An Australian Treasury official said yesterday (Monday) that covered bond legislation could be in place by Christmas and that APRA will consult on related revisions to regulation. He also discussed a proposed 8% cap on issuance and potential prudential penalties.

Speaking at a conference yesterday, John Lonsdale, general manager, financial system division, markets group, at the Treasury, said that the department is working towards giving Treasurer (and deputy prime minister) Wayne Swan the option of introducing a bill into parliament early in the Spring session, which started today (Tuesday). That could allow passage of the bill by the time the session ends in late November, with Royal Assent being given by Christmas. Lonsdale said that alternatively the legislation would probably be passed in early 2012, after which it would be up to industry to progress.

“Covered bonds could become, over time, an important source of funding for the Australian banking system,” he said. “Covered bonds could provide cheaper, more stable, and longer duration funding for the Australia banking system over the medium term.

“They also provide an alternative debt instrument for investors to invest in. In this sense, allowing ADIs to issue a small amount of covered bonds assists both issuers and investors to diversify their risks.”

Lonsdale said that the Australian Prudential Regulation Authority (APRA) will revise some of its prudential standards to facilitate covered bond issuance and that he expects the regulator to consult on these in the coming months.

The Treasury released proposals for covered bond legislation in March and the subsequent consultation finished in April.

Lonsdale said that while “the devil is in the detail” when it comes to such legislation, he could not discuss the final wording of the bill that will be introduced to parliament. He nevertheless gave some insights into the Australian government’s thinking.

“Although the draft legislation attempts to obtain international best practice, it does not simply replicate the European framework, which in general is highly prescriptive, and is adapted for the Australian context,” said Lonsdale. “One benefit of the diversity in offshore jurisdictions is that we can observe how these frameworks operate in practice, allowing us to pick and choose those features that seem to work best.”

He said that one agreement had, for example, been reached with industry stakeholders that the country should introduce a specific legislative framework rather than simply allow Australian approved deposit-taking institutions (ADIs) to issue unregulated covered bonds. He noted that this was the route that New Zealand, the US and Canada were also taking.

Lonsdale said that the issue of asset encumbrance that comes with covered bond issuance and how this affects unsecured creditors had come to the fore in light of the financial crisis.

“The proposed legislative cap of 8% on covered bond issuance by ADIs seeks to address any asset encumbrance concerns, while also meeting regulatory best practice,” he said. “As well as looking at offshore best practice, we have listened closely to the views of stakeholders on how the new Australian legislative framework should be designed.”

He highlighted that there are two 8% caps in the draft legislation, “legislative” and “prudential”. He explained that the first limits issuance at the time of issue, while the second applies continuously with prudential penalties possible if topping up of the cover pool puts the ADI in breach of issuance limits.

“In essence, the prudential cap provides an ADI additional flexibility in exceptional circumstances, while providing a strong prudential incentive to remain within the eight per cent benchmark,” said Lonsdale.

[Note: While he said the above, Lonsdale’s comments are somewhat unclear on the calculations he is discussing; while he refers to covered bond issuance relative to total assets, the draft legislation includes a limit on the value of the cover pool relative to total assets and he does not explicitly mention this.]

He said that these measures, alongside the introduction of a permanent financial claims scheme, would maintain depositor protection even if the introduction of covered bonds might breach the previous “depositor preference” concept hitherto enshrined in the Banking Act.

Lonsdale expanded upon APRA’s oversight of covered bonds under the proposed legislation, saying that it will have the power to prevent ADIs from issuing or topping up covered bonds under certain circumstances, “such as the ADI experiencing severe financial stress or breaching the requirements of the Banking Act 1959”. However, he noted that APRA has no power over assets providing security to covered bondholders once they have been transferred to a cover pool.

Expectations of pooled covered bond issuance from smaller Australian financial institutions were dampened by Lonsdale, when he said that “an aggregation model is not likely to be used in the period immediately after the covered bond bill becomes law”. However, he said that the possibility of aggregation models should provide opportunities in the medium to longer term.

“The government is interested in providing a mechanism to allow smaller ADIs to issue covered bonds into the Australian market in particular,” he said.

Lonsdale said that during the consultation process investors had requested regulatory disclosure requirements for covered bonds, and that he expects the Australian Securitisation Forum to work to develop such a framework, similar to one developed for residential mortgage backed securities (RMBS).

A copy of Lonsdale’s speech can be found here.