The Covered Bond Report

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Little impetus for law given KHFC benefits, says Fitch

There appears to be little impetus for the introduction of a legal framework allowing South Korean banks to issue covered bonds on a standalone basis given that KHFC can already fund banks’ loan portfolios through covered bond issuance that, unique to Korea, provides for off-balance sheet treatment, Fitch said yesterday (Tuesday).

The rating agency noted that covered bond issuance is attractive to Korean banks because it allows them to achieve off-balance sheet treatment of the loans – something unique to Korea – by selling loans to Korean Housing Finance Corp (KHFC). KHFC is the only entity in Korea that can issue covered bonds under a quasi-legislative framework, and will likely be the sole source of Korean covered bonds in 2012, and potentially also in 2013, said Fitch.

The rating agency said that the off-balance sheet treatment of KHFC covered bond funding contrasts with the treatment of assets in a securitisation, which under Korean International Financial Reporting Standards implemented this year remain on a bank’s balance sheet unless the entire capital structure of a transaction is sold to investors.

In addition, Fitch said that the potential to achieve off-balance sheet treatment of loans is attractive to banks because of a limit on financial institutions’ loan-to-deposit ratios that was recently introduced by the Korean government as one of several measures to constrain rampant growth in household debt.

“Discussions with market participants indicate that off-balance sheet treatment of covered bonds is their key attraction for Korean banks, given the current structure of the market,” said the rating agency. “Benefits such as a diversified funding base, cheaper cost of funding and longer term funding are not a primary consideration.”

But the drivers for covered bond issuance could change if a legal framework were created to allow banks to issue covered bonds directly, added Fitch.

The absence of such a framework is one of several factors that Korean market participants cite as limiting the growth of covered bonds from Korea, according to Fitch, with a move by the Financial Services Commission (FSC) to require a minimum proportion of fixed rate loans in any loan cover pool another limiting factor.

“The intention is to force households to hedge their exposure to variable interest rates and thus limit any shock from potential rising interest rates,” said Fitch.

Around 5% of Korean residential loans carry a fixed rate of interest, according to the rating agency, with the FSC at the end of June setting out a goal of increasing this to 30% by 2016. “If this were translated into a requirement that 30% of loans in a cover pools are fixed rate, it would take some time for banks to originate the loans required to back new issuance,” said Fitch.

The FSC and Financial Supervisory Service (FSS) also at the end of June issued best practice guidelines that the regulators described as intended to provide a framework for covered bond issuance to help diversity banks’ financing instruments and encourage more long term and fixed rate mortgage lending.

FSC chairman Kim Seok Dong in a parliament audit session on 10 October said that the commission will consider establishing covered bond legislation.

In the absence of a covered bond framework only one Korean bank has issued a covered bond on standalone basis – Kookmin Bank, under Korea’s ABS Act – although Woori Bank recently awarded Royal Bank of Scotland the mandate to arrange a covered bond programme. KHFC issues covered bonds under an act governing the institution and the bond is backed by pooled collateral from its member banks.