Why the Government wants to let smaller banks issue 50% more covered bonds
The Government wants banks to commit 50% more assets to covered-bond security pools. The reform could lower funding costs for mid-sized banks, but comes with risks for depositors.
Australia's smaller banks have long faced a competitive disadvantage: they generally pay more to raise funds than their larger rivals. A new Government proposal could help narrow that gap.
On 23 October, Treasurer Jim Chalmers announced draft regulations increasing the covered-bond limit from 8% to 12% of a bank's Australian assets — a 50% increase.
The reform follows a recommendation from the Council of Financial Regulators' review of small and medium-sized banks.
What is a covered bond?
Banks fund their lending through customer deposits, wholesale borrowing and other sources.
A covered bond is a form of wholesale borrowing secured against a designated pool of assets, usually residential mortgages.
Unlike ordinary unsecured bank bonds, covered bonds provide investors with two sources of repayment: a claim against the issuing bank and security over the underlying assets.
This additional protection generally allows banks to borrow more cheaply and for longer periods.
Why is there a limit?
Covered bonds were introduced in Australia in 2011, subject to restrictions designed to protect depositors and financial stability.
Assets supporting covered bonds are effectively reserved for those investors if a bank fails. They are consequently less available to satisfy other creditors.
The current legislation limits the value of assets committed to covered-bond security pools to 8% of a bank's Australian assets.
The Government proposes increasing that limit to 12%.
Consider a bank with $50 billion in Australian assets.
Currently, it can place up to $4 billion of assets in covered-bond security pools. The proposal would increase that capacity to $6 billion.
That is an additional $2 billion of potential collateral, although the amount actually borrowed would be smaller because covered bonds require more security than their face value.
Will smaller banks benefit?
Potentially, but not equally.
The major banks already enjoy economies of scale, strong credit ratings and well-established access to wholesale investors.
Medium-sized banks may gain disproportionately if additional covered-bond funding reduces their reliance on more expensive borrowing.
Very small banks, however, may lack the scale to establish economical covered-bond programs.
What is the economic trade-off?
Greater covered-bond issuance could reduce funding costs and strengthen mortgage competition.
But it also increases asset encumbrance: the proportion of bank assets reserved for secured creditors.
This could weaken the position of depositors and other creditors if a bank fails.
The Council of Financial Regulators therefore supports a moderate increase rather than removing the restriction.
The real test is whether cheaper funding translates into more competitive lending, without materially weakening depositor protection.
Current limit 8% Australian assets in cover pools | Proposed limit 12% 50% increase in capacity |
| 1. ISSUING BANK Borrows money and remains responsible for repaying bondholders. |
| ↓ Designates eligible mortgages as collateral |
| 2. COVERED-BOND SECURITY POOL Mortgages and other permitted assets provide additional security. |
| ↕ Investor funding and repayment claims |
| 3. BOND INVESTORS Have claims against the issuing bank and the designated security pool. |
| Existing 8% limit | $4bn |
| Proposed 12% limit | $6bn |
| Hypothetical bond funding | $1 billion |
| Hypothetical funding-rate reduction | 0.25 percentage points |
| Gross annual interest saving | $2.5m |