Australian regulatory and central bank officials warned of an overreliance on secured funding at an ASF conference yesterday (Monday), while Moody’s has played down the risks of subordination of unsecured creditors and discussed the implications of recent APRA and RBA Basel III measures.

Charles Littrell, executive general manager, policy, research and statistics at the Australian Prudential Regulation Authority (APRA), said that a historic shift may be underway from banks being mainly unsecured borrowers to banks pledging “a great deal of collateral” as they turn to a mix of collateral-based funding, whether that be securitisation, covered bonds, more collateral for trading exposures, and the probable exploration of repos in the context of liquidity and other needs for authorised deposit-taking institutions (ADIs).

“Although each of these initiatives individually may give an ADI cheaper funding or better trading terms,” he said, “a whole industry with lots of collateral pledged is most unlikely to make the remaining depositors and unsecured creditors safer.

“This is an issue that APRA and other regulators will need to wrestle with over the next several years.”

Also speaking at the Australian Securitisation Forum in Sydney, Guy Debelle, assistant governor, financial markets at the Reserve Bank of Australia (RBA), said that investors clearly prefer secured debt in the prevailing risk-averse environment, but that the trend toward predominantly secured issuance is not sustainable.

“Banks can’t encumber their balance sheets through secured issuance to such an extent that unsecured issuance, and even deposit gathering, is no longer possible,” he said. “Too much issuance of covered bonds and you’re effectively back in the unsecured world.”

Although a cap of 8% on assets encumbered by the issuance of covered bonds by Australian ADIs protects deposits, he added, the introduction of covered bonds subordinates unsecured debt holders to a degree.

“Any pricing gain obtained from issuing covered bonds is likely to be offset to some extent by a demand from unsecured debt holders for more compensation in the future,” he said. “So I see the role of covered bonds as primarily broadening the potential investor base rather than a means of reducing overall funding costs for banks.”

Debelle said that Australian banks are primarily likely to turn to covered bonds as an offshore funding source because domestic investors are more comfortable with MBS.

He questioned the extent of the differences between the various forms of bank wholesale funding, noting that they are all claims on a bank’s balance sheet in one form or another, and that the main difference is the degree of credit enhancement provided by subordination in the case of RMBS or overcollateralisation (and additional recourse to the balance sheet) in the case of covered bonds.

“The strong motivation for the current preference of investors for secured issuance is about repositioning themselves towards the front of the creditor queue,” said Debelle. “That is the fundamental point of differentiation between the various forms of funding.

“But ultimately, everyone can’t be at the front of the queue.”

He suggested that the prevailing market is sending misleading signals about the risks associated with the different types of funding.

“In due course, investors in bank paper might again come to the realisation that there is not as stark a difference between secured and unsecured issuance, as current pricing would suggest,” he said. “Investors need to heed the seminal words of The Saints: ‘Know Your Product’ and do the necessary due diligence.”

He concluded by calling for a return to a situation where banks are able to raise funding by various means – equity raising, deposits, unsecured wholesale funding, asset backed issuance, and covered bonds – because at various points in time some markets are more functional than others.

“A world where the only source of funding available is secured is just not sustainable,” he said.

Moody’s played down risks of subordination of unsecured creditors stemming from covered bond issuance in a report published yesterday, attributing this mainly to an 8% asset encumbrance cap set out in Australia’s covered bond legislation.

“This limit will ensure that sufficient high quality assets are left to support the claims of unsecured creditors,” it said. “Therefore, covered bond issuance by Australian banks will not affect the ratings of their unsecured obligations.”

It noted that it would consider the use of covered bonds to replace another form of secured funding as positive for ratings, but that it would view negatively the use of covered bonds to replace customer deposit funding, which would increase a bank’s reliance on wholesale funding, particularly secured funding.

Moody’s said that a low historical reliance on secured funding by Australia’s major banks places them in a strong position to raise such funding in the form of covered bonds without significantly prejudicing the interest of unsecured creditors.

This is in part due to most of Australian major banks’ secured funding historically being in the form of securitisation, with a large part of the pre-crisis international investor base unlikely to return, despite some resurgence in domestic demand.

“This is yet another reason why the banks’ new ability to tap covered bond markets, which have remained liquid through the crisis period, is an important credit positive for the banks,” said Moody’s.

It estimated that banks’ secured funding will continue to account for no more than 11% of total funding, even if the banks do not grow their assets from prevailing levels. Assumptions informing the rating agency’s estimate are that banks issue the maximum amount of covered bonds allowed under the 8% limit and use it to replace government guaranteed debt funding while securitisation levels remain static.

“This is well within our tolerance level for the banks’ existing unsecured debt ratings,” it said.

Repo rules, Basel III eligibility prospects boost covered bonds

Measures announced by APRA and RBA last Wednesday (16 November) could boost bank demand for covered bonds to the detriment of RMBS, according to Moody’s vice president and senior credit officer Richard Lorenzo.

APRA released a discussion paper on the Basel III liquidity framework, while RBA announced changes to its list of repo-eligible securities and margins, and released details of a committed liquidity facility (CLF) designed to help banks fulfil liquidity coverage ratio (LCR) requirements under Basel III.

Daniel Yu, analyst, financial institutions group at Moody’s, told The Covered Bond Report that RBA for the first time introduced an explicit reference to covered bonds as part of the changes it announced, with there previously having been no need to do so because Australian banks only recently received regulatory approval to issue such debt.

Covered bonds are included in an “ADI-issued securities” category in RBA’s list of eligible securities, with separate margin scales based on debt with minimum ratings of Aaa, Aa3, A3, Baa1, and “other rated”.

In addition to announcing a broader range of repo-eligible securities – to ADI-issed debt rated the equivalent of at least Baa1 rather than A3 – the RBA said that it will increase haircuts on securities pledged with the central bank.

Yu said that unsecured instruments will be subject to a relatively larger increase in margin than covered bonds (that are rated triple-A).

In a report, Yu and colleagues said that the favourable repo margin on covered bonds relative to unsecured bank debt will benefit Australia’s major banks because it has the potential to increase demand for such securities, of which the major banks are likely to be the main issuers.

It also noted that over the longer term APRA could deem covered bonds eligible for LCRs as Level 2 high quality assets, which would further raise their attractiveness for investors.

“However, this would only come when APRA deems such securities a reliable source of liquidity, even during stressed market conditions,” said the rating agency, “with one indicator being the existence of a secondary market with liquidity that meets APRA standards.

“Given that Australian banks have only just commenced issuing covered bonds, we do not expect to see any positive credit implications for at least a number of years.”

Moody’s noted that at 15bp, the fee for accessing the CLF is lower than what the market expected and on its own would not be high enough to deter banks from relying on the facility, and said that RBA has tried to address this by increasing the haircuts charged on the assets that institutions will post as collateral to the CLF.

“However, we note that the haircuts for standard asset-backed securities were unchanged while the increase for covered bonds, which are rated the equivalent of Aaa, were marginal,” said Moody’s. “Investing in these securities will allow banks to take advantage of a low fee without exposure to higher haircuts.”

In a separate report senior credit officer Lorenzo said that Moody’s anticipates APRA will accept covered bonds as a Level 2 high quality asset once Australian covered bonds prove themselves a liquid asset in Australia. This, in addition to covered bonds being cheaper to repo, gives reasons for ADIs to buy covered bonds over RMBS, he said.

“This new demand gives further reasons why higher-rated banks (in the Aa-rated range) will issue covered bonds instead of RMBS, but most lower-rated banks (below the Aa range) will continue to issue RMBS,” he said.

Know your product: