The Reserve Bank of New Zealand favours a legislative framework for the development of a market in covered bonds.  This bank funding mechanism is popular in Europe but has been used only once in New Zealand and is prohibited in Australia.The RBNZ proposed a "conservative" cap of 10 per cent of total assets, in a paper published on Friday. The cap on issuance is needed to ensure the large banks continue to derive a rating benefit from their Australian owners, since no covered bonds are permitted by the Australian Prudential Regulation Authority. In Australia, APRA's view is that covered bonds are inconsistent with the Banking Act, which requires that an ADI's assets in Australia are available to meet the ADI's deposit liabilities in Australia, prior to all its other liabilities.Covered bonds, however, give investors in those bonds priority over certain assets (usually home loans).In New Zealand the only bank to issue covered bonds is Bank of New Zealand, which has sold NZ$425 million to local investors."We are aware that a number of other banks are in the process of developing their own programs," said the RBNZ.The RBNZ noted that as banks were allowed to sell covered bonds equal to 20 per cent of assets this was a level at which credit ratings agencies may begin to factor in asset encumbrance. There is no guarantee, however, that a bank could issue funding up to this level and still retain its rating.Until the framework is finalised, including any legislative support, the RBNZ will allow the development of the covered bond market to continue.