Banking reform in Australia, Covered Bonds & Basel III impacts

Publication | 23 December 2010


by Petar Kuessner

Over the last two weeks, long awaited Australian and international regulatory reforms have been announced by the Australian Government, the Basel Committee on Banking Supervision, the Reserve Bank of Australia and the Australian Prudential Regulation Authority which will have significant impacts on the financial services industry in Australia.  In particular, the Australian Government’s decision to allow Australian banks, building societies and credit unions to issue covered bonds promises finally to place Australian authorised deposit-taking institutions (“ADIs”) on a level playing field with their international competitors which are already permitted to issue covered bonds.  However, questions remain as to whether that playing field will be level between all ADIs and how non-ADI financial institutions will be impacted by the Government’s decision.  In the days following these announcements, some of the dust has started to settle, allowing further analysis of these decisions in light of the initial market reaction and regulators’ responses to these successive releases of new domestic reform measures and international rules.

This Legal Update provides an overview of the Government’s package of reforms, the decision to allow ADIs to issue covered bonds, how some of the recently announced Basel III reforms might impact on Australian covered bonds and some of the likely issues that keen observers of the development of a framework for covered bond issuance by ADIs will be watching over the coming months.

The Australian financial services industry reforms announced

On 12 December, The Hon Wayne Swan MP, Deputy Prime Minister and Treasurer, The Hon Bill Shorten MP, Assistant Treasurer, and The Hon David Bradbury MP, Parliamentary Secretary to the Treasurer, announced the Australian Government’s package of reforms to be made to the Australian financial services industry in a report entitled “Competitive and Sustainable Banking System”.  The report has been published following a period of public debate in Australia regarding the degree of competition in Australia’s financial services industry.

On the same day, and as part of this reform package, the Australian Government also released a draft bill which aims to empower the Australian Competition and Consumer Commission (“ACCC”) to prevent financial institutions from price signalling to their competitors in a way that would undermine competition. The draft legislation is entitled the Competition and Consumer Amendment Bill (No.1) 2011.

If you would like to read:

  • the Australian Government report entitled “Competitive and Sustainable Banking System”, click here.
  • the Australian Government’s draft price signalling legislation entitled Competition and Consumer Amendment Bill (No.1) 2011, click here.
  • the text of the speech given by the Deputy Prime Minister and Treasurer, the Assistant Treasurer and the Parliamentary Secretary to the Treasurer when they released the report, click here.
  • a separate Legal Update published by Norton Rose Australia on the draft price signalling legislation, click here.

The reforms are set out into three streams:

Stream One - Empower consumers to get a better deal

Stream One aims to achieve this outcome through measures, including:

  • banning exit fees on new (but not existing) home loans from 1 July 2011 in conjunction with other reforms already made to the National Credit Code
  • a feasibility study to be conducted on account portability
  • a new one-page key facts sheet to be given to home loan borrowers which aims to more clearly describe all the payments to be made by borrowers
  • empowering the ACCC to take action over anti-competitive price-signalling, as described above
  • reforms to credit card regulation aimed at obtaining a “better deal” for credit card holders
  • a community awareness and education campaign
  • establishing a taskforce with the Reserve Bank of Australia (“RBA”) to monitor ATM fees and competition between ATM providers

Stream Two - Support smaller lenders to compete with the big banks

Stream Two aims to achieve this outcome through measures, including:

  • building a new “pillar” in the banking system by supporting the mutual credit union and building society sector.  It appears that other non-bank financial institutions will be excluded from this Government support proposal
  • confirming that that the Financial Claims Scheme that commenced in October 2008 would remain as a permanent feature of the Australian financial system, but with a review of the $1 million cap to occur and for a new cap to be set from October 2011
  • introducing a third tranche of Government support for the RMBS market.  The AOFM will be provided with a further A$4 billion to invest in AAA/Aaa-rated Australian RMBS.  This brings the level of potential Government direct investment to A$20 billion, in conjunction with the two prior commitments by the Australian Government of A$8 billion each
  • supporting the further development of bullet bonds in Australian RMBS transactions.  Bullet bonds differ from the usual RMBS pass-through bonds by paying the full principal amount of the bond on their maturity date, rather than passing through principal amounts on periodic payment dates throughout the life of the bonds (similar to an amortising loan).  Two recent transactions involving the CBA/BankWest SWAN and the Bendigo and Adelaide Bank TORRENS programmes contained bullet bond tranches.  The Australian Government recognises bullet bonds as an important milestone in the development of the Australian RMBS market.  The Australian Government also favours them because they can be structured to be eligible for inclusion in certain fixed income indices, such as the UBS Composite Bond Index, which opens up RMBS bullet bonds to a broader pool of potential investors, especially institutional investors who invest the substantial funds available in Australian superannuation funds

Stream Three – Secure the long-term safety and sustainability of our financial system

Stream Three aims to achieve this outcome through measures, including:

  • allowing ADIs to issue covered bonds.  The remainder of this Legal Update focuses on this significant development
  • developing a deep and liquid corporate bond market.  The Australian Government has proposed a number of initiatives in this area.  First, the Treasury will finalise reforms to reduce red tape associated with issuing corporate bonds to retail investors.  Second, the Australian Government will facilitate the trading of Commonwealth Government Securities on a securities exchange in Australia which will also provide retail investors with a more visible pricing benchmark for investments in corporate bonds.  Third, the Treasury will work on reforms recommended by the Australian Financial Centre Forum to align disclosure standards for retail corporate bonds with the process allowed for share entitlement offers.  There are some other initiatives also outlined in the report

What are Covered Bonds?

Covered bonds have issued by financial institutions in continental Europe for centuries.  Covered bonds are dual-recourse corporate bonds issued or guaranteed by financial institutions.  Thus, bondholders have a claim on both the issuer (and guarantor, where applicable) of the bond and (if that is insufficient to repay the bondholders) a claim on a cover pool of assets secured in priority to the bondholders.  Covered bonds are typically issued under specific covered bond legislation or regulation (eg, Germany, France, Italy, Ireland and, more recently, the UK) or under a contractual arrangement that emulates a legislative regime (often called Structured Covered Bonds).  The dual recourse nature of covered bonds usually enables covered bonds to achieve a AAA/Aaa rating.  From an issuer perspective, these features of covered bonds result in both the obligation to bondholders and the cover pool of assets remaining on the balance sheet of the issuer, which distinguishes covered bonds from securitised debt which can achieve off-balance sheet treatment in certain circumstances.  In addition, an important difference between covered bonds and securitisation is that covered bonds do not involve credit risk transfer.  The credit risk on the underlying asset pool remains with the issuer, which must then hold capital against the risk of default.  However, issuers of covered bonds typically obtain cheaper funding in the wholesale markets.

Why have ADIs been prohibited from issuing covered bonds until now?

Section 13A(3) of the Banking Act 1959 (Cth) (“Banking Act”) provides that if an ADI becomes unable to meet its obligations or suspends payment, then (subject to certain prior ranking liabilities owed to the Australian Prudential Regulation Authority (“APRA”)) the Australian assets of the ADI must be used to meet its deposit liabilities to account holders in priority to all other liabilities (the “depositor priority rule”).  Because covered bondholders have priority over the asset cover pool, APRA has prohibited ADIs from issuing covered bonds on the basis that they would breach the depositor priority rule.  APRA has maintained this view despite submissions made to it over recent years seeking to change its position.

Why has the Australian Government now allowed Australian Covered Bonds?

In announcing that ADIs would be permitted to issue covered bonds, the Australian Government announced that it would make facilitating amendments to the Banking Act on details of a legislative framework during the first sitting of Parliament in 2011 following targeted consultations with the main Australian financial regulators.  

Although unclear, it appears that the Australian Government appears to favour a legislative regime rather than the issuance of structured covered bonds.  A legislative regime will also likely involve amendments to Australia’s prudential framework with the supervisory role of APRA and other Government agencies further defined in relation to covered bonds.  Anecdotal evidence also suggests that banks can achieve marginally cheaper funding under legislative regimes.

The Treasury will also consult on the appropriate cap to be placed on covered bond issuance by individual ADIs.  The report suggests 5 per cent of an Issuer’s total Australian assets as an example cap, although the prospect of assessments being made on individual ADIs raises the possibility of the cap varying between individual ADIs, thus possibly providing relative funding advantages between different ADIs.  The cap aims to ensure a substantial buffer of assets to cover claims of depositors, reducing the likelihood of any levy on ADIs being made under the Financial Claims Scheme.

The Australian Government’s view is that a deep and liquid covered bond market would also assist the investment of part of the large pool of Australia’s superannuation national savings into productive investment throughout the Australian economy.  Although not stated in the report, it is expected to facilitate some superannuation investment away from a traditionally strong concentration in shares into fixed income investments, in order to produce more balanced superannuation investment outcomes.  

The Australian Government also has the view that allowing ADIs to issue covered bonds would provide ADIs with access to cheaper, longer term and more stable funding which would strengthen the financial position of ADIs and give them greater diversity of funding options.

Permitting covered bond issuance also must be viewed in conjunction with the Australian Government’s decision to transform the Financial Claims Scheme into a permanent feature of the Australian financial system, thus providing a degree of protection to depositors with ADIs despite covered bondholders having priority over the asset cover pool secured for the covered bonds.

Will covered bonds benefit all financial institutions equally?

In the absence of any other rules supporting lower-rated regional ADIs, including regional banks, it is expected that the higher rated larger banks will be able to issue covered bonds at a lower funding cost than other ADIs.  Covered bonds issued by higher rated banks need fewer credit and other structural enhancements than lower rated ADIs, which provides the funding cost advantage.  The report does not mention whether this issue will be addressed, but the overall theme of the proposed reforms would suggest that a policy that seeks to address this funding imbalance might be an element of the final covered bond framework.  In this context, it is interesting to note that on Monday 13 December (the day after the reform package was announced), the aggregate market capitalisation of Australia’s four major banks rose by A$3.4 billion by the end of trading in Australia’s equity markets, whereas by contrast, the share prices of regional banks fell.

Non-bank financial institutions in Australia, many of whom have traditionally funded their operations through the wholesale securitisation market, will not be able to issue covered bonds.  Although the additional A$4 billion direct Government investment in AAA/Aaa rated RMBS is aimed at supporting their ongoing funding requirements, they face competition from ADIs that will be able to access cheaper funding through covered bond issuance.

Basel III rules announced and their impact on Covered Bonds

On 16 December, the Basel Committee on Banking Supervision of the Bank for International Settlements (“Basel Committee”) announced its new global framework for regulating banks and banking systems, known as Basel III.  The Basel Committee also released a number of documents relating to the new framework.

If you would like to read the following reports issued by the Basel Committee:

  • Basel III: A global regulatory framework for more resilient banks and banking systems (“Basel III Framework document”), click here.
  • Basel III: International framework for liquidity risk measurement, standards and monitoring (“Basel III Liquidity document”), click here.
  • Guidance for national authorities operating the countercyclical capital buffer (“Basel III Countercyclical Buffer document”), click here.
  • Results of the comprehensive quantitative impact study (“QIS document”), click here.
  • Public announcement by the Basel Committee on the release of the Basel III framework and the results of the quantitative impact study, click here.

While the full scope of the new Basel III global framework for regulating banks and banking systems is beyond the scope of this Legal Update, interested observers of covered bonds and the development of a covered bond market in Australia will note some important aspects of the new Liquidity Coverage Ratio (“LCR”) requirement that will feature in the Basel III framework.

The Basel III Liquidity document states that the objective of Basel III framework “is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source” and clarified that the LCR is designed to “promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality assets to survive a significant stress scenario lasting for one month”.  The LCR will be implemented with an observation period and will include a provision to review its operation to avoid any unintended consequences.

Meanwhile, the following day, on 17 December, in a joint media release, the RBA and APRA announced the joint approach agreed by the RBA and APRA in relation to the implementation of the LCR in Australia.  The RBA and APRA recognise that, under the new LCR, the majority of high-quality liquid assets are likely to take the form of Government securities.  

This causes potential difficulties in jurisdictions where there is a relative scarcity of Government securities, such as Singapore, Hong Kong SAR, Saudi Arabia and Australia.  To that end, the new Basel III framework allows up to 40% of the high-quality liquid assets to comprise corporate bonds and (importantly) covered bonds rated AA- or above (and other assets), which reflected a political bargain struck at the G20 Conference in Seoul in November 2010.  Therefore, covered bonds rated at least AA- will be available to satisfy this element of the LCR.  

However, in their joint media release, the RBA and APRA announced that ADIs may establish a committed secured liquidity facility with the RBA which is sufficient in size to cover any shortfall between the ADIs’ holdings of high-quality liquid assets and its LCR requirement.  Eligible collateral for use under this facility will comprise all assets which are eligible for repurchase (repo) transactions with the RBA under normal market operations.  

Those facilities will count towards an ADI meeting its LCR requirement.  Under the RBA’s current repo eligibility criteria, “ADI-issued Debt Securities” rated at least A- and “Other AAA-rated Debt Securities” rated AAA (among others) qualify as Eligible Securities for Buy Repos.  As covered bonds typically are AAA rated, they can be expected to satisfy the rating requirements of the RBA’s current repo eligibility criteria as Eligible Securities for Buy Repos.  Therefore, provided other aspects of the RBA’s repo eligibility criteria are addressed in structuring the covered bonds, ADIs can expect to be allowed to use AAA rated covered bonds in this way to meet their LCR requirement.

Allowing ADIs to issue covered bonds has also neatly dealt with the outstanding issue from the finalisation of the Basel III framework of how ADIs will satisfy their LCR requirement in the absence of a significant quantity of high-quality Australian liquid assets and its impact on the ability of ADIs to meet their LCR requirement.  A deep and liquid market in ADI-issued covered bonds can be expected to significantly ease the LCR requirement pressure on ADIs under the joint approach announced by the RBA and APRA.

If you would like to read the joint RBA/APRA announcement (as published on the RBA’s website), click here.

International issues potentially affecting Australian Covered Bonds

Recent amendments in the EU to Directive 2003/71/EC (“Prospectus Directive”) made by Directive 2010/73/EU (“Amendment Directive”) which were published on 11 December 2010 make significant amendments to the Prospectus Directive.  The amendments aim to simplify and reduce some of the burdens on small and medium sized enterprises and assist them to access the capital markets in the European Economic Area (“EEA”).  ADIs contemplating issuing covered bonds into the EEA will need to be aware of those amendments and the timeline for their implementation.

If you would like to read our publication on the Amendment Directive, click here.

ADIs issuing covered bonds will also be interested in ensuring that their covered bonds are eligible for the repurchase and discount window facilities of the European Central Bank and the Bank of England, as ineligibility would likely cause them to become less attractive to EU investors.

In addition, following the experience of the UK which started with structured covered bonds in 2003 and moved to a legislative regime in 2008, it can be expected that the Australian Government will seek to provide ADIs with a framework that enables Australian covered bonds to compete on the international stage with other covered bonds.  For example, UK structured covered bonds did not meet the requirements of Article 22.4 of the EU Co-ordination Directive on Undertakings for Collective Investment in Transferable Securities 85/611/EC (“UCITS Directive”) which is important, because certain regulated funds and other entities are able to hold higher proportions of their assets in UCITS compliant covered bonds.  This made non UCITS-compliant UK structured covered bonds a less desirable investment than UCITS-compliant covered bonds among a significant class of investors.  One of the drivers behind the UK moving to a legislative framework was to put UK covered bonds on a level playing field regarding UCITS Directive compliance.  It can be expected that the Australian Government will be mindful of this experience in structuring Australia’s legislative covered bond framework.

Further amendments to the international regulatory landscape will need to be monitored so that covered bonds issued by ADIs are not relatively disadvantaged in the international capital markets.

What next?

The announcements made in the last two weeks in respect of covered bonds will be followed by consultations by Treasury and a proposed legislative framework from the Australian Government.  Interested participants in the Australian market are already engaging in the early stages of this process.  For example, the Australian Securitisation Forum has already formed a Covered Bonds Working Group, held its first meeting and will be convening smaller issue-specific sub-groups to examine particular issues.  It can be expected that other interested bodies will likewise convene interested members and prepare to make submissions to Treasury and Government.  Market participants will also be interested in the rating methodologies to be employed by the rating agencies for Australian covered bonds.

Norton Rose Group has Australian and Global expertise in Covered Bonds

Norton Rose Group has an experienced team of partners and lawyers across multiple offices with global expertise in covered bonds.  Members of our team have worked on covered bond programmes across a number of European jurisdictions.  Members of Ogilvy Renault, which joins the Norton Rose Group in 2011, have worked on a number of covered bonds programmes in the Canadian market, including structuring the first covered bond programme in the Canadian market.  Members of our Australian team have worked on covered bond programmes in Europe and on the first covered bond programme established in Australia/New Zealand.

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