House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 1 Covered Bonds

Outline of chapter

1.1 This Banking Amendment (Covered Bonds) Bill 2011 (this Bill) amends the Banking Act 1959 to enable ADIs, which includes banks, credit unions and building societies, to issue covered bonds. This measure was announced by the Deputy Prime Minister and Treasurer on 12 December 2010.

Context of amendments

What is a covered bond?

1.2 A covered bond is a dual-recourse bond (or secured debt instrument) issued by banking institutions (which in Australia are ADIs). The ADI issuing the covered bond has an ongoing obligation to make principal and interest repayments to covered bondholders (that is, the investors).

1.3 The dual-recourse nature of covered bonds comes from the fact that covered bondholders have two mechanisms to recoup their investment in the event that the issuing ADI is in default (that is, the ADI does not meet its payments to covered bondholders). The covered bondholders firstly have recourse to the ADI, and should the ADI not meet its contractual obligations, the covered bondholders have recourse to a specified pool of high quality assets (called the cover pool of assets). If the cover pool of assets is insufficient to meet the covered bondholders claim, then the covered bondholders retain recourse back to the issuing ADI for any outstanding residual amounts due to them. Any residual claim of covered bondholders on the ADI would rank below most depositors and claims by government.

1.4 Issuers of covered bonds generally seek a AA or AAA credit rating for the covered bond issue. Further, the rating of the covered bond issues is typically higher than the credit rating of the issuing ADI reflecting the dual-recourse nature of covered bonds and the high quality of the asset pool securing the covered bonds. In addition, many covered bond markets (particularly in Europe) are heavily regulated which has the effect of protecting the interests of covered bondholders, and supporting a higher-than-otherwise credit rating of covered bond issues.

1.5 The recourse to the ADI issuing bonds and the pool of assets securing covered bondholders (and the consequent retention of credit risk by the ADI issuer) distinguishes covered bonds from other asset-backed securities (such as residential mortgage-backed securities (RMBS)) where the credit risk held by the holder of the security is on the pool of assets only. The dual-recourse nature of covered bonds also differs from ADI wholesale funding where the claim is only against the issuer (that is, the claim is not secured against any particular assets of the issuing ADI). This is illustrated in Diagram 1.1 above.

Current law

1.6 The preference provisions in the Banking Act 1959 have impeded ADIs issuing secured debt, such as covered bonds. These provisions have historically ensured that depositors in Australia have the first claim (that is, ahead of all other creditors, including secured creditors) on all of an ADI's Australian assets. However, in October 2008, the Government introduced a new protective framework for depositors called the Financial Claims Scheme (FCS) which ensures (currently and once the cap is changed) that 99 per cent of Australian deposit accounts are protected in full.

>Protection for depositors<

1.7 Under the FCS, the Australian Government protects most depositors up to a cap (which is currently set at $1 million but will change to $250,000 from 1 February 2012 as announced by the Government on 11 September 2011), and will fully pay these depositors in the unlikely event that an ADI fails. The FCS ensures (currently and once the cap is changed) that 99 per cent of Australian deposit accounts are protected in full. Further, the Australian Government confirmed on 12 December 2010 as part of its Competitive and Sustainable Banking package that the FCS is a permanent feature of Australia's banking landscape. This Bill makes no amendments to the legislation governing the operation of the FCS.

1.8 In the unlikely event of the FCS being activated, and the even more unlikely event that the sale of a failed ADI's assets be insufficient to recover taxpayer funds in full, the FCS allows the Australian Government to levy the banking industry afterwards to recover any outstanding amount. This means Australian taxpayers are fully protected.

1.9 Further, as an additional protection for depositors, this Bill includes a regulatory cap on the amount of covered bonds an ADI can issue. This regulatory cap ensures that only a small proportion of an ADI's assets in Australia are included in a cover pool (or cover pools) for the benefit of covered bondholders in priority of the ADI's other creditors in Australia. The regulatory cap on the issuance of covered bonds further reduces the likelihood that a levy on the banking industry would ever be required under the FCS.

Benefits of the covered bond measure

1.10 Allowing ADIs to issue covered bonds may assist them in their funding task in four respects.

1.11 First, covered bonds diversify an ADI's funding base. They allow ADIs to issue a new class of securities which may be attractive to a new class of investors who wish to bear less risk relative to other forms of bank funding. Consequently, having the capacity to issue covered bonds will improve ADIs' access to funding.

1.12 Second, covered bonds offer a potentially cheaper form of wholesale funding for ADIs, because the risk to investors associated with covered bonds is generally lower than other forms of wholesale funding.

1.13 Thirdly, covered bonds may provide the opportunity to raise funds with longer maturity, say with a 5 to 15 year term. This compares with ADI wholesale funding which is typically in the maturity range of up to 4 years, although ADIs could issue longer-dated paper if they wish to do so and there is investor appetite. Lengthening the term of funding can be beneficial for ADIs as longer-term funding more closely aligns the maturity profile of an ADI's liabilities with the maturity profile of an ADI's assets (that is, loans). Further, any shift towards long-term funding has stability benefits for the Australian banking system and will assist ADIs to meet the international regulatory reforms to bank liquidity requirements.

1.14 Finally, covered bonds are typically structured with repayment of the principal at the maturity date (that is, a bullet security). In contrast, securitisation vehicles like RMBS typically have the principal repaid in instalments over time (in line with repayment of the underlying assets which can be uncertain). This makes covered bonds potentially more attractive to investors such as superannuation funds seeking more predictable returns relative to some securitisation products.

Summary of new law

1.15 The following provides a summary of the covered bond framework set out in this Bill.

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ADIs issuing covered bonds : ADIs are able to issue covered bonds subject to complying with the requirements of this Bill.

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Cap on covered bond issuance : The issuance of covered bonds by an ADI is limited by a cap placed on the value of assets contributed by an ADI to the cover pool of assets. This cap is set at 8 per cent of an ADI's assets in Australia. This cap prevents covered bondholders having a claim over more than 8 per cent of an ADI's assets in Australia at the point of issuance of covered bonds. In effect, this cap limits the subordination of unsecured creditors such as depositors arising from the preferred claim on assets securing the ADI's liabilities to covered bondholders.

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Ring-fencing the cover pool of assets : The cover pool of assets providing security to covered bondholders and service providers needs to be held by a covered bond special purpose vehicle. The covered bond special purpose vehicle beneficially owns the cover pool assets. .

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Australian Prudential Regulation Authority's powers : The Australian Prudential Regulation Authority (APRA) has the power to restrict the issuance of covered bonds where, inter alia, the ADI has not complied with the covered bond legislation. APRA has no direction making powers over assets held by the special purpose vehicle for the benefit of covered bondholders and service providers. However, APRA has a power to provide a direction in respect of assets held by the covered bond special purpose vehicle which are not for the benefit of covered bondholders and service providers.

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Eligible assets : The eligible assets which can be included in the cover pool are specified in this Bill. These assets are essentially high quality assets (such as residential mortgages).

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Maintenance of the cover pool : The ADI is required to maintain the cover pool of assets so that the value of these assets is sufficient to meet 103 per cent of the face value of the outstanding covered bonds. This may involve the ADI transferring additional assets to the cover pool and/or replacing assets in the cover pool over time. APRA has the power to prevent an ADI maintaining the cover pool in particular circumstances, such as the ADI being in financial difficulties.

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Cover pool monitor : The ADI issuing the covered bonds is required to appoint a cover pool monitor. The functions of the cover pool monitor include assessing the maintenance of a register of assets in the cover pool and the ADI's compliance with maintaining the value of the cover pool. The cover pool monitor is also required to report on the status of the cover pool every six months.

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Winding up the cover pool : In the event of resolving a failing ADI, an ADI statutory manager or external administrator has no powers over assets held by the covered special purpose vehicle for the benefit of covered bondholders and service providers apart from pursuing any of the ADI's contractual claims on the covered bond special purpose vehicle. This supports the principle that the resolution process relating to a failing ADI and the resolution process relating to the covered bond special purpose vehicle should be separate from each other.

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Arrangements involving several ADIs : This Bill allows a group of ADIs to enter into an arrangement to facilitate the issuing of covered bonds.

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Prudential standards : APRA is able to set prudential standards with respect to the issuance of covered bonds by ADIs. Further, this Bill provides guidance to APRA in setting these prudential standards. In particular, assets in the cover pool are to be treated as assets of the ADI provided that assets in the cover pool are no more than 8 per cent of the ADI's assets in Australia. APRA may impose different (more stringent) prudential requirements on any assets over the 8 per cent cap.

Detailed explanation of new law

1.16 Schedule 1 of this Bill amends the Banking Act 1959 to allow ADIs to issue covered bonds and establishes a regulatory framework for covered bonds issued by ADIs.

Coverage of covered bond legislation

1.17 This Bill applies to ADIs regulated by APRA. However, this Bill does not apply to foreign ADIs [ Schedule 1, item 22, paragraph 25(a )]. In essence, a foreign ADI is a foreign owned bank incorporated overseas which has been granted an authority to carry on banking business in Australia but is not permitted to accept retail deposits (currently set at amounts less than $250,000) from individuals and non-corporate institutions. A foreign ADI is not subject to the depositor preference provisions (that is, Division 2) of the Banking Act 1959 . A foreign owned bank incorporated in Australia is an ADI as defined in the Banking Act 1959 , and is permitted to accept retail deposits in Australia from individuals and non-corporate institutions and is therefore subject to the requirements set out in this Bill.

1.18 In addition, this Bill does not apply to covered bonds issued by ADIs which are secured wholly by assets which are not assets in Australia [ Schedule 1, item 22, paragraph 25(b )]. That is, it does not apply to a foreign branch of an ADI which issues covered bonds secured entirely by foreign assets.

Definitions

1.19 In this Bill, the term a 'covered bond' is defined as a bond, note or debenture issued by an ADI where the liabilities to the covered bondholders (that is, payment of principal and interest) are:

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recoverable from the ADI issuing the covered bonds; and

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secured by assets beneficially owned by a covered bond special purpose vehicle.

[ Schedule 1, item 1, subsection 5(1 ) and item 22, subsection 26(1 )]

1.20 The term 'covered bond special purpose vehicle' is defined in terms that its purpose must relate only to covered bonds [ Schedule 1, item 4, subsection 5(1 ) and item 22, subsection 26(2 )]. This Bill does not specify the legal form of the covered bond special purpose vehicle, so it can be a trust or a company. In essence, the covered bond special purpose vehicle would only hold assets linked in some way to an ADI issuing covered bonds.

1.21 The covered bond special purpose vehicle beneficially owning a pool of assets supports the key principle underpinning a covered bond. That is, there is a clearly identifiable pool of otherwise unencumbered assets which are solely devoted to meeting the claims of covered bondholders. In the event of insolvency of the ADI, this pool of assets is available to meet the claims of covered bondholders. In practice, this means that the covered bond special purpose vehicle is bankruptcy remote from the ADI issuing the covered bonds.

1.22 The covered bond special purpose vehicle may hold assets for a range of purposes relating to the issue of covered bonds. This includes assets securing liabilities to covered bondholders, service providers, derivative counterparties and the issuing ADI.

1.23 The covered bond special purpose vehicle could also hold trust back assets (that is, assets held by the covered bond special purpose vehicle on trust for the ADI). Trust back assets are not held by the covered bond special purpose vehicle for the benefit of covered bondholders and service providers, but they are held by the covered bond special purpose vehicle on trust for the ADI for administrative reasons. . This is because trust back assets relate to an asset held for the benefit of covered bondholders and service providers. For example, a mortgage over a house may support loans other than just a housing loan provided as security for covered bondholders. To ease administration of application of the mortgage security, the interest in the mortgage is transferred to the covered bond special purpose vehicle and provides security for both the housing loan which provides security to covered bondholders and the other loans which do not providing security to covered bondholders. The loans which do not provide security to covered bondholders may also be transferred to the covered bond special purpose vehicle for administrative reasons.

1.24 The term 'cover pool' is defined as assets beneficially owned by the covered bond special purpose vehicle to the extent that those assets secure liabilities to covered bondholders equally or in priority to other liabilities [ Schedule 1, item 3, subsection 5(1 ) and item 22, subsection 26(3 )]. The reference in subsection 26(3) to 'other liabilities' could mean liabilities of either the ADI or the covered bond special purpose vehicle. In other words, the cover pool of assets comprises those assets securing the covered bond special purpose vehicle's liabilities to covered bondholders and assets securing other liabilities of the covered bond special purpose vehicle or liabilities of the ADI which rank equal or below covered bondholders. Further, the cover pool does not include assets securing liabilities which rank ahead of liabilities to covered bondholders.

1.25 The cover pool of assets includes what the industry calls contractual over-collateralisation. Contractual over-collateralisation is where the ADI is required to ensure under the contractual arrangements that the value of assets in the cover pool secured for the benefit of covered bondholders exceeds their claim by a particular amount. For example, the ADI may be contractually obliged to maintain assets equal to $110, while the liabilities of the covered bond SPV to covered bondholders total $100. The covered bondholders would have a claim over the additional assets ahead of the ADI, and consequently the value of the cover pool of assets typically exceeds the amount owed to covered bondholders. The commercial reason for providing over-collateralisation is to enhance the credit rating of the covered bond.

1.26 Another group of assets is what the industry calls voluntary over-collateralisation. Voluntary over-collateralisation is where the ADI voluntarily adds additional assets to the covered bond special purpose vehicle as a 'management buffer' to ensure that the cover pool of assets never falls below the contracted amount.

1.27 The cover pool of assets may or may not include assets securing liabilities relating to voluntary over-collateralisation, service providers of the ADI and covered bond special purpose vehicle (for example, the cover pool monitor), and derivative counterparties. This depends on where the liabilities relating to voluntary over-collateralisation, service providers and derivative counterparties rank relative to liabilities to covered bondholders.

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If assets securing liabilities relating to voluntary over-collateralisation, service providers and derivatives rank equally or behind covered bondholders, then these assets are in the cover pool.

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If assets securing liabilities relating to voluntary over-collateralisation, service providers and derivatives rank ahead of covered bondholders, then these assets are not in the cover pool, and are subject to application of subsection 13A(3) in the Banking Act 1959 which provides priority to most depositors in Australia.

1.28 The term 'covered bond liabilities' of the ADI issuing the covered bonds has two limbs. The first limb is that covered bond liabilities of the ADI are liabilities to covered bondholders and any other liabilities secured by assets beneficially owned by the covered bond special purpose vehicle [ Schedule 1, item 2, subsection 5(1 ) and item 22, subsection 26(4 )]. Other liabilities of the covered bond special purpose vehicle would include liabilities to services providers relating to the issue of covered bonds (such as the cover pool monitor and derivative counterparties), and liabilities to the ADI issuing the covered bonds (such as loans provided to the covered bond special purpose vehicle so it can acquire assets from the ADI). However, covered bond liabilities of the ADI does not capture trust back assets because these assets do not secure liabilities of the covered bond special purpose vehicle and because the covered bond special purpose vehicle does not beneficially own these assets.

1.29 The second limb of the definition of covered bond liabilities of the ADI excludes certain liabilities secured by assets held by the covered bond special purpose vehicle. In particular, covered bond liabilities of the ADI do not include liabilities of the covered bond special purpose vehicle to the ADI, excluding liabilities relating to derivatives and provision of services, which are secured by assets in priority to liabilities to covered bondholders [ Schedule 1, item 2, subsection 5(1 ) and item 22, subsection 26(5 )]. An example of a liability which could be excluded under the second limb of the definition of covered bond liabilities is voluntary over-collateralisation. In particular, a liability relating to voluntary over-collateralisation (referred to by the industry as the demand loan) is excluded from covered bond liabilities in the circumstance where the ADI has a claim over the assets securing this liability in priority to liabilities to covered bondholders.

Cover pool monitor

1.30 A cover pool monitor must be appointed for each cover pool [ Schedule 1, item 22, subsection 30(1 )]. The cover pool monitor must either:

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be registered as an auditor under Part 9.2 of the Corporations Act 2011 ;

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hold an Australian financial services licence issued under the Corporation Act 2001 covering provision of financial services as a cover pool monitor; or

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is exempt from holding an Australian financial services licence under the Corporations Act 2001 covering provision of financial services as a cover pool monitor.

[ Schedule 1, item 22, subsection 30(2 )]

1.31 The most relevant exemption from holding a Australian financial services licence is likely to be paragraph 911A(2)(h) of the Corporations Act 2001 . This paragraph provides an exemption for an entity where the entity is regulated in a foreign jurisdiction, obtains written approval from ASIC and the services being provided are to wholesale investors.

1.32 This Bill specifies that the ADI issuing the covered bonds cannot be the cover pool monitor of its own cover pool. Further, the cover pool monitor cannot be an associated entity of the ADI issuing the covered bond [ Schedule 1, item 22, subsection 30(3 )]. The ADI issuing covered bonds is identified by the term 'issuing ADI', which links the ADI issuing the covered bonds with a particular cover pool and covered bond special purpose vehicle. [ Schedule 1, item 22, subsections 26(6 )]

1.33 The meaning of an associated entity is the meaning set out in section 50AAA of the Corporations Act 2001 . In essence, the cover pool monitor cannot be an entity controlled by the ADI issuing the covered bond. This is to ensure that the covered bond monitor is independent of the ADI issuing the covered bond. The independence of the cover pool monitor is important because the board or trustee of the covered bond special purpose vehicle is not required to be independent of the ADI. The cover pool monitor is likely to be a firm in the auditing business, or a firm with expertise in managing assets on behalf of investors.

1.34 In essence, the role of the covered bond monitor is to assess the issuing ADI's compliance with meeting its obligations, and to provide an opinion in respect this compliance. In particular, the cover pool monitor's role includes:

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assessing the keeping of an accurate register of the assets in the cover pool by either the issuing ADI or covered bond special purpose vehicle; and

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assessing the issuing ADI's compliance with the requirements in respect of the nature of the assets in the cover pool, and the value of the cover pool of assets.

[ Schedule 1, item 22, paragraphs 30(4 )( a)and ( b )]

1.35 These functions may be performed by the cover pool monitor with the aid of sampling methods in accordance with auditing standards made under the Corporations Act 2001 . [ Schedule 1, item 22, paragraph 30(7 )]

1.36 In addition, the cover pool monitor's role is to provide reports in relation to the above matters to the issuing ADI (or substitute entity), who in turn is required to make the reports available to covered bondholders or their representatives [ Schedule 1, item 22, paragraphs 30(4 )( c )]. This report is to be provided at least every six months [ Schedule 1, item 22, paragraphs 30(6 )]. This time period is consistent with what is proposed in the case of credit institutions in the United Kingdom issuing covered bonds. The cover pool monitor may be required to provide reports relating to the cover pool to APRA, should APRA make a request in writing. [ Schedule 1, item 22, paragraphs 30(4 )( d )]

1.37 The cover pool monitor is required to provide the issuing ADI and the relevant covered bond special purpose vehicle (such as the covered bond trustee in the event the covered bond special purpose vehicle is a trust) with any report it provides to APRA. [ Schedule 1, item 22, subsection 30(5 )]

1.38 A regulation-making power is provided to expand on the functions of the cover pool monitor. [ Schedule 1, item 22, paragraph 30(4 )( e )] There is nothing in the legislation that would prevent the cover pool monitor agreeing to take on additional responsibilities specified in contractual arrangements.

Structure of covered bonds involving one ADI

1.39 Reflecting the above requirements, the covered bond structure where the ADI issues the covered bond is illustrated in Diagram 1.2 (see next page).

1.40 Under this structure, the ADI issues the covered bond to investors and receives the proceeds of the covered bond sale from investors. The ADI makes the interest and principal payments to covered bondholders. The ADI is required to establish a covered bond special purpose vehicle. The ADI provides a loan to the covered bond special purpose vehicle so that this entity can purchase the assets supporting the issue of covered bonds from the ADI. The covered bond special purpose vehicle purchases and holds these assets for the benefit of the covered bondholders and other creditors of the covered bond special purpose vehicle. The ADI is required to appoint a cover pool monitor to oversee the assets held by the covered bond special purpose vehicle. The cover pool monitor is required to be independent of the ADI.

Covered bond arrangements involving several ADIs

1.41 A feature of covered bonds in offshore jurisdictions is their high credit rating. . This mainly stems from a high quality and diverse pool of cover assets, from large regular issues and the credit rating of the issuer. As a way to obtain these characteristics, smaller ADIs can pool their assets together in order to issue covered bonds. This has been done successfully in offshore jurisdictions. Providing a mechanism to do this could facilitate smaller ADIs issuing covered bonds into the Australian market in particular.

1.42 Consequently, this Bill provides a model for entering into arrangements involving several ADIs. This model involves the ADIs participating in the arrangement establishing a new entity, called the aggregating entity. This entity would not be an ADI, and would issue a debt instrument secured by covered bonds issued by each of the ADIs to the aggregating entity [ Schedule 1, item 22, subsection 27(1 )]. In essence, the aggregating entity aggregates the covered bonds issued by the ADIs participating in the arrangement. The ADIs participating in this arrangement would be subject to the same regulation applying to the case where there is only one ADI in the arrangement relating to issuing covered bonds.

1.43 This arrangement involving a number of ADIs establishing an aggregating entity is illustrated in the Diagram 1.3.

1.44 Regulations may prescribe other arrangements involving several ADIs to facilitate the issuing of covered bonds. [ Schedule 1, item 22, subsection 27(2 )]

Restriction on issuance of covered bonds

1.45 This Bill includes a regulatory cap on the amount of covered bonds an ADI can issue. This regulatory cap ensures that only a small proportion of an ADI's assets in Australia are included in a cover pool (or cover pools) for the benefit of covered bondholders in priority of the ADI's other creditors in Australia. Further, it limits the subordination of the ADI's unsecured creditors in Australia, including depositors. The regulatory cap on the issuance of covered bonds also reduces the likelihood that a levy on the banking industry would ever be required under the FCS.

1.46 This Bill specifies that the regulatory cap on the value of the cover pool of assets is set at 8 per cent of an ADI's assets in Australia [ Schedule 1, item 22, section 28 ]. The numerator in this calculation is the aggregate value of assets in all the cover pools the ADI has contributed to. As mention above, the numerator, that is, the cover pool, includes assets relating to contractual over-collateralisation.

1.47 The denominator in the calculation, that is, the value of assets in Australia, will need to be estimated at an appropriate point in time. APRA has the power to provide a prudential standard in respect of this matter.

1.48 The 8 per cent cap is tested immediately before the issuance of a new covered bond. That is, if issuing the new covered bonds results in the cap being exceeded, then the ADI is not permitted to issue those new covered bonds. This means that the regulatory cap is tested at a particular point in time rather than continuously through time. This approach to setting the regulatory cap provides ADIs with flexibility in managing their asset portfolio. Further, this approach does not prevent an ADI transferring assets to the cover pool after issuance of the covered bonds even if this transfer would cause the 8 per cent cap to be exceeded.

1.49 This Bill also specifies that APRA may direct an ADI not issue a covered bond [ Schedule 1, item 22, subsection 29(1 )]. The circumstances where this power could be used are where:

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APRA has reason to believe that the ADI has not complied with Division 3A of the Banking Act 1959 (which deals specifically with ADIs issuing covered bonds);

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APRA has reason to believe that the ADI has not complied with any other legislative requirements in the Banking Act 1959 , a prudential regulation or prudential standard in respect of issuing covered bonds; or

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APRA has issued the ADI a direction under section 11CA of the Banking Act 1959 .

[ Schedule 1, item 22, subsection 29(2 )]

1.50 APRA is required to provide any direction as a written notice to the ADI. This Bill indicates that this notice is not a legislative instrument [ Schedule 1, item 22, subsection 29(3 )]. Subsection 29(3) is included to clarify that this notice is not a legislative instrument within the meaning of section 5 of the Legislative Instruments Act 2003 . This approach is consistent with the approach used elsewhere in the Banking Act 1959 (for example, see section 13BA(3) and section 13E of the Banking Act 1959 ).

1.51 This Bill includes a number of provisions dealing with administrative matters in respect of APRA's directions-making powers relating to covered bonds. These provisions are the same as those provisions in section 11CA of the Banking Act 1959 which also deals with APRA's directions-making powers. These provisions include the following:

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The direction may deal with the time by which, or period during which, it is to be complied with [ Schedule 1, item 22, subsection 29(4 )].

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The ADI is required to comply with the direction despite anything in its constitution or any contract or arrangement to which it is a party [ Schedule 1, item 22, subsection 29(5 )].

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APRA may, by notice in writing to the ADI, vary the direction if, at the time of the variation, it considers that the variation is necessary and appropriate [ Schedule 1, item 22, subsection 29(6 )].

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The direction has effect until APRA revokes it by notice in writing to the ADI. APRA may revoke the direction if, at the time of revocation, it considers that the direction is no longer necessary or appropriate [ Schedule 1, item 22, subsection 29(7 )].

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APRA's decision to issue a direction in respect of covered bonds is subject to review by the Administrative Appeals Tribunal as set out in Part VI of the Banking Act 1959 [ Schedule 1, item 22, subsection 28(8 )].

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Information relating to directions and revocations of directions under this section is subject to the secrecy requirements in Part 6 of the Australian Prudential Regulation Authority Act 1998 , unless the information has been published in the Gazette under section 11CE of the Banking Act 1959 [ Schedule 1, item 22, subsection 29(9 )].

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The power for APRA to provide a direction in respect of covered bonds does not limit any other powers of APRA to give directions [ Schedule 1, item 22, subsection 29(10 )].

1.52 This Bill also makes a number of consequential amendments to the general provisions relating to APRA issuing directions to ensure that these provisions also apply to any direction issued by APRA in respect of covered bonds. These amendments include a reference in the relevant places to the new section 29 in the Banking Act 1959 . [ Schedule 1, items 6 , 10 to 17, 20 , 21 and 23, subparagraph 9A(2 )( a )( ii ), subsections 11CD(1A ), subsection 11CD(2 ), subsection 11CD(3 ), subsections 11CE(1 ) and ( 2 ), paragraphs 11CE(3 )( a ) and ( b ), subsections 11CE(4 ), paragraphs 11CG(1 )( b ) and ( 2 )( a ), subsection 11CG(2A ), paragraph 14B(1 )( a ), subparagraph 16BA(6 )( a )( iii ) and subparagraph 62A(1B )( a )( ii )]

Eligible assets that can be included in cover pools

1.53 This Bill specifies the types of assets which can be included in the cover pool. The reason for doing this is that the assets in the cover pool need to be of sufficient quality to give investors confidence in the timely payment of claims attaching to the covered bond in the event the ADI issuing the covered bonds fails. That is, regulation of the assets eligible to be included in the cover pool provides increased certainty and confidence to investors, and assists in obtaining the highest possible credit ratings. The approach adopted in this Bill is consistent with the approach adopted in other countries.

1.54 Eligible assets which can be included in the cover pool include:

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an at call deposit held with an ADI and convertible into cash within 2 business days;

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bank accepted bills or certificates of deposit not issued by the ADI issuing the covered bonds that are eligible for repurchase transactions with the Reserve Bank and mature within 100 days;

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a government debt instrument issued by the Commonwealth, a State or a Territory;

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a loan secured by a residential property;

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a loan secured by a commercial property;

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a contractual right relating to the holding or management of another asset in the cover pool (for example, a mortgage insurance policy and a right for compensation in the event the ADI does not meet any of its contractual obligations in respect to managing the assets in the cover pool); and

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a derivative (within the meaning of section 761D of the Corporations Act 2011 ) used for the purposes of protecting the value of another asset in the cover pool, hedging risks in relation to another asset in the cover pool and liabilities secured by assets in the cover pool.

[ Schedule 1, item 22, paragraphs 31(1 )( a ) to ( h )]

1.55 This Bill includes a regulation making power to add other assets to this list [ Schedule 1, item 22, paragraph 31(1 )( i )]. This regulation making power is not limited by the kind of assets listed in this Bill (as set out above) [ Schedule 1, item 22, subsection 31(2 )]. Further, this Bill includes a regulation making power to remove assets from the list. [ Schedule 1, item 22, subsection 31(3 )]

1.56 One of the functions of the cover pool monitor is to assess the ADI's compliance with this requirement [ Schedule 1, item 22, paragraph 30(4 )( b )]. APRA also has the power to request reports in respect of assets held in the cover pool. [ Schedule 1, item 22, paragraph 30(4 )( d )]

Maintenance of the cover pool

1.57 One of the key requirements of a covered bond is that the ADI issuing the covered bond has an ongoing obligation to maintain the value of assets in the cover pool. Many countries set a legislative minimum level of over-collateralisation to provide comfort to investors that there will be sufficient assets in the cover pool to meet the claims of covered bondholders.

1.58 Accordingly, this Bill specifies that the value of assets in a cover pool must be at all times at least equal to 103 per cent of the face value of covered bonds secured by that cover pool. Over-collateralisation of 3 percentage points is broadly similar to the minimum benchmark set in a number of European countries. The minimum amount of 103 per cent can be changed by regulation. [ Schedule 1, item 22, subsection 31A(1 )]

1.59 The implication of the requirement to maintain the value of the cover pool of assets is that the issuing ADI may be required to transfer additional assets to the cover pool and/or replace existing assets in the cover pool with new assets to ensure compliance with this requirement.

1.60 This Bill specifies that the ADI cannot comply with the requirement to maintain the cover pool in circumstances where APRA has issued the ADI a direction under the Banking Act 1959 [ Schedule 1, item 22, subsection 31A(5 )]. This direction would prevent the ADI transferring additional assets to the cover pool and/or replacing existing assets in the cover pool with new assets.

1.61 This is given effect by making a minor amending subsection 11CA(2) of the Banking Act 1959 . This subsection specifies the kind of directions APRA may give in respect of an ADI, an authorised non-operating holding company and any of their subsidiaries. The amendment adds the words 'or asset' to paragraph 11CA(2)(n) of the Banking Act 1959 . This has the effect that APRA may direct an ADI not to transfer any amount or asset to a cover pool held by a covered bond special purpose vehicle [ Schedule 1, item 7, paragraph 11CA(2 )( na ))]. A consequential amendment subsection 11CA(2) to ensure consistency with the amendment to paragraph 11CA(2)(n). [ Schedule 1, item 8, subsection 11CA(2 )]

1.62 Subsections 11CA(1) and (1AA) of the Banking Act 1959 sets out the circumstances where APRA may issue a direction of this kind. These circumstances include when APRA has reason to believe that, inter alia, the ADI is unable to meet its liabilities, there has been a material deterioration in the ADI's financial condition, the ADI is conducting its affairs in an improper or financially unsound way, the failure to issue a direction would materially prejudice the interests of the ADI's depositors, and the ADI is conducting its affairs in a way that may cause or promote instability of the Australian financial system. This suggests that if APRA were to issue a direction preventing the ADI from maintaining the cover pool, then the ADI is likely to have been issued other directions about its affairs because of concerns about its ongoing viability.

1.63 For the purposes of calculating the value of the assets in the cover pool, a maximum limit is placed on the value of loans secured by residential and commercial property. In particular, if the sum of the outstanding principal amount of the loan secured by a residential property and the outstanding principal amount of any equal or prior ranking loans is greater than 80 per cent of the value of the residential property, then this loan is included in the cover pool with a value of 80 per cent [ Schedule 1, item 22, subsection 31A(3 )]. For example, assuming the value of the outstanding principal amount of a loan secured by a residential property is $85,000, and there is no prior ranking loans and the value of the residential property is $100,000, then the value of the loan for the purposes of subsection 31A(1) is $80,000. The value of the property for this test is determined by reference to the most recent valuation of the property. .

1.64 A similar test applies to loans secured by a commercial property. The only difference is that the limit is set at 60 per cent of the value of the commercial property. [ Schedule 1, item 22, subsection 31A(4 )]

1.65 The 80 per cent and 60 per cent limit for residential and commercial property respectively is comparable to the limits set in many other jurisdictions. The Bill contains a regulation making power to change this limit. [ Schedule 1, item 22, subsections 31A(3 ) and ( 4 )]

1.66 This Bill specifies that the ADI must ensure that the value of bank accepted bills and certificates of deposits in the cover pool is no greater than 15 per cent of the value of all assets in the cover pool [ Schedule 1, item 22, subsection 31A(2 )]. This requirement applies continuously through time. This ensures that the cover pool is mainly comprised of loans made by the ADI. This requirement is also consistent with the practice in Europe.

1.67 However, the 15 per cent limit on the value of bank accepted bills and certificates of deposits does not apply in particular circumstances. These circumstances include where compliance would be inconsistent with the need to deal with an asset to satisfy a call on the security in relation to a covered bond (such as winding up the cover pool). [ Schedule 1, item 22, subsection 31A(6 )]

1.68 This Bill does not specify a maximum level of over-collateralisation. This provides maximum flexibility for ADIs to determine the level of over-collateralisation based on their particular commercial considerations. However, as mentioned above, any contractual over-collateralisation, which would include the legislative minimum over-collateralisation of 3 per cent, counts towards the 8 per cent cap on the issuance of covered bonds.

APRA's powers in respect of the cover pool

1.69 As mentioned above, subsections 11CA(1) and (1AA) of the Banking Act 1959 sets out the circumstances where APRA may issue a direction to an ADI. In addition, subsection 11CA(2) of the Banking Act 1959 specifies the kind of directions APRA may give in respect of an ADI, an authorised non-operation holding company and any of their subsidiaries. This means that APRA may have the power to issue directions in respect of assets in the cover pool held by a covered bond special purpose vehicle (which could be a subsidiary of an ADI).

1.70 However, this Bill specifies that APRA must not direct, or give a direction, that would cause the covered bond special purpose vehicle to make a payment or not make a payment, or to deal or not deal in an asset which secures covered bond liabilities of the ADI. [ Schedule 1, item 9, subsection 11CA(2AA )]

1.71 As mentioned above, the covered bond special purpose vehicle may have liabilities to the ADI (other than liabilities relating to derivatives or the provision of services) secured by assets which rank ahead of the covered bond special purpose vehicle's other liabilities. An example of these assets could be voluntary over-collateralisation. Also, as mentioned above, the covered bond special purpose vehicle may hold assets on trust for the ADI (known as trust back assets). Consequently, assets relating to voluntary over-collateralisation and trust back assets could be returned to the ADI for the benefit of the ADIs depositors and other non-secured creditors. However, APRA's direction making powers set out in Division 1BA of the Banking Act 1959 may not apply to the covered bond special purpose vehicle.

1.72 Accordingly, this Bill specifies that APRA may direct a covered bond special purpose vehicle to return assets to the issuing ADI to the extent that such assets are not securing covered bond liabilities (that is, assets relating to voluntary over-collateralisation and trust back assets) [ Schedule 1, item 22, subsection 31F(1 )]. The circumstances where such a direction can be made is limited to the circumstances set out in subsection 11CA(1) of the Banking Act 1959 . [ Schedule 1, item 22, subsection 31F(2 )]

1.73 APRA is required to provide any direction as a written notice to the ADI. This Bill indicates that this notice is not a legislative instrument [ Schedule 1, item 22, subsection 31F(3 )]. Subsection 31F(3) is included to clarify that this notice is not a legislative instrument within the meaning of section 5 of the Legislative Instruments Act 2003 . This approach is consistent with the approach used elsewhere in the Banking Act 1959 (for example, see section 13BA(3) and section 13E of the Banking Act 1959 ).

1.74 The penalty if the covered bond special purpose vehicle does not comply with any direction issued by APRA is the same penalty that would apply to an ADI not complying with a direction as set out in section 11CG of the Banking Act 1959 . [ Schedule 1, item 22, subsection 31F(11 )].

1.75 This Bill includes a number of provisions dealing with administrative matters in respect of APRA's directions-making powers relating to covered bonds. These provisions are the same as those provisions in section 11CA of the Banking Act 1959 which also deals with APRA's directions-making powers. These provisions include the following:

•

The direction may deal with the time by which, or period during which, it is to be complied with [ Schedule 1, item 22, subsection 31F(4 )].

•

The ADI is required to comply with the direction despite anything in its constitution or any contract or arrangement to which it is a party [ Schedule 1, item 22, subsection 31F(5 )].

•

APRA may, by notice in writing to the ADI, vary the direction if, at the time of the variation, it considers that the variation is necessary and appropriate [ Schedule 1, item 22, subsection 31F(6 )].

•

The direction has effect until APRA revokes it by notice in writing to the ADI. APRA may revoke the direction if, at the time of revocation, it considers that the direction is no longer necessary or appropriate [ Schedule 1, item 22, subsection 31F(7 )].

•

APRA's decision to issue a direction in respect of covered bonds is subject to review by the Administrative Appeals Tribunal as set out in Part VI of the Banking Act 1959 [ Schedule 1, item 22, subsection 31F(8 )].

•

Information relating to directions and revocations of directions under this section is subject to the secrecy requirements in Part 6 of the Australian Prudential Regulation Authority Act 1998 , unless the information has been published in the Gazette under section 11CE of the Banking Act 1959 [ Schedule 1, item 22, subsection 31F(9 )].

•

The power for APRA to provide a direction in respect of covered bonds does not limit any other powers of APRA to give directions [ Schedule 1, item 22, subsection 31F(10 )]. .

•

If a direction is given under subsection 31F(1), the Banking Act 1959 applies in relation to this direction as if the covered bond special purpose vehicle were an ADI, and the direction were given under section 29 of the Banking Act 1959 [ Schedule 1, item 22, subsection 31F(11 )]. This ensures that the general provisions relating to APRA issuing directions also apply to any direction issued under subsection 31F(1). An example is that APRA may publish in the Gazette notice of any direction provided to the covered bond special purpose vehicle under subsection 11CE(1) of the Banking Act 1959 .

Winding-up the cover pool

1.76 A key principle is that a resolution process relating to a failing ADI, and the resolution process relating to the covered bond special purpose vehicle, should be separate from each other. This is given effect by specifying that an ADI statutory manager or an external administrator has no powers (apart from contractual powers) in relation to assets held by the covered bond special purpose vehicle to the extent that those assets secure cover bond liabilities. [ Schedule 1, item 22, section 31C ]

1.77 One implication of this limitation is that in the event an ADI statutory manager or an external administrator is appointed to an ADI that has issued covered bonds, the covered bondholders or their representative may wish to appoint an administrator to the covered bond special purpose vehicle. This may lead, in the event of the ADI not making payments due to covered bondholders, to the wind-up of the covered bond special purpose vehicle with covered bondholders seeking repayment through sale of assets held in the cover pool.

1.78 Alternatively, upon the appointment of an ADI statutory manager or external administrator to the ADI, and cessation of payments by the ADI of amounts due on the covered bondholders, covered bondholders may choose not to wind-up the covered bond special purpose vehicle. Instead, covered bondholders may elect, as an alternative to the immediate sale of assets held in the cover pool, to receive the interest and principal payments relating to the covered bonds sourced from the covered bond special purpose vehicle. Under this scenario, the cover pool of assets provides the source of funds for such payments to covered bondholders.

Depositor preference provisions and assets test

1.79 The current preference provisions set out in subsection 13A(3) in the Banking Act 1959 currently impede ADIs issuing secured debt, such as covered bonds. This follows since this subsection requires that liabilities in respect of protected account holders in Australia (which include most depositors in Australia) rank ahead of secured and other unsecured creditors in the distribution of a failed ADI's assets in Australia.

1.80 This Bill specifies that the assets of the ADI for the purposes of subsection 13A(3) of the Banking Act 1959 do not include any interest in an asset (or part of an asset) in a cover pool of the issuing ADI [ Schedule 1, item 18, subsection 13A(3A )]. This is because such assets are first available to meet the claims of covered bondholders and, consequently, are not available to meet the claims of creditors listed in subsection 13A(3) in the event an ADI is unable to meet its obligations or suspends payment. However, as mentioned above, most depositors will continue to be protected by the FCS. The FCS ensures (currently and once the cap is changed) that 99 per cent of Australian deposit accounts are protected in full. This amendment has no implications for the treatment of securitisation transactions such as RMBS, or any implications for any other security arrangements which an ADI may grant.

1.81 It is noted that the loans provided by the ADI to the covered bond special purpose vehicle to fund the acquisition of assets from the ADI would constitute assets in Australia for purposes of section 13A(3). The value of such assets would represent the amount repayable to the ADI in the event the covered bond special purpose vehicle is wound-up.

1.82 If the ADI is unable to meet its contractual terms relating to the issue of the covered bonds such as being unable to meet interest and principal payments to the covered bondholders, then covered bondholders would make a claim on the cover pool of assets held by the covered bond special purpose vehicle. If this occurs, and in the event the cover pool of assets is insufficient to meet the claims of covered bondholders and service providers, any residual claim of covered bondholders and service providers on the ADI would rank below most depositors and claims by government (see paragraph 13A(3)(f) of the Banking Act 1959 ). This outcome arises without making any amendments to subsection 13A(3) of the Banking Act 1959 .

1.83 Subsection 13A(4) of the Banking Act 1959 requires the ADI to hold assets in Australia with a value equal to or greater than the amount of its deposit liabilities in Australia. To ensure that issuing covered bonds has no impact on this requirement, this Bill specifies that for the purposes of subsection 13A(4):

•

the ADI's deposit liabilities are taken not to include an amount equal to the total face values of covered bonds issued by an ADI; and

•

the assets of the ADI do not include:

-

any interest in assets (or part of an asset) in the cover pool of an issuing ADI; or

-

any loan from the ADI to a covered bond special purpose vehicle that relates to assets (or part of an asset) in a cover pool of the issuing ADI.

[ Schedule 1, item 19, subsection 13A(4A )]

1.84 The amendment indicating that the ADI's deposit liabilities are taken not to include an amount equal to the total face values of covered bonds issued by an ADI is included for clarity reasons given the term 'deposit liabilities' is not a defined term in the Banking Act 1959 .

1.85 The amendment excluding an interest in assets (or part of an asset) in a cover pool of issuing ADI makes it clear that no interest in such assets can be included in an ADIs assets in Australia as they are not available to meet deposit liabilities in Australia. Any loan (or part of a loan) from the ADI to a covered bond special purpose vehicle funding a covered bond special purpose vehicle's holdings of such assets is similarly excluded from the ADIs assets in Australia as such loans again do not represent assets which would necessarily be available to meet deposit liabilities in Australia.

1.86 Similar to the new subsection 13A(3A), the new subsection 13A(4A) has no implications for the treatment of securitisation transactions such as RMBS, or any implications for any other security arrangements which an ADI may grant.

Protection of certain contractual rights

1.87 Subsection 11CD(1A) of the Banking Act 1959 indicates that in the event APRA issues a direction, this does not allow the contract, or a party to a contract (other than the ADI or a subsidiary) to deny obligations under the contract, accelerate any debt under a contract or close out any transaction relating to the contract. This is to enable APRA to implement corrective measures aimed at securing the continued prudent operation of an ADI without triggering a potential demand for repayment of all its debts.

1.88 Further, section 15C indicates that in the event an ADI statutory manager is in control of an ADI, this does allow the contract, or a party to the contract, to deny obligations under the contract, accelerate any debt under a contract or close out any transaction relating to the contract. This enables the statutory manager to determine whether an affected ADI could be reconstructed without winding up an ADI.

1.89 In essence, these two subsections seek to prevent the acceleration of claims on an ADI because of the issuance of a direction or appointment of a statutory manager when such actions need not necessarily prevent or impede any obligations being met as they fall due. However, they could prevent covered bondholders accelerating their claim against the covered bond special purpose vehicle in circumstances where APRA has issued an ADI a direction not to make payments to covered bondholders, or where an ADI statutory manager prevents the ADI making payments to covered bondholders.

1.90 Consequently, this Bill specifies that subsection 11CD(1A) of the Banking Act 1959 does not apply if the ADI has failed to make payments to the holders or representatives that it would have been required to make if a the direction under subdivision A or B of Division 1BA or section 27 had not been given [ Schedule 1, item 22, subsection 31B(1 )]. In these circumstances, covered bondholders or their representatives could invoke acceleration against assets in the cover pool.

1.91 Similarly, this Bill specifies that subsection 15C(2) does not apply if the ADI has failed to make payments to the holders or representatives that it would have been required to make if the ADI statutory manager was not in control of the business of the ADI [ Schedule 1, item 22, subsection 31B(2 )]. That is, the appointment of a statutory manager by itself does not permit a covered bondholder to accelerate debt and claim security but will permit this to occur should the statutory manager prevent the ADI meeting its payment obligations to the covered bondholders. In these circumstances, the covered bondholders could also invoke acceleration against assets in the cover pool including the exercise of their security interest in those assets.

Prudential standards relating to covered bonds

1.92 Under Division 1A of the Banking Act 1959 , APRA may issue prudential standards (as defined in section 11AF of the Banking Act 1959 ) relating to an ADI issuing covered bonds. This Bill specifies that APRA may provide prudential standards on any matters relating to covered bonds including:

•

the issuing of covered bonds;

•

assets in cover pools; and

•

maintenance of cover pools.

[ Schedule 1, item 22, subsection 31E(1 )]

1.93 A prudential standard relating to these matters may require the ADI and the covered bond special purpose vehicle or vehicles to collectively satisfy particular prudential requirements. [ Schedule 1, item 22, paragraph 31E(2 )( a )]

1.94 The powers set out in the Banking Act 1959 in relation to existing prudential standards would apply in relation to prudential standards dealing with covered bonds as set out in subsection 31E(1). This result arises because subsection 31E(1) refers to the term 'prudential standard' which is defined in subsection 5(1) of the Banking Act 1959 . The definition indicates that a prudential standard means a standard under section 11AF of the Banking Act 1959 . Consequently, all of the requirements relating to prudential standards set out in section 11AF would apply to a prudential standard relating to matters set out in subsection 31E(1).

1.95 As mentioned above, this Bill does not apply to either foreign ADIs issuing covered bonds, or an ADI issuing covered bonds secured entirely by foreign assets. This Bill does not restrict APRA's authority to make prudential standards in relation to such ADIs.

1.96 This Bill also provides direction to APRA in setting prudential standards in respect of the assets and liabilities associated with issuing covered bonds. In particular, for the purposes of applying the prudential standards, the assets in the cover pool are to be treated as the ADI's assets, provided that the value of the cover pool (or pools) does not exceed 8 per cent of the ADI's assets in Australia [ Schedule 1, item 22, subsection 31D(1 ) and ( 2 )]. This 8 per cent benchmark, which can be amended by regulation, is the cap on the issuance of covered bonds. The 8 per cent benchmark for prudential standards purposes applies continuously through time rather than at a particular point in time. Consequently, any additional assets which an ADI may be required to sell to the covered bond special vehicle special and allocate to the cover pool after the initial issuance of covered bonds are captured.

1.97 In addition, for the purposes of prudential standards, any liability of the ADI to the special purpose vehicle that relates to an asset, or part of an asset, which is treated as an asset of the ADI is disregarded [ Schedule 1, item 22, subsection 31D(3 )]. An example of such a liability could be a derivative between the ADI and the covered bond special purpose vehicle.

1.98 Similarly, for the purposes of prudential standards, any liability of the covered bond special purpose vehicle to an ADI that relates to an asset, or part of an asset, which is treated as an asset of the ADI is disregarded [ Schedule 1, item 22, subsection 31D(4 )]. An example of such a liability is the loan provided by the ADI to the covered bond special purpose vehicle to fund the acquisition of assets in the cover pool from the ADI. Such a loan can be apportioned between that component which relates to assets treated as assets of the ADI for prudential purposes and that component which relates to assets not treated as assets of the ADI for prudential purposes.

1.99 APRA retains the right to impose a different treatment in prudential standards in respect of any assets in the cover pools in excess of 8 per cent of the ADIs assets in Australia [ Schedule 1, item 22, paragraph 31E(2 )( b )]. This may include treating amounts of assets in the cover pool over the 8 per cent limit in a similar way as over-collateralisation in a securitisation transaction which may be required to be deducted from the ADI's capital.

1.100 Further, APRA retains the right to impose prudential standards in respect of any liability of the ADI to a covered bond special purpose vehicle that relates to an asset, or a part of an asset, that is not treated as an asset of the ADI, that are different from disregarding the liability as specified in subsection 31D(3) [ Schedule 1, item 22, paragraph 31E(2 )( c )]. Similarly, APRA also retains the right to impose prudential standards in respect of any liability of a covered bond special purpose vehicle to the ADI that relates to an asset, or a part of an asset, that is not treated as an asset of the ADI, and to impose in prudential standards requirements that are different from disregarding the liability as specified in subsection 31D(4) [ Schedule 1, item 22, paragraph 31E(2 )( d )]. For example, APRA may require such a liability to be recognised as a subordinated loan in the accounts of the ADI and subject to a penal capital treatment.

Application and transitional provisions

1.101 The commencement date is the date of Royal Assent of this Bill [ Item 2, commencement ]. There are no transitional provisions.