Following on from our June 2012 banking and commercial law legal update, the Finance and Expenditure Select Committee (the Select Committee) has recently heard submissions on the Reserve Bank of New Zealand (Covered Bonds) Amendment Bill (the Bill) in which a wide variety of views were presented. The Select Committee has now recommended that the Bill, which enshrines covered bonds in law, be passed with minor amendments "generally in the nature of clarification".

Covered bonds are securities through which bondholders have an unsecured claim on the issuer as well as a security interest over a certain group of assets called the "cover pool". This enables the bondholder to have a dual recourse security which generally attracts the highest AAA credit rating. There were two key conflicting views presented to the Select Committee by Ivo Geoffrey Bertram, Senior Associate at the Institute of Policy Studies at Victoria University and representatives from and on behalf of the major banks in New Zealand.

Mr Bertram recommended that covered bonds be banned rather than given statutory preference on the basis that for the most part they were not designed to reduce risk to investors, but instead operated to transfer risk from the investors to other parties. If not banned, he recommended that they should be subject to stringent regulations, oversight and transparent reporting requirements.

The major bank representatives submitted that it is not correct that covered bonds operate to transfer the risk to the taxpayer and instead, the structure of covered bonds meant that the risk to the investor is decreased by setting the duration of the funding and thus improving liquidity and funding balance-sheet management.

The Select Committee report concluded that the risks covered bonds may create for unsecured creditors, such as bank depositors, are justified and outweighed by the benefits offered by issuing covered bonds. The primary benefit noted in the Select Committee's report was the reduced likelihood that a bank will default in times of financial stress but it was also noted that there would be reduced funding costs for banks from issuing covered bonds which could be passed on to unsecured creditors if banks can pay higher deposit rates.

The Bill sets the permitted volume of covered bonds at 10% of a bank's assets. The Select Committee considered whether this was a sufficiently conservative limit and determined that it was satisfactory. It was noted that the ratings agencies had assessed the issuance of covered bonds by New Zealand banks with a 10% limit as "ratings positive" for unsecured debt. The report does suggest, however, that changes in the market could mean the limit should be revised, such as where funding conditions become more difficult and it might be prudent to let banks encumber assets above the 10% limit for a period of time.

The Bill will now be returned to the House for its second reading.