I move: "That the Bill be now read a Second Time."
This Bill is an amending Bill, but it is a very important one which is urgently required in order to introduce some necessary technical changes to its parent Act, the Asset Covered Securities Act 2001. I might clarify at the outset for Deputies that the term "asset covered securities", or ACS, is a sort of Irish brand name for covered bonds issued under our legislative framework as set down by the 2001 Act.
The 2001 Act was a landmark piece of legislation for our internationally-focused financial services sector. It facilitated the establishment in Ireland of a robust legislative and regulatory basis for the issuance of covered bonds by Irish-based specialist banks. The ability to issue covered bonds is now a very important tool for banks' liquidity as it enables them to use some of their existing loans — currently restricted to residential mortgage loans and loans to public sector institutions under the 2001 Act — to raise new funding on a cost-efficient basis. This new funding can then be used for further lending operations by the banks.
This involves putting the relevant loans into a "cover assets pool" and then issuing bonds, that is, asset covered securities, against that pool. The loans in the pool serve as collateral backing for the bonds and the interest and principal repayments on those loans are used to meet the interest payments on the bonds and eventually to redeem them. Meanwhile, the funding raised from the bond issue can be used to make further loans.
This technique is not exactly a recent innovation. It originated in the form of the German Pfandbriefe model about 150 years ago. However, it was only over the past decade or so that other member states with developed financial services industries began facilitating this type of activity. This has, in part, been necessitated by the changing pattern of consumer saving. Up until relatively recent times, banks could rely on substantial savings and deposit accounts to help fund their lending programmes. However, with more and more savings now going directly into investment funds and pension schemes, it is important for banks to be able to draw on diversified sources of funding in order that the financial system can effectively support economic activity.
The term "asset backed securities", ABS, covers a very wide spectrum of financial products, but covered bonds are at the tightly-regulated and low-risk end of that spectrum. This refers to the fact that investors in our covered bonds have a preferential claim on the cover assets in the assets pool, the value of which invariably exceeds the value of the bonds outstanding.
The main features of this type of covered bond activity can be characterised as follows. First, the right to issue such bonds is governed by specific legislation — in Ireland's case, the Asset Covered Securities Act 2001. Second, the issuing credit institution is subject to special prudential and regulatory supervision. Third, the set of eligible cover assets is tightly restricted and set down in the legislation and must also meet certain credit quality requirements. Fourth, it is an "on balance sheet" activity, that is, the loans are not sold off to some special purpose vehicle, as with a securitisation operation. The loans remain on the balance sheet of the issuing bank and-or group. Also, the bondholders are equally-ranking, and, as I have mentioned before, they have priority claim on the relevant assets in the cover assets pool in the event of the default of the issuer. Finally, the cover assets pool must contain sufficient collateral assets to cover bondholders' claims throughout the whole term of the covered bonds.
I take it that it will be clear to Deputies from these details that the ACS sector is a very tightly controlled and carefully regulated one. In fact, it might even be described as micro-regulated, reflecting investors' preferences for a high-quality, low-risk investment product.
To complete this overview of the covered bonds landscape, I should explain that this activity takes place in the wholesale sector of the banking industry and that the bonds are not aimed at retail investors. Those who invest in these bonds are, for the most part, professional institutional investors such as pension funds, investment funds and banks, including even central banks. Those investors are located worldwide, so Irish covered bonds are now a global capital markets product. The attraction of these bonds is that they provide investors with access to a security that is supported by high quality assets over which the investors maintain a robust, preferential claim.
While our asset covered securities legislation was landmark financial services legislation, it was also pioneering. When originally introduced, there was no ready-made blueprint available for such legislation from another common law jurisdiction to guide in constructing a statutory framework for this type of financial activity. While the concept has been on the continent for 150 years in the form of German Pfandbriefe, from which our legislation drew inspiration, there were many areas where national discretion had to be exercised and carefully balanced judgment calls made.
Nevertheless, the legislative and regulatory framework developed in Ireland was widely regarded as a best practice regime and even an improvement in certain respects on those of some other long-established jurisdictions in this market. Some of the features pioneered by Ireland have been taken up by other countries when introducing new covered bonds systems or by others updating their existing covered bonds frameworks. The legislation has been a major success and has underpinned the development of Ireland as an international location for the covered bond issuance. Since the enactment of the 2001 Act, bonds to the value of over €60 billion have been issued under the framework. It is expected that further issues to the extent of approximately €10 billion may be made this year.
Asset covered securities are, therefore, a significant element of Ireland's success in international financial services activity. Total employment in Irish-based international financial services firms stands at more than 19,000. It is an important source of revenue for the Exchequer. The total yield of corporation tax from IFSC companies in 2006 was over €1 billion, according to the Revenue Commissioners, approximately 17% of total corporation tax. Our entry into the covered bonds niche sector has been a particular success for the IFSC regime, generating significant employment, incomes and tax revenue and creating an international profile for Ireland as an important centre for covered bond issuance. This amending Bill will build on our existing success and will help to ensure our ongoing competitive position in this highly competitive sector, thus underpinning existing employment and creating the opportunity for further growth and sustained competitive advantage.
As with any new prototype, even in a specialist area of financial services legislation, the day-to-day operation of the model inevitably brings to light some areas where the link between theory and practice requires some refinement over time. The Bill will provide greater legal clarity and will facilitate greater flexibility when operating certain provisions. Accordingly, it is necessary to make a number of technical changes to the 2001 Act.
The definition of "duration" in the 2001 Act required clarification which is being addressed by way of amendments in sections 20 and 35. The new definition is in line with standard industry practice. Members may have noted the plethora of amendments — over 20 — whereby the term "comprised" is substituted for the word "included". These all follow from section 2(n) which inserts a new definition of the term “include” into the 2001 Act. This definition is needed to make it clear that the insertion of an asset or contract into the cover assets pool does not mean the continued maintenance of that asset in that pool. This is because it is necessary to actively manage the assets in the pool on an ongoing basis. It is particularly important to reassure the counter-parties to a hedge contract that the hedge collateral held in the pool can be returned to them when the contract so requires.
There are also related consequential amendments affecting entries in the registers which are kept to record the assets in the cover assets pools. Another technical change relates to the use of derivatives in the cover assets pool. Derivatives, such as swaps, are used to hedge various risks such as currency risks, credit risks or interest rate risks. It is also being made clear to hedge counter-parties that the hedge collateral is protected for them in the event of the issuing bank's insolvency. This is ensured by holding the hedge collateral in the pool but as a separate asset category from the other assets in the pool. Without this amendment, the counter-parties to hedge contracts would be less willing to hand over collateral to back their hedge contracts if that collateral were not properly safeguarded for them while in the pool. Accordingly, the section 5(a) amendment provides important legal clarity to the 2001 Act.
While the initial urgency for this Bill arose from the need to achieve greater legal clarity for some provisions of the 2001 Act, such as some of those I have just outlined, other strategic considerations have since come into prominence. From 1 January 2007, the EU's capital requirements directive, CRD, came into force across the European Union giving legislative effect within the EU to the Basel 2 Agreement on the capital requirements for credit institutions. We now have a window of opportunity in exploiting some of the reforms introduced under the CRD. It is not just a question of aligning our regime with the provisions of the CRD so as to enhance our competitive advantage; it is also the case that if we do not align our asset covered securities framework quickly with the CRD's, our covered bonds may become less attractive as investment products for foreign banks and other entities which hold these bonds.
At the same time, by being an early mover in incorporating the CRD's reforms into our asset covered securities regime, we will undoubtedly gain some competitive advantage for those who issue those bonds under our legislative and regulatory framework. It could lead to more Irish financial institutions taking up this activity and encourage overseas issuers to locate in Ireland, with all the associated benefits for the economy with high quality jobs, tax revenue and the development of our international financial sector.
The modernisation to the asset covered securities framework prompted by the CRD includes the definition of "public credit". This is being modified to bring it in line with the CRD definition. New Zealand and Australia will be added to the existing list of non-EEA countries — Canada, Japan, the Swiss Confederation and the USA — whose assets may be included in a cover assets pool.
To reflect the developing nature of the asset covered security business, it is proposed to provide for the use of loans to highly-rated multilateral development banks such as the IBRD, the EIB, the Asian Development Bank etc. It will also cover loans to international organisations such as the IMF and BIS. The pool eligibility criteria for so-called substitution assets — essentially cash held on short-term deposit with highly-rated banks — are being brought into line with the CRD. Inter alia, this involves reducing the Irish limit for substitution assets of 20% on a pool asset basis to 15% on a covered bonds outstanding basis. It will also involve more frequent property valuations. The CRD requirement for annual valuations for commercial property and three yearly valuations for residential property are covered by the amendments.
The amendments provide for the inclusion of residential and commercial mortgage backed securities, that is, units of mortgage securitisation issues, in the cover assets pool and meet the requirements of the CRD in this regard. The current provisions which restrict the level of public credit covered securities to 50 times the institution's funds level are being modified as a result of changing risk weighting of public sector loans under the CRD.
Under existing legislation, covered bonds can effectively only be issued against residential mortgage loans and loans to public sector institutions. However, a new type of designated credit institution, a designated commercial mortgage credit institution, is introduced to issue covered bonds secured on commercial mortgage loans. This innovation, too, is inspired by the provisions of the CRD.
The opportunity is also being taken in this legislation to modernise the legal framework in the light of international developments in this sector since the 2001 legislation was put in place. For instance, the 2001 Act requires that the asset covered securities be fully, that is 100%, collateralised. Some other jurisdictions have specified a requirement that there be a degree of over-collateralisation. It is appropriate that Ireland, too, should strengthen the safeguards for investors by introducing mandatory over-collateralisation of 3% in the case of residential mortgage loan and public sector loan pools and 10% in the case of the proposed new commercial mortgage loan pools. It will, of course, still be open to issuers to give a contractual commitment to investors that they will maintain even higher levels of collateralisation than are statutory required by the reforms in the Bill.
This is technical and complex legislation. The reforms I have outlined have been carefully drafted in consultation with industry legal experts, the Financial Regulator and by the Parliamentary Counsel. The proposals have also been formally vetted and cleared by the European Central Bank which confirmed it had no problems with them. I shall be bringing forward a few amendments on Committee Stage which are of a minor technical nature and to correct some cross-references.
While this is an amending Bill and as such is just making modifications to an existing framework Act, I cannot over-emphasise the importance of the early adoption of these reforms for the ongoing effectiveness of this important sector of our financial services industry and for the wider economic activity it underpins. I commend this Bill to the House.
