Investors like covered bonds who are willing to tolerate lower risks

With securitized assets, as is the case, covered bonds proved to be the additional credit over; on bearing, these bonds do not possess abilities of contractual cash flow to the investor concerned.

By Kalim Ur Rahman

Covered bonds were introduced by Frederick The Great in 1796 in Prussia while it was launched in Denmark in 1795.  Backed by cash flows, covered bonds are actually debt securities derived by public sector loans or mortgages. Created in securitization, these possess similarities of asset-backed securities in many aspects. Usually with appropriate capital charge, assets of the said covered bonds are emerged on the consolidated balance sheet of the issuer. The issuer of these bonds, which is any bank in most of the cases, the covered bonds are an obligation of the issuer concerned.

The term dual recourse is used sometimes where against the issuer, the investor has recourse. Where assets come off the balance sheet in accounts, there exist some other variables as well. Global outstanding covered bonds volume, with the matters as happened in the corresponding year 2012, stood at euro 2813 billion, while the biggest markets were considered to be Spain with 440 billion Euros, Germany 525 billion Euros, France 362 billion Euros, while the share of Denmark had the share of 366 billion Euros.

The covered bond is considered to be a corporate bond as well because of its vital enhancement specification. It is recourse of the pool of any fixed assets, which possess the qualification of securing or covering the bond if the originator represents or shows any disability being solvent. As they become disable to meet their financial requirements in liquid cash or by disposing their fixed assets or businesses. With securitized assets, as is the case, covered bonds proved to be the additional credit over; on bearing, these bonds do not possess abilities of contractual cash flow to the investor concerned. As the world economies witnessed the global financial crisis outbreak in the year 2008, but before this conundrum, these bonds were provided with AAA credit ratings. Since a lot many loans which backed these kinds of bonds possess poor governance system, a steep decline was seen in the credit ratings of these bonds that led to the said severe crunch as a major contributor.

The underlying pool as well as the covered bond remains in the domains of the financials of the issuers, this can be considered being an advantage to the investor. On the other hand, there is the responsibility of the issuers that the covered bond should be consistently backed by the pool; or else, in case of possessing the status of being default; the investor has the recourse to both the issuer and the pool.

On the other hand, Bank Special Purpose Vehicle structure has been used by the Australian financial institutions; on balance sheet, it exists with pools of collateral nature. The assets of the financial institutions and broader operations are being offered to Australian covered bond holders among other dividends which may bring with them. Contrary to this situation, the stakeholders would bear the brunt of risks involved in the banking operations. Over Australian cover bonds, European give priority to their own cover bonds. This trend has been more in practice because risk weighting is provided to banks and insurance companies by the European regulators, which is also called brownie points when they assess their capital reserves. On the other hand, there is a belief among offshore investors that vital correction is needed in the Australian property market while it is over-valued as well. 

Around two billion dollars per month would need to be issued by each of the four large domestic banks of Australia. The treasurer may be considered to possibly be in the situation of risk to hold back insurance if in a shorter period, funding spreads or costs, rather the financial institutions and banks issue it at the competitive market rate and press ahead on a hope that these would probably pass on higher costs. Fact of the matter is that Australian banks are not being provided with the earmarked benefit by the covered bonds. On the other hand, covered bonds may become cause of dividend to the Australian banks and other financial institutions when concerns of sovereign debt are resolved.

Australian Prudential Regulatory Authority (APRA) has expressed his objections in principle about the covered bonds earlier. The Australian government at the apex of the fiscal crunch in the year 2008 had given an announcement to take guarantee of liabilities of wholesale banks, deposits and insurers. These guarantees are further outlined in two vital factors, i.e. financial claims schemes, which covered deposits of the ADI to one million dollars free of any charge. The second one is wholesale funding and guarantee of large deposits. This covers deposits of ADI’s over dollar one million and against a specified fee, which depends upon the credit ratings. The guarantee of wholesale funding and large deposits ended to new liabilities in March 2010.

On the other hand these were still covered by the August end of dollar 118 billion worth. At the corresponding duration, amid competitive and sustainable banking system package announcement in the year 2011, the FCS received dominant factor in the Australian financial system while the coverage limit would reported to be decreased to 250,000 dollars, while Australian ADI’s coverage deposits for overseas will be removed. Since FCS has become a permanent feature of the Australian financial system, APRA’s objections now have mitigated effect.

The covered bonds actually give the consumer a better chance of the deal. These provide assistance to smaller lenders which may compete large banks while securing sustainability and long term safety measures for the financial institutions of Australia. The Shadow Treasurer gave remarks upon the announcement of the ‘Competitive and Sustainable Banking System’ package, i.e, ‘we welcome launching of covered bonds and price signaling legislation by the Coalition. They acknowledged the government’s plan which has much in the package. There was need sought by the coalition of review in the banking system. Which means the coalition supported the issuance of the covered bonds on one hand and on the other hand it demanded a financial inquiry into this development procedure. Community and Small banks will not get the same benefit as large banks have by the covered bonds. The smaller banks and financial institutions have fewer resources to access the covered bonds market, yet again, these bonds would entrench the dominance of the large bank’s markets. Contrary to this, the home loans would possess fewer markups in such circumstances.

The funding resources of the banks will result in diversification. Low ranked securities cost will be increased since these become riskier. The banks and financial institutions will start borrowing increased amount from overseas in a bid to enhance domestic property sector. Covered bonds are secured by the assets of high quality. This would outrank depositors in the bank assets claim which is an attractive part for the bond holders. This would also help ensure continuation of reasonably prices credit provision to small businesses and households at large. Smaller banking and financial institutions would be accommodated with aggregated and pooled structures of the covered bonds.

As the market develops, some building societies and credit unions would become able to access new funding form amidst large banks which takes most benefit out of the covered bonds.  The sources of funding are allowed to be diversified by the covered bonds. Covered bonds are liked the most and appreciated by the investors who are willing to tolerate lower risks as compared to other forms of funding being offered by the banks and other financial institutions. Covered bonds can cause to bolster credit ratings and boost the base of potential investors.  The protection of the depositor in the existing mechanism should be retained through depositor preference while it must be enhanced and clarified to all regulated institutions that take the deposit amount. There are some special kinds of assets that can be included in the cover pools that those can be convertible into amount within 48 business hours. The banks accepted Bill or deposit certificate that meet the following criteria: these are matures in 100 days’ time and can be repurchased with RBA. Another condition is that it should not be issued by the ADI which issues the covered bonds where these are also have the notion of security by the cover pool assets.


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