Stronger Framework Would Help China Covered Bonds Develop, Says Fitch

Covered bond issuance could expand funding options for banks in China, but Fitch Ratings believes the country still lacks specific regulation that would help covered bonds out of China appeal to a wider pool of investors.

Strong mechanisms for asset segregation, protection against foreign-exchange risks for cross-border issuance and granular cover pools would strengthen the framework and support the development of the market.

Chinese commercial banks have a deep and diverse pool of financial assets, some of which are now being securitized to generate funding. Securities backed by mortgages and automotive loans have already attracted international investors.

China's covered bond market is still in a very early stage of development, but Fitch believes it could become the largest in Asia if it is able to meet investor expectations, which include the use of a standardized legal regime or covered bond regulation that is supported by regulators and commercial banks.

The priority ranking of covered bond holders is supported in all countries that have dedicated covered bonds legislation, ensuring that the security over the cover pool can be enforced when the issuer is unable to meet repayments. This type of legal framework does not yet exist in China.

In China, there is a risk that assets held by financial institutions could be subject to a moratorium, and beneficiaries of assets held as security could be subordinated to depositors and other creditors in the bankruptcy process.

Broadly effective segregation of cover assets will also be important, whether it is achieved through an exemption to bankruptcy laws or through a transfer of the assets to a special purpose vehicle (SPV). Ring-fencing mitigates set-off, commingling and claw-back risks, and protects covered bondholders from other creditors' claims.

In China, exemptions to bankruptcy laws have not yet been put in place for the benefit of covered bonds. However, securitizations rated by Fitch utilize the asset-owning SPV model. The same segregation method could be used for covered bonds out of China in the absence of a change to the bankruptcy law.

For cross-border issuance, international best practice would see cross-currency swaps used to mitigate currency mismatches between the foreign-currency-denominated covered bonds and the cover assets denominated in local currency. Fitch would not rate covered bonds above their issuer's long-term rating if the entire programme was unhedged, given the potential for extreme foreign-exchange volatility.

Finally, covered bonds rated by Fitch above their issuer ratings are generally secured by granular cover pools, where the assets are able to provide sustainable cash flows for covered bond payments.

In most established covered bond jurisdictions, cover assets are restricted to mortgage loans or public-sector exposures. This is because these are relatively homogeneous assets, originated in well-developed markets, and for which default and recovery performance can be tracked over a number of years. These assets usually comprise a large proportion of a bank's balance sheet and Fitch expects an issuer to maintain sufficient unencumbered assets to replenish the cover pool over time.

Some covered bond markets that did not initially have specific legislation in place, such as New Zealand, started issuing covered bonds based on contractual arrangements. However, no market has developed successfully without having domestic banking authorities involved in setting standards and monitoring programmes. We believe registration and oversight by regulators tend to make investors more comfortable with a debt instrument.



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