Banks want covered bonds, but could taxpayers be left with the risk?

Banks such as NAB are reportedly positioning themselves to use covered bonds to raise funds.

Australian banks are positioning themselves to take advantage of new laws allowing them to use the new instrument of covered bonds to raise funds.

Our large banks especially have enthusiastically welcomed the government’s move to introduce covered bonds (passed by federal parliament last week) - and no wonder, they have lot to gain from the new financial instrument.

But smaller financial institutions are likely to be disadvantaged, while the aspects of the legislation also raises the issue of moral hazard and whether risk of a major bank bailout is being transferred onto the taxpayer.

What are they?

While the abolition of exit fees on mortgages dominated media reporting on bank reforms announced by Treasurer Wayne Swan last year, covered bonds are much more significant move.

Allowing authorised deposit-taking institutions (ADIs) to issue covered bonds has long-term implications for banks, investors, depositors and the financial system as a whole.

Covered bonds are similar to securitised debt, with the basic purpose to free up cash, tied up in assets such as mortgages, for on-lending.

Covered bonds offer yet another advantage to the issuing bank – it can raise funds at a lower cost.

AAP
As the bonds are covered or secured by “ring-fenced” assets, the banks would typically pay a lower interest rate on these bonds which would consequently reduce overall funding costs for banks.

Whether the savings will be passed on to bank customers is a separate issue – but if the past is an indicator, it seems very unlikely.

Further, as covered bonds are generally fixed interest instruments, the interest rate risk for the issuing bank is known and can be suitably managed.

Additionally, maturity mis-match, a typical headache for banks, is also avoided since such bonds are issued for longer term, which provides certainty of funding.

Typically wholesale funding constitutes nearly half of bank funding. Covered bonds would add another arrow in the bow of banks diversifying their funding base.

However, the covered bonds scheme designed in Australia is different than in some of the other countries.

For instance, according to the Federal Reserve Bank of Cleveland, the cover pool remains on the balance sheet which involves a capital charge and hence restricts risk-taking by banks.

Securitisation is therefore more profitable for banks than covered bonds, as it frees capital.

As the risk still resides with the issuer, unlike in securitisation, they are likely to be more cautious in issuing covered bonds.

In Australia, the covered pool of assets against which bonds are to be issued will be transferred to and owned by a special purpose vehicle –similar to securitisation - and as such would be removed from the bank’s balance sheet, avoiding the capital charge.

Good for some, not others

So Australian banks have succeeded in having their cake and eating it too. They have avoided the capital charge but retained the benefits of covered bonds.

Smaller institutions feel disadvantaged. AAP

The small financial institutions have to go through a long drawn out process of either creating a separate ADI, or using an aggregator special purpose vehicle.

Such institutions would continue to be at a disadvantage in terms of added cost of such intermediary arrangements.

Further, it is doubtful if wholesale investors would be comfortable in investing in such a cover pool where assets of disparate institutions with varying credit quality standards are pooled together.

The Reserve Bank of Australia occasionally voices its concern about poor credit quality in smaller financial institutions.

Consequently, the covered bond scheme puts major banks at advantage vis-à-vis small financial institutions.

The funding cost advantage envisaged in major banks may not be forthcoming in small financial institutions for above reasons.

It is possible, however, that their overall funding costs would be lower under the covered bonds route as compared to the securitisation route.

The investors would have several benefits. The ring fencing of the cover pool and double-recourse (should the value of cover pool be insufficient, investors would have recourse to other assets of the issuer) means added security for the investor.

Further, fixed interest means certainty of return. These will be desirable features for wholesale investors such as superannuation funds.

Moral hazard

The Greens have opposed the covered bonds scheme. They contend that depositors’ first call on ADIs asset is now subordinated for assets under the cover pool.

The Bill states that depositors would have insurance under the financial claims scheme anyway. The insurance is up to $1 million until 11 February 2012 and would be up to $250,000 permanently thereafter.

Also the cover pool has been restricted to 8% of issuers assets at the time of transferring the pool which lowers depositors’ subordination.

Depositors will have government insurance, plus a first call on ADI assets except cover pool assets.

AAP

According to the legislation, the taxpayer is covered since if ADI fails, then whatever the taxpayer contributes to save it would be recovered through a levy on ADIs.

The “too-big-to-fail” headache

However, it is foolhardy to think so.

By inserting such a clause in the Bill, the government is officially accepting that it will bail out banks, so what was implicit (ADI may have doubted that the government may not rescue them and refrained from excessive risk taking) will now become an explicit guarantee – a law - further increasing moral hazard.

Again, the solution may work in the case of small ADI failure. If one of the major banks fails, a system-wide disaster would engulf remaining ADIs too.

Would a private ADI really exist in that scenario for government to impose the levy? The combined total assets of two of our majors are equal to Australia’s GDP, which shows the enormity of the problem.

If the doomsday scenario becomes a reality, the only solution would be bank nationalisation, so the tax payer would be further entrenched.

The Greens consider the above to be transfer of risk to the taxpayer by the ADIs. There is some truth in this view.

But moral hazard issue is already in-built in a financial system which consists of “too-big-to-fail” (TBTF) institutions, now called systemically important financial institutions.

As the global financial crisis demonstrated (and the TBTF institutions know this very well) taxpayers can’t afford to make TBTF fail. TBTF are a permanent headache of the tax payer.

The UK’s Independent Commission on banking has well summarised the situation:

“The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers. Nor do ordinary depositors have the incentive (given deposit insurance to guard against runs) or the practical ability to monitor or bear those risks.

"For the future, then, banks need much more equity capital, and their debt must be capable of absorbing losses on failure, while ordinary depositors are protected.”

In sum, covered bonds are a mixed blessing. ADIs (read major banks) would benefit significantly by the new avenue of funding. Investors such as super funds would have a new avenue for investment.

It is the depositors and more importantly the tax payers who would continue to be left uncovered.