Australia: Australian covered bonds coming soon

Last Updated: 16 December 2010
Article by Andrew Jinks

David Bushby: We're speaking with Andrew Jinks who is a partner in the Banking and Financial Services Group at Clayton Utz in Sydney.  A warm welcome to Boardroom Radio, Andrew.

Andrew Jinks: Thank you very much.

David Bushby: Andrew, on Sunday we saw the Government opening its doors for banks, credit unions and building societies to issue covered bonds in an effort to provide a new source of funding for the sector.  Firstly, what are covered bonds and how do they work?

Andrew Jinks: Well in the context of what we're discussing it's effectively debt instruments issued by banks, credit unions, building societies (known as ADIs) which are secured by, or covered by, a specific pool of assets that have been set aside by the bank to be made available just to repay the notes.  There are similarities with securitised residential mortgage backed securities in that there's a dedicated pool of assets and then cashflows for that and it's raising debt in the markets, but in a securitisation the ADI has sold the assets across to an SPV, special purpose vehicle, which has issued the debt, whereas covered bonds, it's all on-balance sheet, the notes are liabilities of the ADI, the covered pool is still held by the ADI but it's only available to service the specific debts of the covered bonds.

David Bushby: So what is so risky or offensive about these covered bonds for them to be prohibited until now?

Andrew Jinks: Well Australia has a sort of a unique section in its Banking Act which provides that in essence depositors are to have priority in respect of all Australian assets of an ADI if the ADI goes insolvent, and APRA has had a view that covered bonds, both in terms of setting aside a dedicated pool of assets and also in having certain obligations to effectively make good and replace losses in that pool, means that the investors are getting a degree of priority over depositors that isn't consistent with the Banking Act, so that's sort of the background to APRA's concern.

David Bushby: So what's led to the change of heart and are depositors going to be adequately protected if a bank or credit union goes belly‑up in the next, I guess arguably, inevitable downturn?

Andrew Jinks: I think so.  In terms of the change of heart, most major jurisdictions have some sort of covered bond regime. 

The UK and New Zealand have both had issuances, and have actually either finished (in the case of the UK) or going down the path (in the case of New Zealand) to put legislation in place to allow covered bonds. 

Quite recently a Canadian issuer actually issued a covered bond into Australia and so I think there's been some sort of international pressure as to why is Australia out there and not following the path.  Obviously in the context of increased competition and the sort of whole review of the banking sector being in line sort of with international standards I think is something that the Treasury's looking at and if this is an additional arrow to the funding bow then I think they're in favour of it and so have effectively overridden APRA in that regard.

In terms of adequate protection there are a few things in the reform package they've talked about.  The financial claim scheme will be maintained; it's effectively a guarantee for depositors of deposits up to a million dollars, that number may move.  They've also mentioned a reform scheme and that they may levy a fee on the banks to fund that financial claim scheme.

But on top of that there are just other capital protections because the bank continues to own these assets it still has to have set capital aside with the RBA in respect of the assets, it has a lower cost of funds so at the end of the day it's got more money and that can only help it both in a business sense and also in a sort of risk of insolvency sense.

And the other thing to bear in mind is if for any reason the pool is less than the value of the notes so when, if the bank goes insolvent and the assets are sold and they don't pay up the notes in full, the obligations of the ADI to the noteholders in respect of the balance of the covered bonds are just normal debt obligations and they will rank behind depositors under section 13(a) of the Banking Act which deals with depositor protection.

So it is only a loss of depositor protection in respect of a pool of assets and the reform paper has indicated that there will be a limit on the total number of assets that can be set aside.  I think the example they gave was 5%. APRA might push for something lower, the institutions might push for something a bit higher. That 5% buffer together with all the other protections would mean that there's a fairly low risk that depositors are going to be in effect worse off by the arrangements, particularly because a lot of this could actually be achieved by a securitisation in a way that doesn't breach the Banking Act either.

David Bushby: And Andrew, just in terms of next steps to implementation, I guess when are we looking likely to see our first ADI Australian covered bond issue?

Andrew Jinks: Well the reform package has indicated that they're going to do this by way of a change to the Banking Act.  That would suggest that we'll have a form more like the old style UK structured covered bonds, the New Zealand structured covered bonds, where you actually have a third party SPV providing a secured guarantee to noteholders.

There's another step which is the sort of the regulated covered bonds where you actually have a legislative regime in place dealing specifically with covered bonds  It may well be that Australia will go down that path if there's demonstrable benefit to have a covered bond regime by just the theoretically smaller changes to the Banking Act.

David Bushby: Well, so what, in terms of timing, when does that decision process take place, when do we start to see action?

Andrew Jinks: They have indicated that they propose to put the changes forward in the next sitting, the first sitting of 2011 which is early next year. Whether we see that ... I've heard other people being a little bit more pessimistic and talking about the middle of next year.  One client sort of said we should be seeing something in 12 months.  I'd like to see something before then but we've taken a while to get here so I'm not necessarily holding my breath.

David Bushby: Indeed, we'll keep a close eye on it but thank you again for your time today Andrew.

Andrew Jinks: Thank you very much.

David Bushby: That was Andrew Jinks, a partner in the Banking and Financial Services Group at Clayton Utz in Sydney.

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