Covered Bonds and Bank Liquidity

Key takeaways

• Dual recourse - to the issuing bank AND to the cover pool - is what makes them cheap.
• Unlike RMBS, the mortgages stay on the bank's balance sheet.
• Australian issuance is capped at 8% of an ADI's Australian assets.
• The RBA's Committed Liquidity Facility was phased out at the start of 2023.

How does a covered bond differ from RMBS?

Both are ways of using mortgages to raise funding, but the risk transfer is opposite.

The dynamic pool is the key protection. If a mortgage in the cover pool falls into arrears or breaches eligibility, the bank must replace it with a performing loan. Investors are therefore insulated from deterioration in a way RMBS holders are not.

Why is there a cap?

Because covered bonds advantage bondholders at depositors' expense. Assets pledged to a cover pool are encumbered - in a failure, covered bondholders have first claim on them, and unsecured creditors including depositors and the Financial Claims Scheme rank behind for those assets.

Australian legislation therefore limits covered bond issuance to 8% of an ADI's assets in Australia. That is a deliberate balance: cheap funding is useful, but not to the point where the best assets on the balance sheet are all pledged away from depositors.

It is a good example of a prudential rule that is invisible to borrowers but shapes what funding options a lender has, and therefore what it can afford to charge.

What happened to the Committed Liquidity Facility?

The CLF was an RBA arrangement that allowed banks to meet their liquidity coverage ratio requirements using a committed facility with the RBA, introduced because Australia has a relatively small stock of government debt for banks to hold as high-quality liquid assets.

As Commonwealth and state government debt on issue expanded substantially, that constraint eased. The RBA reduced the facility progressively and it was phased out from the start of 2023, with banks now expected to meet liquidity requirements by holding genuine high-quality liquid assets.

The practical consequence is that banks hold more government securities than they used to, which is a small structural cost that sits in the funding stack behind every loan they write.

Frequently asked questions

What is a covered bond?

A debt security issued by a bank and secured against a ring-fenced pool of mortgages that remains on the bank's balance sheet. Investors have recourse to both the bank and the pool, which lowers the funding cost.

Why are covered bonds capped in Australia?

Because pledging assets to a cover pool encumbers them ahead of depositors and other unsecured creditors. Australian law caps issuance at 8% of an ADI's Australian assets to limit that subordination.

Does the Committed Liquidity Facility still exist?

No. The RBA reduced it progressively and phased it out from the start of 2023, as the growth in government debt on issue gave banks sufficient high-quality liquid assets to hold directly.

Do covered bonds affect my mortgage rate?

Indirectly. They are one of the cheaper components of a bank's funding mix, and the blended cost of that mix is one input into what the bank charges for lending.

Related reading

• Where Banks Actually Get the Money They Lend You
• Securitisation and RMBS: How Non-Banks Fund Loans
• Deposit Rates vs Loan Rates: The Lag

Sources

• Banking Act 1959 - covered bond provisions — Commonwealth of Australia
• The Committed Liquidity Facility — Reserve Bank of Australia