Australia looks set to become the first OECD country to do away with Additional Tier 1 capital instruments for domestic banks, after the financial system supervisor said they do not fulfil their intended purpose.
In a discussion paper released on Tuesday, the Australian Prudential Regulation Authority proposed banks phase out AT1 notes and replace them with “cheaper and more reliable forms of capital that would absorb losses more effectively in times of stress.”
If enacted, the current regulatory minimum of 1.5% of risk-weighted assets that internationally active banks must hold as AT1 capital would be replaced with a combination of 1.25% Tier 2 and 0.25% Common Equity Tier 1 capital.
Smaller banks would fully replace AT1 with Tier 2, alongside a reduction in their Tier 1 requirements.
“The announcement has garnered a lot of attention and, though views are mixed, most people, I believe, see this is a logical step because AT1 has proved unfit for purpose,” a DCM manager said.
“Credit Suisse showed AT1 doesn’t work as ‘going concern’ capital but instead acts as ‘gone concern’ capital, which helps absorb taxpayer losses but can’t put a failed bank back on its feet,” he said.
On March 20 2023, Swiss regulator Finma ordered Credit Suisse's AT1 bonds to be written off to zero, a shock decision that prompted clarification calls in other jurisdictions.
If APRA's changes go ahead following a two-month consultation period, the transition to a simpler capital framework will begin on January 1 2027 with all current AT1 paper on issue expected to be replaced by 2032.
APRA previously set a total capital requirement of 18.25% of RWA by 2026 for the four major banks which includes raising their Tier 2 component to 6.5% of RWA by then.
The new proposals indicate a new 7.75% Tier 2 component requirement from 2032 with the remaining 10.5% comprising CET1 capital which includes common shares, retained earnings and other accumulated income.
For the majors, “the total amount of regulatory capital that APRA requires banks to hold would remain unchanged and banks would remain unquestionably strong,” APRA said.
AT1 capital instruments will continue to be eligible as regulatory capital until their first call dates. APRA is not considering changes to AT1 settings for insurers.
The DCM manager believes major banks will increase their annual Tier 2 supply, but not dramatically, to around A$5bn (US$3.3bn) from A$4bn, with approximately half raised locally and the rest offshore, especially via the deep US dollar and euro markets.
“Given foreign appetite for Australian banks that offer a bit of yield this extra issuance would be easily absorbed. Secondary market Tier 2 levels were steady after the APRA bombshell, though the extra supply and Tiers 2's new position on the front line of defence in any bank crisis – after equity capital – should, theoretically, place some upward pressure on spreads,” he said.
Australian bank AT1 spreads tightened on the announcement, while a new A$800m (US$538m) ANZ Bank New Zealand Kangaroo perpetual non-call six AT1 attracted huge demand before clearing well inside initial guidance. Australian banks' US dollar AT1s gained 0.5–1 point in early trade on Tuesday, with their US dollar Tier 2 bonds widening 2bp–3bp, according to a note from Nomura's sales and trading desk.
Contagion risks
APRA chair John Lonsdale said AT1 is supposed to stabilise a bank so it can continue to operate during a period of stress and support resolution by providing the necessary capital to prevent a disorderly failure. However, citing last year’s global banking turmoil, he noted that "international experience has shown that AT1 does not fulfil this function in a crisis situation due to the complexity of using it, the potential for legal challenges and the risk of causing contagion”.
“These [contagion] risks are heightened in the Australian context due to the unusually high proportion of AT1 held by retail investors,” Lonsdale said.
Australian dollar AT1 notes are sold via the retail market and draw huge demand from retail investors, led by self-managed super funds and underpinned by the availability of franking credits, a form of tax rebate on dividend payments.
Participation is fuelled by the retail market's modest A$5,000 minimum ticket size versus the A$500,000 minimum in the wholesale market.
Retail investors have been switching out of bank deposits, the first A$250,000 of which are federally guaranteed, into AT1 notes, which represents a potential threat to financial market stability.
“Converting their investments into equity or writing them off could undermine confidence in the financial system and impact the stability of other institutions – a complication that risks impeding the speed of decision-making in a crisis,” warned APRA member Therese McCarthy Hockey when releasing a discussion paper 12 months ago. Based on feedback to that paper, APRA estimated that retail investors held 20%–30% of outstanding domestic AT1 notes.
“Replacing AT1 with more reliable forms of capital will enable banks to more quickly and confidently use their capital buffers in a crisis scenario and is expected to reduce compliance costs for banks,” Lonsdale said on Tuesday.
“It will also strengthen the proportionality of the prudential framework by embedding a simpler approach to capital requirements for small and mid-size banks compared to the new requirements for large banks.”
Bank AT1 notes have been strong, reliable earners for Australian retail investors over the last couple of decades, with current returns in excess of 7% including franking credits.
“There are no obvious ‘safe’ alternatives that provide such returns with bank deposits, for example, paying 4.5%. The winding down of AT1 leaves room for more corporate bond supply in the retail market, but this can hardly compensate for the loss of AT1,” the DCM manager said.
Australia is not the first country to consider the possibility removing AT1 instruments.
In March, in response to the turmoil that followed Credit Suisse's collapse, the Dutch finance ministry said “the abolition of various capital instruments, including AT1 capital with sometimes an opaque design and suboptimal behavioural incentives, can both reduce regulatory pressure and promote risk management”.
Even before Credit Suisse, some European regulators have questioned whether AT1s are fit for purpose, with the chief executive of the Bank of England's Prudential Regulation Authority in 2022 setting out the concept of a single buffer of common equity to replace the current regime.
However, most market participants expect European regulators and issuers to favour modifications of the product, to improve its functioning in crises, rather than its removal. They point to the scale of the €208bn (US$231m) European AT1 market, its wholly institutional investor base, and European banks' contrasting capital needs as reasons to see limited read-across from APRA's proposals.
(Additional reporting by Tom Revell)