The FSA will also relax its previous restrictive stance on the amount of covered bonds a bank can issue, allowing the UK market to grow.
Both measures should help UK covered bonds overcome any remaining objections or obstacles to their becoming a front ranking sector of the European covered bond market.
A new letter from the FSA to UK banks is expected to set out a legal framework for the product and acknowledge the benefits of covered bonds.
The FSA has privately approved every issue of UK covered bonds, but last year it expressed concerns that if a bank issued too much of the instrument, it could hurt the interests of depositors. Covered bondholders would have a preferential claim over the bank's mortgages if the bank became insolvent.
The regulator made it clear issuance would be kept within strict limits, giving the figure of 4% of total assets as a guide.
Now, the FSA is expected to say that it believes the liquidity benefits for a bank of being able to issue covered bonds outweigh the FSA's prudential concerns about depositors.
Giving UK covered bonds a defined status in law should allow them to qualify as covered bonds under Ucits, the EU directive that governs unit trust investment, as well as the new Capital Requirements Directive (CRD) rules.
That in turn should mean they can have the 10% risk weighting that other covered bonds enjoy.
In almost every country covered bonds are issued according to a statute that sets out rules governing them, and investors draw considerable comfort from that legal underpinning.
But in the UK there is no law — since 2003 banks like HBOS have created structures that have the credit features of mortgage covered bonds using existing common law instruments, such as assignments and guarantees.
These have been well accepted by investors around the world, but because they lack an established legal framework, UK covered bonds are still risk weighted at 20% rather than 10%, and are not eligible for the preferential allocations allowed for covered bonds under Ucits (Undertakings for Collective Investment in Transferable Securities).
Now the FSA is thought to be working on a definition of covered bonds for the UK that would give them a recognition in law. Since the FSA's rules have the force of law, primary legislation — an act of Parliament — would not be required.
The regulator believes its own rule would be enough to win Ucits, CRD and risk weighting clearance.
Besides defining criteria and rules for a covered bond, the FSA needs to establish how eligibility would be checked and certified.
The regulator will decide in the next six months how it will find the resources for that supervisory role.
Previous restrictive stance
The FSA's previous published position on covered bonds was contained in a letter to the British Bankers' Association last August.
In that, it warned that heavy covered bond issuance by a UK bank could lead the FSA to impose stricter capital requirements on it. The regulator suggested that issuance of even 4% of a bank's total assets might be excessive.
Since then the FSA has backed away from that 4% figure, and adopted a more accommodating stance in its dealings with banks issuing covered bonds — which so far comprise HBOS, Northern Rock, Bradford & Bingley and Abbey.
The new letter is expected to make this position explicit, although it is unlikely to contain any firm rules on how much banks can issue — the FSA will continue to deal with issuers individually.
The pronouncement is likely to be greeted warmly by UK banks, which will welcome the greater freedom to use their new funding technique.
Regrets may come from investment banks' securitisation departments, since more covered bond issuance could well mean less mortgage securitisation by the UK banks.
The FSA's interest in dealing with covered bonds was demonstrated by its dispatch of a delegate to a meeting of the European Covered Bond Council in Paris this week.
The ECBC, which was set up by the VDH, the Association of German Mortgage Banks, has helped lobby and inform the FSA about covered bonds.
The VDH had campaigned to preserve the special status of covered bonds that rely on an established legal framework.
Also at the plenary session was Enrico Cantarelli, a member of the Consiglio degli Esperti at the Italian Treasury, to discuss Italy's planned covered bond market after parliament passed legislation last month.