I welcome the government’s decision to follow my lead and introduce covered bonds to the Australian scene. I originally proposed this initiative in October 2010 as part of my nine point plan for banking reform. The Treasurer has now belatedly followed suit, copying this and other elements of my plan in his banking package announced in December 2010.

The government’s bill amends the Banking Act 1959 to enable Authorised Deposit-Taking Institutions to issue covered bonds.

Covered bonds are a form of fund raising which is widely used by banks in other countries, including in Europe and in New Zealand. In Australia they have not previously been allowed to be issued by institutions established under the Banking Act. The government’s amendments to the Banking Act will allow banks, credit unions and building societies to raise funds by issuing these securities.

Covered bonds are attractive to investors because they have very low credit risk. The bonds issued by a financial institution are secured (or covered) by a pool of assets. The legislation provides that the value of assets in a covered bond pool must be at least 103 per cent of the value of the covered bonds, so in this sense the bonds are oversecured. 

In the event of insolvency the holder has recourse to the pool of assets underpinning the bonds. The holders of covered bonds have first rights to the pool of assets covering them, ahead of shareholders, and ahead of other holders of debt. 

Covered bonds may sound similar to asset backed securities which have been a feature of the Australian market for many years. But they differ in two crucial respects.

The first difference is that asset backed securities are backed only by certain specified assets. And the cash flows are linked to those assets. If those assets go bad – as happened in the US with some mortgage backed securities – then the cash flows and value of the bonds is commensurately reduced.

With covered bonds, the pool of assets can be substituted. Bad assets can be rotated out and good assets rotated in. This means that the quality of the assets backing the bond – and over which the bond holders have first claim in the event of default – is always of the highest quality.

The value of the bond cannot be reduced by assets going bad unless the ADI has no good assets left to rotate into the pool. And in the Australian environment that is extremely unlikely if the regulatory authorities are doing their job.

The other difference is that the covered bond debt and the underlying asset pool remain on the issuer's balance sheet. In the event of default, the investor has recourse to both the pool assets and the issuer.

These advantages mean that covered bonds carry lower risk than other secured investments. This provides issuing institutions with cheaper funding, and potentially more stable and longer duration funding in the wholesale capital markets.

The move to introduce covered bonds is welcomed by the Coalition, but the process by which the Treasurer is introducing new regulations on the financial system is far from ideal. What we have seen this year has been an ad hoc response to a range of issues. There has been no master plan; no ultimate goal for an improved financial system against which the various changes can be judged.

Many of the government’s reforms have been stolen from the opposition. The bill before us to introduce covered bonds is a straight steal and the idea to empower the ACCC to prosecute anti-competitive price signalling was announced as part of my nine point plan for banking reform. The Treasurer included it in his banking plan in December last year.

Developing a deep and liquid corporate bond market by launching the trading of Commonwealth government securities on a securities exchange was also part of my October banking reforms. And once again the Treasurer adopted it in his plan last December.

But there is one element of my plan that the government refuses to adopt. And that is to commission a full root and branch review into the Australian financial system, a granddaughter of Campbell or a son of Wallis.

The competitive environment of the global and Australian financial systems has changed fundamentally following the global financial crisis. It would be prudent to ensure that our competitive structures and regulatory institutions are appropriate for the new world.

Such a review would provide a longer-term perspective on the desirable structure of the Australian financial system and a list of integrated reforms to achieve the desired goals, should further change be required.

Only then would consumers of financial services be able to appreciate the impact of reforms and be assured that government had a vision for the financial system that would best serve consumers’ interests.

The Coalition is achieving real and worthwhile improvements to public policy when the government adopts our ideas. We look forward to the day when the Australian people give us the privilege to be the real government.

Joe Hockey is the federal member for North Sydney and Shadow Treasurer.

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Great Joe, that's one idea, what about a massive sovereign wealth fund based on a proportion of the company tax received (Half shielded by covered bonds, October 14). No need to reduce the company tax rate as it's similar to that imposed by developed countries with welfare and advanced medical services. With the Norwegan wealth fund there are restrictions that limit the amount any government can draw down in the life of any parliament - so another government can't get ther hands on it. I think you should have a crack at caps on middle class welfare - manup and cap the amount of tax free income a superannuate can draw down. I think It's a disgrace that some people with millions in super are paying no tax - you could then raise the tax free allocation on income tax. There's your homework for the weekend - get cracking.
I think this is a truly horrific development (Half shielded by covered bonds, October 14). What is not made clear is that deposit holders in these banks are now exposed to losses when the 'assets' go bad.
The fact that this has bipartisan sponsorship is all the more scary.
On the contrary.
Covered bonds are a disaster, presaging a legal quagmire in a future banking crisis.
Covered bonds turn liabilities (depositors' funds) into an asset.
The baseness of this move merely reinforces the reality of the power of the Big 4 over Canberra.
A 'full root and branch review into the Australian financial system' is long overdue, but its main function would be to re-examine the failures induced by the Campbell and Wallis reviews.
It is of great concern to me that if the government guarantees individual deposits of up to $250,000 then in effect the government is the real guarantor of covered bonds (Half shielded by covered bonds, October 14).
I don't know what other assets banks have apart from all the mortgages they hold and thus does this mean that peoples' homes can be handed over to covered bond holders as well as depositors' money? Do our banks really need another source of funding? I thought they were awash with people's savings now.
Joe, I think this is a good summary of covered bonds (Half shielded by covered bonds, October 14). I have heard the term before but never understood what it means.