The Australian Prudential Regulation Authority has put bank hybrid securities on notice with the release of a discussion paper proposing changes to the capital framework requirements for banks.
APRA is proposing that banks phase out the use of AT1 capital instruments (often called hybrid bonds, or capital notes) and replace them with cheaper and more reliable forms of capital that would absorb losses more effectively in times of stress.
The changes would spell an end to the current hybrid capital instrument with Australian banks having an estimated $43 billion of outstanding hybrid securities on issue.
The total amount of regulatory capital that APRA requires banks to hold would remain unchanged and banks would remain ‘unquestionably strong’.
Also read: Capital Notes – What Are They and Should You Invest?
APRA Chair John Lonsdale said it is essential to have the right settings in place to protect depositors and financial system stability in the unlikely event of a bank failure.
“The purpose of AT1 is to stabilise a bank so that it can continue to operate as a going concern during a period of stress, and support resolution with the capital that is needed to prevent a disorderly failure.
“Unfortunately, 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 risks are heightened in the Australian context due to the unusually high proportion of AT1 held by retail investors.
“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.
“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,” Mr Lonsdale said.
Under APRA’s proposed approach for bank hybrid securities:
- Large, internationally active banks would be able to replace 1.5 per cent AT1 with 1.25 per cent Tier 2 and 0.25 per cent Common Equity Tier 1 (CET1) capital.1
- Smaller banks would be able to fully replace AT1 with Tier 2, with a reduction in Tier 1 requirements.
Capital notes are a hybrid product and a perpetual unsecured security that combines features of both shares and bonds – hence the term hybrid security. Issuing them has been a way for banks and companies to borrow money from investors.
APRA has said it will keep hybrid securites in place for insurance companies.
Coolabah Capital’s portfolio manager and chief investment officer Christopher Joye said, “While this was a surprising solution from the regulator, which was not anticipated by the market, we had many years ago argued to APRA that the banking system would be better served by getting rid of hybrids altogether and simplifying their capital structures.”
The transition period would begin on Jan. 1, 2027 and all hybrids will be replaced by 2032.
For existing investors, APRA does not envision an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates.
APRA has conducted a program of bank hybrid securities industry consultation and a two-month discussion period has now commenced.
Footnote:
1.These measures are as a percentage of risk-weighted assets (RWA). Tier 2 is an existing, cheaper form of capital, which is designed to be used to support resolution actions when a bank has reached the point of non-viability.
