The Australian Government has included a mechanism for small financial institutions to pool their assets and issue covered bonds in an amendment to the Banking Act tabled by the Treasurer yesterday.The amendment, Banking Amendment (Covered Bonds) Bill 2011, is designed to enable approved deposit-taking institutions to issue covered bonds. The Government is keen to make sure small institutions will be able to participate in the emerging covered bond market.The model proposed in the legislation involves a group of small approved deposit-taking institutions establishing a new entity, called the aggregating entity.This entity, which would not be an ADI, would issue a debt instrument. This would be secured by covered bonds issued by each of the ADIs. The institutions participating in this arrangement would be subject to the same regulation applying when only one ADI is issuing covered bonds.The Government recognises that allowing ADIs to issue covered bonds gives them access to a wider funding base; offers the potential for cheaper funding (because they are low risk securities); gives them the opportunity to issue into a market that supports long maturities (up to 15 years), and allows them to issue securities that have a structure (with repayment of the principal at maturity) that appeals to superannuation funds.The chief executive of the Australian Securitisation Forum, Chris Dalton, said the Government had struck the right balance in providing a comprehensive framework without being too prescriptive.A covered bond is a secured debt instrument issued by a banking institution. Bondholders have two mechanisms to recoup their investment in the event that the issuing ADI is in default. They have recourse to the institution and to a specific pool of assets.The retention of credit risk by the institution is what distinguishes covered bonds from other asset-backed securities. The dual-recourse nature of covered bonds distinguishes them from other wholesale funding, where the claim is only against the issuer.The preference provisions of the Banking Act, as interpreted by the Australian Prudential Regulation Authority, have stopped the issuance of covered bonds in Australia. The Act says depositors have first claim on all of an ADI's assets. The introduction of a permanent Financial Claims Scheme gave depositors protection. It also gave the Government scope to relax the preference provisions.Assets that are eligible for inclusion in the cover pool include loans secured by residential property, loans secured by commercial property, and at-call deposits convertible into cash within two business days.Also eligible are bank bills and certificates of deposit maturing within 100 days that are not issued by the ADI issuing the covered bonds and are eligible for repurchase by the Reserve Bank.The Bill also allows contractual rights relating to the holding or to the management of another asset in the cover pool, as well as derivatives used for the purpose of protecting the value of another asset in the cover pool.As a protection for depositors there is a regulatory cap on the quantity of covered bonds an ADI can issue. The cap is set at eight per cent of the ADI's assets