Australian banks, building societies and credit unions will be allowed to issue covered bonds as part of the federal government's banking reform package announced in December 2010. The package is aimed at increasing competition in the banking sector. The Treasurer indicated that the government will release draft amendments to the Banking Act 1959 during the first sitting of Parliament in 2011. These amendments have not yet been released.

The announcement, which was welcomed by the Australian financial markets, followed a long campaign to permit the issue of covered bonds by Australian authorised deposit taking institutions (ADIs). The Australian Prudential Regulatory Authority (APRA) had consistently refused to allow banks to issue covered bonds, as they believed it was inconsistent with the deposit holder protection regime enshrined in the Banking Act.

Covered bonds, which are commonly issued in off-shore markets (particularly in Europe) and more recently in New Zealand, provide a direct claim on the issuing bank together with recourse to a segregated pool of assets. Investors are attracted by the high credit quality of covered bonds and the fact that they have a claim against the issuer and there is a segregated pool of assets over which they hold security. It is anticipated that covered bonds will provide an alternative and cheaper form of funding than issuing RMBS or using straight corporate debt. It is expected this will expand the investor base and increase demand for Australian fixed income securities.

It is proposed that a cap will be placed on their use for individual institutions - the reform package refers to a cap of "five percent of an issuer's total Australian assets", however, this cap has not yet been confirmed. The cap is intended to minimise any impact on the assets protecting deposit holders. ADIs will be keen to see flexibility regarding the level of the cap and an acknowledgement that one size does not fit all ADIs.

Aggregated funding structures which will permit credit unions, building societies and regional banks to access the covered bond market are also a key topic of discussion.

It is expected that short form changes to the Banking Act will be enacted followed by more detailed subordinate legislation and/or APRA prudential standards. We will keep you posted as this significant change in the Australian Banking sector progresses.