13 Dec 2010

Australia opens the door to covered bonds

Australian banks, credit unions and building societies will soon be able to issue covered bonds as part of the Australian Federal Government's package of banking reforms aimed at increasing competition within the banking sector, announced on Sunday 12 December 2010.

What was in the package?

This package consists of three streams of reform:

1. "Empowering consumers to get a better deal" which includes such reforms as banning exit fees for new home loans and boosting consumer flexibility to transfer their deposits and mortgages;

2. "Supporting small lenders to compete with big banks" which includes the Government committing to invest a further $4 billion in the Australian Office of Financial Management's investment programme to support the RMBS market and facilitating issuance of bullet RMBS as an alternative to traditional RMBS; and

3. "Secure the long term safety and sustainability of our financial system" which includes reforms on covered bonds and measures to develop a liquid corporate bond market.

In this Alert we will examine the implications of the third stream for the wholesale capital markets.

What is a covered bond and APRA's stance

It has often been said that a covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the issuer becomes insolvent. This enhancement typically results in the bonds being assigned AAA credit ratings by credit rating agencies.

One major advantage of covered bonds for investors is that both the debt and the underlying asset pool remain on the issuer's consolidated balance sheet, and issuers must ensure that the asset pool adequately secures or covers the covered bonds. In the event of default, the investor has recourse to both the asset pool and the issuer.

The asset pool which backs the covered bonds is segregated from the claims of other creditors. The Australian Prudential Regulation Authority (APRA) has up until this point in time prohibited the issuance of covered bonds by Australian financial institutions as it is of the view that in the insolvency of an ADI issuer the covered bondholders would take priority over other creditors (including depositors), as so covered bonds would contravene the depositor protection standards set out in the Banking Act.

In addition, a key feature of a covered bond is that the value of the assets in the covered pool must, at all times, be at least equal to the aggregate principal amount outstanding of the covered bonds, together with any applicable over-collateralisation (the so-called asset coverage test). This represents a potential disadvantage to depositors as the issuing ADI is obliged to top up the asset pool should the value of the assets fall (thus potentially making more of the ADI's assets unavailable to depositors).

Why the move to covered bonds

The Government's announcement that it will amend the Banking Act to permit the issuance of covered bonds by Australian financial institutions with the requisite credit ratings is seen as a step towards giving such Australian ADIs access to cheaper, more stable and longer duration funding in the wholesale capital markets. This is because the credit rating ascribed to covered bonds is often higher than that of the issuer itself, as covered bondholders have recourse to a segregated asset pool which the issuer is obliged to maintain in accordance with the asset coverage test. The offshore covered bond market has traditionally been accessed by highly rated financial institutions. It will be interesting to see whether the Australian covered bond market will evolve along similar lines.

Moreover, as covered bonds are typically rated AAA they attract conservative investors looking to diversify into mortgage securities without diluting the credit quality of their overall portfolios. Properly structured, covered bonds issued by Australian ADIs may also be attractive to European pfandbrief investors.

Because of these features, the Government is looking to the covered bonds market to attract investment from Australia's superannuation funds in a way that has not really occurred so far. This sentiment is echoed in a statement by Pauline Vamos, CEO of the Association of Superannuation Funds of Australia who stated in today's Australian Financial Review that Australian superannuation funds would be interested in buying more AAA rated bank bonds, particularly those covered by domestic housing.

Protecting depositors

Australian Treasurer Wayne Swan stressed in yesterday's announcement that allowing financial institutions to issue covered bonds would not have an adverse effect on depositors. In particular, he reiterated that Australian depositors will continue to have their deposits protected under the Financial Claims Scheme and that this will be a permanent feature of Australia's banking landscape.

The Treasurer has also suggested a cap be placed on covered bond issuances for individual institutions (as an example, 5% of an issuer's total Australian assets, although the exact percentage will be subject to consultation with the industry and may allow for different percentages to apply to different ADIs). This is designed to ensure a buffer of assets is available to cover depositor claims in the event that an ADI issuer becomes insolvent.

It appears from the announcement that the Government intends to introduce a legal framework around covered bonds. Presumably the legal framework will be similar to that in jurisdictions such as Ireland which specifically regulates the segregation of the asset pool and sets out the consequences of an issuer's insolvency. If express legislative provision for a secured covered pool is implemented, it should not be necessary for ADIs to follow the secured SPV guarantee structure used for some of the UK covered bonds.

Furthermore, it is likely that the legal framework will set out APRA's supervisory role in relation to covered bonds and may set certain minimum requirements for covered bonds. Many European countries have, for example, adopted regulated covered bond regimes which comply with Article 22(4) of the Council Directive 85/611/EC (UCITs Directive) under European Union law. Under European Union law, insurers are permitted to hold a greater percentage of such regulated covered bonds, which also benefit from preferential prudential risk weighting. It may be that the Australian legal framework will adopt similar requirements in order for Australian ADIs to have access to European investors.


The Government stated that it would release draft amendments to the Banking Act during the first sitting of Parliament in 2011 (8 February - 24 March), following consultations with financial regulators on the details of a legislative framework. Given this timing it is possible that the first issuance of covered bonds by an Australian financial institution may occur some time in the next 12-months but possibly as early as mid-2011.

Other developments

The Government also announced that it intends to facilitate the trading of Commonwealth Government Securities on a securities exchange in Australia as part of its agenda to encourage retail investment in corporate bonds. A securities exchange is hoped to provide retail investors with a more visible pricing benchmark for investments they wish to make in corporate bonds issued by Australian businesses and encourage retail investors to diversify into fixed-income securities. The Government also alluded to new tax incentives to encourage the Australian public to invest in savings products such as corporate bonds and further streamlining of disclosure requirements for corporate bonds marketed to retail investors.

Senior members of the Clayton Utz securitisation and structured capital markets team have direct experience in the overseas covered bond market having acted on a number of foreign covered bond issuances namely in the UK and the US (including one of the first covered bond issued by a US bank). Clayton Utz has also been actively involved in industry submissions to the Federal Government to permit the issue of covered bonds by Australian ADIs.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.