The Australian government set an 8% limit on the amount of assets that can be encumbered by covered bond issuance in draft legislation released today (Thursday), disappointing covered bond proponents, who have blamed the Australian Prudential Regulation Authority for the restrictive stance. Meanwhile, the Reserve Bank of Australia weighed into the debate.

The government in December announced that Australia’s Banking Act 1959, which had previously been cited by APRA as prohibiting issuance, would be amended to allow covered bonds. Hopes had been further raised recently by suggestions that a 5% limit on issuance that had been floated would be raised to 10%.

But not only is the level proposed in the exposure draft below this, it also refers to the level of assets that can be encumbered by covered bond issuance, rather than being the level of issuance itself relative to total assets.

“A cap on the value of the cover pool of assets (including overcollateralisation) is set at 8% of an ADI’s assets in Australia,” said the Treasury in an associated explanatory memorandum. “This cap prevents covered bondholders having claim over more than 8% of an ADI’s assets in Australia at the point of issuance of covered bonds, and as such this limits the subordination of unsecured creditors.”

This means that covered bond issuance will effectively be limited to a level below 8%.

Some market participants criticised the limit, saying that the government had been swayed by APRA.

“An 8% limit will be inadequate for those ADIs that could and should be making use of covered bonds,” said one. “It’s a bit silly really, but it came at APRA’s insistence.

“I’d be surprised if they really calibrated it and would be interested to see the calculations they went through to get to this number. I wouldn’t be surprised if it was plucked out of the air, like the Basel 8% number.”

However, CBA chief executive Ralph Norris is reported to have described the 8% level as “a good number”.

The restrictive proposals come after APRA last month excluded covered bonds from its initial eligibility criteria for liquidity buffers under Basel III, when it said that no asset classes met the required standards to qualify as Level 2 assets.

“APRA is clearly an on-going opponent of covered bonds, despite having said that it was only the Banking Act that caused their prior objections,” said a market participant. “This is just the latest manifestation of their attitude to covered bonds.”

He was also disappointed by the discretion afforded APRA in the exposure draft, which allows the regulator to impose additional requirements on ADIs. Critics said that this could create uncertainty for not only issuers but also investors regarding the levels of overcollateralisation that might be permitted, for example.

A consultation on the exposure draft finishes on 22 April.

“Robustness should not be overstated”

The Reserve Bank of Australia discussed the pros and cons of covered bond issuance in its latest Financial Stability Review, dated yesterday (Wednesday). The central bank noted that covered bond issuance had recently increased in Europe and had begun in New Zealand and South Korea, and also proved resilient during the financial crisis.

However, the RBA added: “Despite providing more safety to investors, covered bond issuers’ access to debt markets became seriously disrupted during the crisis, suggesting that the robustness of covered bonds should not be overstated.”

The central bank also said that the net effect of increased covered bond issuance on banks’ funding costs is uncertain.

“By committing bank assets to secure payments on covered bonds, unsecured senior bonds as well as more junior debt securities are effectively lowered in rank, so investors in them might demand higher returns to the extent that the impact on credit quality of those securities is perceived as material,” said the RBA. “Total wholesale funding costs therefore might not fall. European banks currently face higher costs of issuing senior debt, but it is not clear how much of the increase stems from the record pace of covered bond issuance, versus investor concerns about recent European Union proposals to change the treatment of senior debt of a distressed bank.”