The Reserve Bank of New Zealand noted the contribution of covered bonds to the changing composition and pricing of bank funding in research published in its latest bulletin, released today (Thursday).

In the quarterly paper, Jason Wong, manager financial markets research at RBNZ, explored how the cost of bank funding relative to the Official Cash Rate (OCR) has developed, noting that the OCR had historically been a good proxy for the cost of funding for banks.

According to Wong, the global financial crisis and regulatory changes have had a significant impact on the relationship between the cost of bank funding and the OCR, with a move towards more stable sources of funding, such as retail deposits and long term wholesale debt, changing the composition of banks’ funding.

Included in the increased use of wholesale long term funding has been New Zealand banks’ use of covered bonds, on a contractual basis since Bank of New Zealand’s debut in June 2010, and with legislation currently going through parliament.

Wong said that the introduction of covered bonds has helped banks attract overseas investors. With the launch of an ASB euro debut on Tuesday, New Zealand’s largest four banks have now issued in the European single currency, with deals also having been launched in other non-New Zealand dollar markets.

“Investors in covered bonds are more risk averse than investors who hold unsecured debt,” said Wong. “Therefore, the issuance of covered bonds has helped banks attract a wide pool of investors that would not have otherwise considered investing in New Zealand bank debt.”

He said that the other benefit of covered bonds is that banks can typically issue longer term maturities, of, say, between five and 10 years.

“This helps extend the term funding for banks,” said Wong. “Unsecured debt issues are more typically for a three to five year maturity.

“The shift towards foreign currency long term debt funding has not only helped banks to secure more stable sources of funding,” he added, “but has also helped them extend the term of funding and, at the same time, diversify their investor base.”

RBNZ has used a long term wholesale debt funding cost indicator in its analyses that has hitherto combined domestic and US dollar elements, but not euros. However, the advent of covered bond issuance is set to change this, said Wong.

“Historically, only a small proportion of debt was raised in that market,” he said, “but it has become a more important source, particularly since the introduction of covered bonds. Going forward we would look to include debt raise in Europe for our funding cost indicators.”