Australian ADIs. It is hoped that the industry can work with APRA to develop guidelines that satisfy APRA's concerns while giving Australian ADIs access to the covered bonds market.

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