Fitch says RBNZ should undertake ongoing covered bond supervision; Could set new global standards

International credit rating agency Fitch suggests the Reserve Bank should undertake ongoing supervision of covered bonds, rather than just of their bank issuers, in contrast to what the central bank is proposing in a consultation paper setting out legislative plans for covered bonds.

Fitch which rates BNZ's NZ$3 billion covered bonds programme - the only existing New Zealand bank covered bonds programme - AAA, says by developing covered bonds regulations the Reserve Bank has the opportunity to raise standards of data transparency and reporting compared with some of the world's established covered bonds markets.

"The level of disclosure and the frequency of information related to both the issued covered bonds and the securing cover assets could be improved globally," Helene Heberlein, managing director and head of Fitch Ratings' covered bond group, says.

Covered bonds are senior debt instruments issued by a bank, usually of five-to-ten year durations, and backed by a dedicated group of home loans known as a “cover pool.” If the issuing bank becomes insolvent, the assets in the cover pool are carved off from the issuer’s other assets solely for the benefit of the covered bondholders. This ring fencing of a chunk of a bank’s balance sheet is why covered bonds are banned in Australia as, in the event of a default by the bank issuer, depositors’ claims are diluted.

However, in New Zealand the Reserve Bank says it's comfortable with banks issuing covered bonds worth up to 10% of their total assets and wants laws passed to enable banks to issue bonds backed by legislation to help attract overseas investors. See detailed story here.

Heberlein says that in its consultation paper the Reserve Bank clearly states a preference for a covered bonds registration process rather than detailed, ongoing monitoring of them.

"In Fitch's view, the absence of prescriptive rules would not prevent the supervisory authorities instructing banks to take corrective action, should a particular concern arise about the covered bonds. However, establishing clear guidelines on the aspects of covered bonds funding which the supervisor will focus on reduces the uncertainty concerning its future intervention."

Heberlein also notes that an initial approval process, on its own, is unlikely to foster long-term confidence if the conditions for keeping covered bonds registered aren't periodically checked, or if issuers can freely choose to de-register existing covered bonds.

"As part of its covered bonds analysis, Fitch gives some credit to statutory oversight over and above the regular supervision of issuing financial institutions."

BNZ last week raised 1 billion euros through a covered bond issue in Europe following its NZ$425 million domestic covered bonds issue in June. Westpac is expected to be the second local bank to issue covered bonds, eyeing an issue during the first half of 2011.

Read Fitch's statement below:

Fitch Ratings believes the Reserve Bank of New Zealand (RBNZ), through its imminent policy on regulation of covered bonds, could use the opportunity to enhance transparency in the New Zealand covered bond market by stipulating minimum disclosure requirements.

"By developing new covered bond regulations, the RBNZ has the opportunity to raise the standard of data transparency and periodic reporting compared with some of the established covered bond markets," says Helene Heberlein, Managing Director and Head of Fitch Ratings Covered Bond group.

"Fitch believes the level of disclosure and the frequency of information related to both the issued covered bonds and the securing cover assets could be improved globally. The increased transparency would be welcomed by all market participants and a regulated uniform definition of data to be reported would enhance consistency and facilitate comparison between all programmes in a given country," she added.

Following the recent issuance of contractual covered bonds in New Zealand and with potential further issuance, the RBNZ is looking to implement a formal covered bond framework to support registered banks' access to this type of funding without jeopardising the soundness of the New Zealand financial system. In its public consultation paper ("Consultation on a policy for the issuance of covered bond in New Zealand"), the RBNZ clearly states its preference for a registration process rather than detailed, ongoing monitoring of future New Zealand regulated covered bonds.

In Fitch's view, the absence of prescriptive rules would not prevent the supervisory authorities instructing banks to take corrective action, should a particular concern arise about the covered bonds. However, establishing clear guidelines on the aspects of covered bonds funding which the supervisor will focus on reduces the uncertainty concerning its future intervention. The proposal, detailed in the consultation paper, is for New Zealand covered bonds to be registered but for the regulator to not undertake any ongoing supervision beyond the supervision of the banks themselves.

The agency highlights that an initial approval process, on its own, is unlikely to foster long-term confidence if the conditions for keeping the covered bonds registered are not periodically checked, or if issuers may freely choose to de-register their existing covered bonds.

As part of its covered bonds analysis, Fitch gives some credit to statutory oversight over and above the regular supervision of issuing financial institutions. Credit is only given to the additional oversight as the regulated nature of credit institutions is already factored in the Issuer Default Ratings (IDR) assigned by the agency, which constitutes a floor for the covered bonds rating due to the dual recourse nature of the instrument.

Apart from the pre-emptive role of the oversight, there are two further main areas where covered bonds regulations may impact Fitch's assessment of the continuity of covered bonds payment upon an issuer default: liquidity gaps and alternative management.

Fitch analyses the likelihood of an interruption of interest or principal payments on the covered bonds in the transition from the issuer to the cover pool to satisfy privileged claims (liquidity gaps). The RBNZ's consultation paper identifies refinancing risk as the primary challenge for the development of robust covered bonds in the New Zealand market. Although the RBNZ is seeking to develop a legislative process to support the ongoing servicing of the bonds in the event of an issuer default, it does not state which measures could be put in place.

Given that New Zealand was one of the first countries to implement reinforced liquidity coverage ratios for domestic institutions in the wake of the global financial crisis, the agency believes investors would certainly be entitled to expect this aspect to be catered for as part of dedicated New Zealand covered bonds regulation.

Fitch views the benefit of regulation to ensure prompt and professional management of the cover pool and privileged creditors following the default of the financial institution.

However, Fitch notes the RBNZ's consultation paper does not mention any such involvement of the banking authorities. For existing New Zealand covered bonds, as in many other contractual programmes, the replacement of the issuer is governed by agreements that divide the responsibility between different parties, such as a back-up servicer and a portfolio sale advisor. In Fitch's view, these arrangements provide less comfort than programmes where the alternative manager is a single party appointed by and reporting to the financial regulator.

The consultation paper states that the RBNZ firmly intends for the legislative framework to rely solely on the ring-fencing of cover assets through a special purpose vehicle (SPV). As such, it will not pursue the alternative route of an integrated issuance model. Fitch does not view any one system as superior or inferior per se for the purpose of ensuring asset segregation. Rather, the agency will review the potential for asset leakage based on legal opinions provided to it, as well as reviewing the dedicated legislation, if any, and the applicable contractual arrangements.

In its public consultation paper, the RBNZ also considers the positive and negative aspects of covered bonds for issuing institutions and their creditors and depositors, and seeks feedback on its proposed 10% maximum limit, which would cap the cover pool in proportion of the bank's total assets. Furthermore, the RBNZ considers it appropriate to set eligibility criteria for the cover assets in line with those in use for its domestic market operations. Finally, it does not specify any minimum over-collateralisation percentage. Fitch will review the final regulation, which is expected in 2011.