Korea Capital Market Institute

Introduction Covered bonds are debt instruments issued by financial institutions, mostly banks. They are secured by a pool of mortgage loans, public sector loans, and ship loans that satisfy certain criteria for investor protection. In general, there are two types of covered bonds: European-style covered bonds and structured covered bonds. European covered bonds provide bondholders with a priority claim on collateral assets (also called cover pool assets) to ensure legal protection. With structured covered bonds, an originator sells its assets to a special purpose vehicle (or a trust). Then, this special purpose vehicle(SPV) issues asset-backed securities (covered bonds) backed by a cover pool of the transferred assets, and guaranteed by the originator. In this structure, covered bond holders have dual recourse to the cover pool and the issuer. In addition, covered bonds have the following characteristics: a financial institution has the primary obligation to pay interest and principal on covered bonds; and high quality assets owned by a financial institution are used as collateral, which is a feature of a secured bond. Covered bonds provide investors with dual recourse, meaning that covered bondholders have priority rights over an issuer with strong creditworthiness and high quality collateral. Since covered bonds are backed by a financial institution’s high quality assets, those who hold deposit accounts and unsecured bonds issued by the issuer have claims inferior to covered bondholders. Covered bonds are strictly regulated in terms of issuance limits and cover pool assets in most countries that have introduced covered bonds. Covered bonds can have significant benefits for issuers, investors, and the economy as a whole. They enable a financial institution to raise funds at a lower cost because covered bonds usually receive a higher rating than the issuing institution. Meanwhile, covered bonds give bondholders priority recourse to assets in the cover pool in the event of bankruptcy. Thus, they provide investors with more choices and opportunities to invest in financial instruments with low credit risk. Furthermore, covered bonds also have advantages from a macroeconomic perspective and stabilize the financial market. Legislative and regulatory frameworks for covered bonds in the EU, US, and UK As of 2011, 27 countries in Europe and 5 countries in non-European regions have covered bond laws. Germany represents countries in which covered bonds are issued under a special legal framework. Denmark, Ireland, Austria, Finland, Luxembourg, and Spain also have covered bond legislation. Among countries where structured covered bonds are issued without special legislation, France and the United Kingdom recently enacted covered bond laws. The United States, Canada, and New Zealand are also working on special laws for covered bonds. Europe has seen a steady increase in covered bond issuance in recent years. Covered bond issuance in 2010 was €613.1 billion and covered bonds outstanding was €2.5 trillion. Even in 2008, covered bond issues in Europe reached €650.6 billion, up more than 40% from a year ago, despite the onset of the global financial crisis. By asset class, mortgage covered bonds took up the largest share (71.5%) of the total amount outstanding, followed by public sector covered bonds. Jumbo covered bonds are the most liquid segment of the covered bond market. Outstanding jumbo covered bonds stood at €1,265.1 billion at the end of 2010. Covered bonds have been a major source of funding for European banks because of lower funding costs and a stable investor base, which includes central banks. As for the United States, Senator Kay Hagan and his colleagues introduced the United States Covered Bond Act in the Senate in November 2011. This bill defines a covered bond, establishes a regulatory framework, and provides priority claims over the cover pool assets to investors. This enables the US to introduce covered bond legislation that is similar to Europe`s. In the meantime, the United Kingdom established a legal system for covered bonds in 2008 during the global financial crisis. Eligible covered bond issuers are deposit-taking institutions regulated by the Financial Services Authority, the UK financial regulator, and issuers should seek the FSA’s approval for covered bond issuance. And a cover pool of assets is required to be separated from an issuer’s own assets and be held by a SPV to make sure that covered bond investors have preferential claims on the cover assets. Korea and covered bonds During the global financial crisis, covered bonds were proposed in Korea as a solution to foreign currency liquidity problems in the banking sector. The Korean government pushed for comprehensive measures to induce a soft landing for household debts in 2011. These measures were introduced to increase long-term fixed-rate bank loans and support banks` long-term funding. To that end, financial regulators published best-practice guidelines for covered bond issuance by banks, thereby introducing a type of regulatory scheme for covered bonds. However, financial institutions are not able to issue European-style covered bonds because no legal grounds exist for giving priority claims over collateral to covered bond investors. If covered bonds are introduced in Korea, then they will bring several benefits to domestic financial institutions. One of the expected benefits is funding diversification, considering that covered bonds are debt securities backed by high quality assets held by financial institutions. Other benefits are better access to long-term funding and lower funding costs. The credit support of underlying collateral enables financial institutions to issue securities with higher credit ratings than their own credit rating. Thus, financial institutions can enjoy better access to long-term funding and lower funding costs. There are several approaches to establishing a legal and regulatory framework for covered bonds in Korea. First, mortgage covered bonds may be introduced through changes to the Banking Act. If the Banking Act is revised, it will be easy to build a regulatory framework for covered bond issuance. With this approach, however, non-bank financial institutions will not be able to issue covered bonds. The second approach is amending the Secured Bond Trust Act to specify eligible covered bond issuers and eligible asset classes, and strengthen protection for covered bondholders. If Korea takes this approach, it will end up having two different systems for general secured bonds and covered bonds. Lastly, Korea could enact special legislation for covered bonds that encompasses the definition of eligible issuers and eligible asset classes, oversight and supervision of issuers, and protection of bondholders in the event of an issuer`s default. This approach will provide Korea with a complete regulatory framework for covered bonds, but create the legislative burden of making a new law. Then, what is the desirable legal and regulatory framework for covered bonds in Korea? First, a wide range of financial institutions should be eligible to issue covered bonds. And the scope of eligible assets should be broadened to include diverse asset classes while at the same time introducing a monitoring system to manage the quality of cover pool assets. Regarding oversight and supervision, regulatory authorities need to regulate eligible assets, issuance procedures while putting an approval system and a disclosure system in place to keep the volume of covered bond issues at an optimal level. Furthermore, covered bond legislation must contain a special provision about priority rights granted to bondholders in the event of an issuer`s default, and specify the related procedure. Currently, Korean banks have little incentives to issue covered bonds because most of them have the highest credit rating (AAA). Nevertheless, if the volume of long-term fixed-rate residential mortgage loans originated by banks increases, banks are likely to issue covered bonds in order to manage risks in the fixed-rate mortgage segment. Generally, unsecured bonds rank behind covered bonds in terms of payment priority because covered bonds are backed by a bank`s high quality assets and give priority claims to bondholders. For that reason, unsecured bank bonds may lose popularity. On the other hand, non-bank financial institutions are expected to benefit from financing capital using their high quality assets when covered bonds are introduced in Korea. In the meantime, covered bonds will offer more choices to investors and increase the average maturity of bonds thanks to an increase in the supply of long-term bonds with higher ratings. And if the regulatory framework is well established, covered bonds will enhance financial stability over the long term.