The Federal Government's proposed banking reforms announced
on 12 December 2010 placed covered bonds back on the Australian
agenda as a more transparent and reliable source of debt funding
for Approved Deposit Institutions (ADIs).
While not currently used as a source of funding in Australia,
covered bonds have been used widely in European markets and more
recently in Asia in the face of the global liquidity crisis.
What are covered bonds?
Covered bonds are secured debt instruments which provide
investors with the ability to claim against both the issuer and a
particular set of assets (the Cover Pool) in a
In the past, arguments against the use of covered bonds in
Australia have been expressed by the Australian Prudential
Regulation Authority (APRA) on the basis that
Cover Pool assets potentially leave ADIs without the means to meet
liabilities owed to depositors, in contravention of depositor
preference obligations under section 13A(3) of the Banking Act
1959, and potentially place stress on the asset base of
While the establishment of a covered bonds market in Australia
will involve amendment to the traditional depositor preference
provisions contained in the Banking Act 1959, the
Government has been quick to reiterate the value of depositor
protection arrangements contained in the financial claims scheme as
well as the supervisory role of APRA.
We can expect to see the following characteristics in an
Australian covered bond market:
Any issue will be secured by the Cover Pool, which will
comprise assets which are segregated or 'ring-fenced' from
the other assets of the issuing entity.
The value of the Cover Pool must, depending on the terms of
issue, be at least equal to the face value of the bonds issued (the
Asset Coverage Test).
Underperforming assets in the Cover Pool will be replaced with
a better quality of asset or the Cover Pool may be topped up with
additional assets, providing accountability for investors and an
incentive for the issuer to ensure the quality of the underlying
If the Cover Pool is insufficient to meet the liabilities owed
to investors, investors can take action against the issuer itself.
This is in contrast to securitisation arrangements where investors
do not have recourse against the sponsor.
The adequacy of the Cover Pool will be supervised by a third
party (which would most likely be APRA).
The Cover Pool will be protected from unsecured creditor claims
and investors will have preference to the Cover Pool in the winding
up of the issuer or in a default event.
The Cover Pool remains on the issuer's balance sheet
providing transparency for investors and regulators.
Change for Australia
We expect to see specific regulation in any new covered bond
framework dealing with the adequacy of Cover Pool assets as well as
potential waterfall provisions in an insolvency or default
The Treasurer has begun discussions around the framework of this
new market by suggesting a cap on covered bonds at a limit of 5 per
cent of the total assets of an issuer. However, it may be the case
that after discussion with industry, different caps apply to
Westpac New Zealand recently issued €1 billion of AAA
rated covered bonds with a cover pool made up of NZ$2.7 billion of
residential mortgage assets. The Reserve Bank of New Zealand has
capped issues by NZ entities at 10 per cent of total assets. This
issue by Westpac New Zealand will be a good case study for the
emerging Australian market.
In the years following the global financial crisis of 2008 many Australian investors lost their life savings as financial products failed and the Australian Stock Exchange shed over 3,000 points.
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