South Korea's financial regulator outlined Tuesday details on covered bond issuance for banks in a bid to help lenders secure stable sources of funding and restructure household debts by promoting long-term, fixed-rate loans.

According to the Financial Services Commission (FSC), the proposed Covered Bond Act stipulated that eligible issuers should have a Bank for International Settlement (BIS) capital ratio of over 10 percent and equity capital of more than 100 billion won ( 90.69 million U.S. dollars).

The act defined the issuer as commercial banks, Korea Housing Finance Crop. (KHFC) and Korea Finance Corp. (KoFC) as well as other institutions equivalent to the above-mentioned ones.

Eligible assets should consist of three classes such as underlying assets, liquid assets and other assets, and those should have at least 105 percent over-collateralization.

Underlying assets include prime mortgage loans with loan-to- value (LTV) ratio of less than 70 percent, loans to governments and public institutions, and government bonds. Liquid assets are consisted of cash and certificate of deposits (CD) issued by banks, while other assets are made up of cash flows from underlying assets and bonds related to derivative trading such as hedging for currency and interest rate risks.

Meanwhile, covered bond issuers should register their issuing schedule and details on cover pool assets with the regulator. The registered issuer will be allowed to issue covered bonds within 8 percent of total assets in the prior fiscal year.

Issuers should establish a separate risk management system for covered bond issuance, and disclose details on the covered bonds such as present value of cover pool assets more than one time every three month.

Covered bonds refer to debt securities issued by banks and secured by a pool of high-quality cover pool assets such as mortgage loans.

Banks can cut funding costs by issuing such bonds as the bonds provide dual recourse, which is recourse to both the issuer and the cover pool, to investors. That nature allows higher credit ratings for the bonds than the issuers.

The nature of the so-called bankruptcy remoteness protects investors from a credit event such as issuer default. Cover pool assets stay on the issuer's balance sheet after the bond issuance, but the underlying assets are isolated from the insolvency of issuers. Bondholders are given priority claim over the cover pools upon issuer default.

The South Korean regulator published in June last year best- practice rule on covered bond issuance for banks as follow-up measures of promoting soft-landing of household debt problem, but there remained a need to legislate a new law for covered issuance as the rule cannot secure the covered bond's beneficial nature of bankruptcy remoteness and priority right over cover pool assets for investors.

In June 2012, the FSC formed a task force to help legislate the Covered Bond Act, and has held a total of seven meetings to draft a bill on the covered bond issuance. The proposed bill is scheduled to be submitted to the National Assembly in December after the 40-day pre-announcement period.

Covered bond issuance was expected to help banks secure stable sources of funds and restructure household debts by promoting long- term, fixed-rate loans. "Covered bond legislation will serve as a solution to household debt problems. It will become a useful source of foreign currency funding in times of market tension, and will be a catalyst for activating a long-term bond market," FSC Chairman Kim Seok-dong said in a seminar held last week.

However, it may risk causing asset liability mismatch risks. " In a typical covered bond program, the underlying assets are usually long-dated mortgage assets with maturities greater than 10 years, while the covered bonds tend to have short- to mid-term maturities averaging three to seven years," Standard & Poor's said in a report.

Covered bonds were not expected to be issued actively in South Korea as banks already have highest credit ratings "Even if the legal and regulatory framework for covered bonds is put in place, covered bond issuance is unlikely in Korea because most domestic banks have the highest domestic credit ratings," said Kim Pil-kyu, senior research fellow at Korea Capital Market Institute (KCMI).

Kim noted that local lenders had little incentive to use their assets as collateral to get higher credit ratings.