Covered bond legislation proposed by South Korea’s financial regulator would allow the country’s banks to reduce their reliance on foreign currency senior unsecured borrowing, while an issuance cap of 8%, possibly reducing to 4%, would stem subordination, said Moody’s today (Monday).

Financial Services Commission offices, Seoul

Korea’s Financial Services Commission (FSC) last Wednesday (24 October) presented draft legislation that will allow the country’s local banks plus Korea Housing Finance Corporation (KHFC) and Korea Finance Corporation (KFC) to issue covered bonds. A press release setting out the main elements of the legislation was ambiguous with respect to an issuance cap proposed, referring to a 4% limit but then also “within a range of 8%”.

Hyun Hee Park, analyst at Moody’s, said that the legislation includes a regulatory cap of 8% on issuance as a percentage of total assets, but that the FSC has indicated that it would seek to reduce the ceiling to 4% via a presidential decree after legislation is passed.

On the basis of the proposed caps, Moody’s does not expect covered bond issuance to lead to significant subordination issues for banks’ senior unsecured creditors, said Park.

Covered bond issuance would allow Korean banks to reduce their reliance on foreign currency senior unsecured bonds issuance and borrowings, she added, which the rating agency estimates accounted for as much as 63% of foreign currency funding among the seven largest banks by foreign currency assets as of June 2012.

“By our calculation, if the seven banks issued 4% of their total assets as covered bonds (the cap preferred by the FSC), it would equal 43% of their total foreign currency bonds issuance and borrowings,” said Park.

Another benefit from being able to issue covered bonds would be a lengthening of Korean banks’ debt maturities, she said, which would boost their capacity to offer long term fixed rate amortising mortgage loans and help address some of the risks arising from the funding mismatch in their mortgage portfolios.

“Recognising structural vulnerabilities of mortgages, the FSC in June 2011 issued a regulatory mandate that banks grow their long term and fixed rate mortgage lending to 30% of their total mortgages by 2016,” said Park. “We see current covered bond legislation as a policy step that will help banks meet this target.”

Jerome Cheng, vice president, senior credit officer at Moody’s, said that the draft Covered Bonds Act provides for strong legal protection, and that it enhances legal certainty and avoids legal disputes.

“The bill specifies both the issuer’s primary obligation to repay the covered bonds and the investors’ rights to submit a senior unsecured claim against a defaulting issuer as well as participate in its bankruptcy and rehabilitation proceedings,” he said.

Additional details are also credit positive in terms of protecting investors’ rights and interests, said Cheng, citing a strong separation of the cover pool from an issuer’s bankruptcy assets and the expansion of eligible assets.

“Requirements to register the details of the covered bonds issuance with the FSC and to keep a separate ledger for the cover pool further enhance protection,” he added. “These provisions are credit positive because they support the separation of assets by registering the pool and identifying its assets, ensuring that covered assets will be available to investors.”

Provisions similar to those of the bill also exist in the covered bonds laws of other jurisdictions, said Cheng.

The draft Act is an improvement on best practice guidelines issues by the FSC and the Financial Supervisory Service (FSS) in 2011, according to Cheng, for example by providing more details on the duties of cover pool monitors: cover pool audits; inspections on compliance with the covered bond issuance plan and relevant laws and regulations; a review of the issuer’s management; disposition and execution of the cover pool; and preparation and submission of a quarterly report to the regulator.