Reserve Bank mulls a covered bond market

By Gareth Vaughan

The Reserve Bank is working on a policy for covered bonds, or debt securities backed by the cash flows of mortgages or other loans, as a potential new source of funding to help trading banks meet the central bank's new core funding rules. In its six monthly Financial Stability Report out on Wednesday the Reserve Bank said it supported the development of covered bonds and was working on the development of a specific policy for them.

This would go out for public consultation in coming months.

"The Reserve Bank has had informal discussions with a number of banks regarding the possibility of  accessing this type of funding," the central bank said. The market for covered bonds, which differ from standard bonds in that investors have specific recourse to the assets that secure, or cover, the bonds in the event of default, is well developed in many European countries including Germany. The European Covered Bond Council describes covered bonds as:

Debt instruments secured by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default. While the nature of this preferential claim, as well as other safety features (asset eligibility and coverage, bankruptcy-remoteness and regulation) depends on the specific framework under which a covered bond is issued, it is the safety aspect that is common to all covered bonds.

With its new core funding ratio (CFR) introduced on April 1 requiring banks to fund 65% of their loans from either retail deposits or long-term wholesale funding with maturities of more than a year, the Reserve Bank notes banks may need, or want, new financial products such as covered bonds to help raise money. The Reserve Bank expects to increase the CFR to 70 and then 75% by mid-2012 although it says it will keep the plan under review in the light of funding market conditions and the banks' experience in complying with the initial requirement.

Last November the Reserve Bank estimated the major banks all had a ratio above the 65% minimum, but only slightly above it in most cases. Although New Zealand lacks the legislative framework to support covered bonds that's in place in Europe, the central bank says there are no regulatory impediments to banks developing structures independently. The new CFR requirement was introduced in the wake of the global financial crisis. The Reserve Bank says New Zealand banks have had an unusually high proportion of their international debt securities maturing within one year compared with other developed countries.

This makes the banks more vulnerable if ‘hot’ international wholesale money markets freeze, as they did after the Lehman Bros collapse. However, KPMG head of financial services Godfrey Boyce, and some executives at the major banks including ANZ New Zealand chief executive Jenny Fagg, have suggested the CFR requirements will raise funding costs for banks and this will ultimately flow through to customers in the form of higher interest rates.

BNZ managing director Andrew Thorburn, meanwhile, maintains the competition for domestic customer deposits is already the toughest it has ever been. In its Financial Stability Report the Reserve Bank notes it is "conscious" there is a limit to the extent that retail deposits can grow to meet banks' core funding requirements.

"As such, banks are likely to need to target additional long-term wholesale funding, either through existing markets, or through new funding opportunities." And one such new funding opportunity could be the development of covered bond programmes, it says.