Reserve Bank confirms 10% limit on total assets banks can use as covered bond collateral; restrains bank hopes for more

By Gareth Vaughan

The Reserve Bank has confirmed banks will be able to use up to 10% of their total assets, as opposed to 10% of the bond issue amount, as collateral for covered bonds.

In a nine page paper providing feedback to the consultation it launched on covered bonds last October, the central bank confirms it will introduce a regulatory limit constraining the transfer of assets into covered bonds to 10% of a bank issuer's total assets.

Twelve formal proposals were received on the Reserve Bank's draft proposals. It says a number of submitters argued the 10% limit should be based on the bond issue amount, rather than the volume of assets encumbered in the covered bond structure. This option would have given the banks about 3% to 5% more available funding because the banks have to pledge more collateral in the form of mortgages than the bond issue amount.

"The Reserve Bank does not consider that a limit based on the face value of the bond would be appropriate as it does not address the primary prudential concern arising from the issuance of covered bonds, namely the encumbrance of assets," the Reserve Bank says.

Nonetheless, it said given a 10% limit on encumbered assets represents a more conservative position than many respondents assumed when they supported an initial 10% limit, the Reserve Bank will monitor market developments and review the appropriateness of this constraint within two years.

Covered bonds are senior debt instruments backed by a dedicated group of home loans known as a “cover pool” usually issued for five to 10 year terms. The way they're structured means if the issuing bank defaults, the assets in the cover pool are carved off - or ring fenced - 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 have been banned by the Australian Prudential Regulation Authority as, in the event of a default by the bank issuer, depositors’ claims are diluted. However, the Australian government said in December it would change the law to allow banks to issue covered bonds.

So far BNZ is the only New Zealand bank to have issued covered bonds raising NZ$425 million from domestic institutional investors and 1 billion euros in Europe. Westpac last month delayed a planned 1 billion euros issue in Europe.

Aside from being a source of cheap funding, the banks say they want to issue covered bonds to help meet the Reserve Bank's core funding ratio (CFR). Introduced on April 1 last year, the CFR sets out that banks must secure 65% of their funding from retail deposits and wholesale sources with maturities of more than one year. The central bank aims to lift the CFR, designed to reduce New Zealand banks reliance on short-term offshore wholesale funding, to 75% during 2012.

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