Yesterday, the Australian Federal Government released its much anticipated exposure draft of the Banking Amendment (Covered Bonds) Bill 2011.
The Bill's release follows a period of consultation between the Australian Treasury and industry participants on the preferred legislative framework for the issuance of covered bonds by ADIs. Although much of the detail in the Bill was foreshadowed by the Australian Treasury during the consultation process, the Bill also contains some unexpected features.
Our initial observations in relation to the Bill are outlined below.
Lifting the covered bond prohibition
The Bill amends the Banking Act 1959 (Cth) to allow covered bonds to be issued by single ADIs through an SPV structure or by multiple ADIs under a choice of two SPV aggregation structures:
- a special purpose ADI established for the sole purpose of issuing covered bonds; or
- an aggregating entity that issues debt instruments backed by covered bonds issued by ADIs.
The requirement under each structure for covered bonds to be issued through an SPV rules out the possibility of the Australian covered bond market adopting the "integrated" structure favoured in some European jurisdictions (eg. Germany and Ireland). The SPV structure, which is commonly used in the UK and Canada (and, more recently, New Zealand), is considered by the Australian Treasury to provide greater transparency to covered bond investors.
Aggregation structures similar to those contemplated by the Bill have been used in some European jurisdictions to enable smaller banks and credit institutions in those jurisdictions to issue "AAA" or highly rated covered bonds. Based on investor feedback during the consultation phase with Treasury, it is possible that the aggregation structures proposed by the Bill will not receive the same level of investor support that the European structures have benefited from.
Covered bond cap
The Bill imposes a cap on the cover pool assets which limits individual ADI issuance to 8% of the value of the ADI's Australian assets, determined immediately prior to the issuance of the relevant covered bond. While this cap is above the 5% cap originally proposed by the Federal Government in its December 2010 announcement, it is below the 10% cap that some ADIs have suggested would make covered bonds more economically viable.
In addition, the cap is assessed by reference to the value of the cover assets (inclusive of overcollateralization) that back the covered bonds, rather than the value of the covered bonds themselves, as the industry had hoped.
Given the level of debate on the cap to date, the cap threshold is likely to be the subject of further submissions by ADIs during the consultation phase for the Bill, which ends on 22 April 2011. Any submissions on the cap threshold are also likely to seek clarification on the method for determining the value of the cover pool and ADI assets (eg. book or market value) for the purposes of assessing compliance with the cap threshold.
The Australian Prudential Regulation Authority (APRA) has been given very broad powers under the Bill, including the power in certain circumstances to veto a covered bond issue by an ADI or stop asset transfers to (including "top-ups" of) the cover pool.In addition, the Bill gives APRA broad rights to impose additional requirements on ADIs in relation to their cover pool issuance, including on a retrospective basis.
The ability for APRA to give directions to an ADI to stop top-ups of the cover pool (section 11CA(2)(na)) is one of the most unexpected features of the Bill. APRA is entitled to exercise this power in a variety of circumstances - including to protect depositors of an ADI, if there could be a material deterioration in the ADI's financial condition, or if the ADI is conducting its affairs in a way that may cause or promote instability in the Australian financial sector (see section 11CA(1)). Under the UK regulated covered bond regime, the issuer is required to top up until its insolvency.
Given APRA's expressed position on covered bonds, there may be some investor concerns over the extent of APRA's discretionary powers to stop top-ups of the cover pool and to impose additional requirements on ADIs in relation to the issuance of covered bonds.
As anticipated, the Bill contemplates that APRA's supervisory powers under the Bill may be supplemented by prudential standards relating to covered bond matters, including the issuing of covered bonds, the types of assets in the cover pool and cover pool maintenance. APRA has not yet released a draft of a proposed prudential standard for covered bonds. However, we expect that a draft will be issued soon.
Notwithstanding which SPV structure is adopted, covered bonds issued under the Bill must comply with certain minimum requirements, including the following:
- The cover pool assets must satisfy an eligible asset test, which requires the cover pool assets to be limited to:
- government debt;
- swaps entered into for the purposes of hedging interest rate or currency risks associated with the SPV's assets and liabilities;
- residential mortgage loans secured by a first mortgage over residential property with a maximum initial LVR of 80%;
- commercial mortgage loans secured by a first mortgage over commercial property with a maximum initial LVR of 60%; and
- any other assets that are prescribed by regulations.
In addition, the value of government debt in a cover pool must not be greater than 20% of the value of all assets in the cover pool at any time.
The range of eligible assets is relatively narrow when compared with the UK regulated covered bond regime. Although the LVR requirements for the residential and commercial mortgages are identical to the UK's (ie. 80% and 60%), at this stage RMBS and CMBS that are eligible under the UK regulated covered bond regime are not permitted (although the addition of further asset classes by regulation is contemplated). In addition, although government debt instruments are included (subject to a 20% cap), it is not clear whether this asset class will include foreign (eg. Greek) as well as Australian government debt.
Asset coverage test
The Bill imposes an asset coverage test by requiring that asset levels in the cover pool be maintained at all times to cover the claims of the bondholders and the service providers. This means that ADIs will be required to top up or substitute assets in the cover pool to ensure that the value of the cover pool assets are sufficient to meet the cover pool liabilities.
This top up or substitution requirement is one of the key features of a covered bond transaction that distinguishes it from a securitisation, where there is no top-up ability for an ADI. Further details on the operation of the asset coverage test will be required for the purposes of assessing compliance with the test, including whether the claims to be "covered" extend to the expenses that may be incurred as a result of the wind-up of the cover pool (as in the UK regulated covered bond regime) and the valuation basis for the cover pool assets.
Cover pool monitor
- The ADI must appoint an independent cover pool monitor (which has an Australian financial services licence) to perform certain functions include establishing and maintaining a register of cover pool assets, monitoring compliance with the asset types and levels in the cover pool and providing any reports requested by APRA from time to time. The cover pool monitor criteria leave open the possibility for independent trustees and other financial services licensees to step up to service this role provided they are comfortable with the very broad (and potentially subjective) reporting function that APRA may require them to discharge.
The above minimum requirements are consistent with many of the features adopted by the European regulated covered bond regimes (ie. UCITS), particularly the UK regulated covered bond regime. However, unlike the UK regulated covered bond regime, there is no registration requirement for issuers or issuances and no requirement for the ADI to provide regular reports to a regulator. Interestingly, as a cover pool monitor is not required under the UK regulated covered bond regime (the UK only requires yearly auditors' reports), the cover pool monitor requirement is more aligned with the German regime, which does require a cover pool monitor to be appointed.
The imposition of a limit on overcollateralisation of the cover pool was another potential regulatory feature that was considered during the consultation process but rejected by the Bill. This suggests that overcollateralisation levels in the Australian covered bond market are likely to be dictated by rating agencies based on maturity mismatch risk and other factors, as is the case for offshore covered bond markets.
The mandatory nature of the minimum requirements suggests that the Bill contemplates a one size fits all "regulated" regime with no ability for ADIs to opt in or out of satisfying the "regulated" requirements, depending on the pricing impact that they may be prepared to absorb. Having said this, the Bill contemplates the enactment of regulations in the future, which may provide some flexibility for ADIs to adopt less regulated structures going forward.
Winding-up of the cover pool
The Bill states that if a statutory manager or administrator is appointed in respect of an ADI that has issued covered bonds, the powers of the statutory manager or administrator will not extend to any assets held in the cover pool or any assets of the SPV. The Explanatory Memorandum accompanying the Bill (see para 1.49) states that this provision is aimed at ensuring that the resolution processes relating to a failing ADI and the SPV need to be separated from each other.
The Explanatory Memorandum further states that none of the key implications of this separation is that the appointment of a statutory manager or administrator to an ADI will not necessarily trigger the acceleration of the covered bonds. In other words, even though the ADI may be prevented from topping-up the cover pool following its insolvency, the cover pool of assets may be sufficient to fund the covered bond liabilities.
The Bill requires any enforcement proceeds in respect of the cover pool to be applied first to cover the liabilities of the service providers of the SPV and secondly to cover the liabilities of the covered bondholders. In contrast the UK regulated covered bond regime requires the bondholders to rank at least pari passu with service providers on an enforcement of the cover pool. In addition, it is not clear under the Bill where the costs of a liquidator, administrator or receiver of the cover pool will rank (one would usually expect these expenses to rank in priority to all other creditors).
In recognition of the priority claim that covered bond investors will have over depositors to the cover pool assets, the Bill amends the "depositor protection" provisions of the Banking Act so that the assets of an ADI in Australia that are to be made available to satisfy the ADI's deposit and other liabilities following its bankruptcy or administration will be determined exclusive of the ADI's interest in any cover pool assets. Furthermore, the requirement for an ADI to hold Australian assets in excess of its Australian deposit liabilities will disregard the ADI's interest in any cover pool assets as well as any liabilities to covered bond holders.
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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