Australian banks could see a rise in capital costs as the Australian Prudential Regulation Authority (Apra) sets its sights on revamping the country’s Additional Tier 1 (AT1) capital market.
Prompted by the recent write-off of Credit Suisse’s hybrid instruments, Apra has published a discussion paper highlighting possible reforms to Australian banks’ hybrid securities to ensure they are “fit for purpose”.
These proposals include increasing the AT1 equity conversion trigger from 5.125% to 7%, reducing the role of AT1 in the capital framework and curbing retail investor participation in the market.
Keeping things stable
Apra notes that AT1 was only used at “the point of non-viability” during recent overseas banking crises, and it is now seeking industry feedback on its ideas to ensure banks can be stabilised as a going concern during a time of stress.
Industry experts think the regulator’s proposals could lead to higher-yielding bank hybrids and increased costs for the country’s lenders over time, even if the impact is expected to be limited.
“If Apra is leaning towards a more going-concern-like capital, it will inevitably push up the cost of AT1 instruments for our banks,” says Frank Mirenzi, vice-president and senior credit officer at rating agency Moody’s.
Conceived by global regulators after the 2008 financial crisis, AT1 hybrids — contingent convertible bonds in Europe — were introduced to enhance banks’ regulatory capital quality. They can be converted to equity or written off to absorb bank losses during a crisis.
Apra rolled out AT1 guidelines in 2013, and since then the volume of outstanding AT1 has grown, currently hovering around A$40bn ($25.4bn).
Retail involvement
However, Australia’s AT1 market structure is distinct from its international peers, with retail participants constituting more than 50% of the investor base.
This has heightened Apra’s concerns that, in the event of a bank failure, imposing losses on these investors would elevate risks and erode confidence in the banking system.
“The whole reason these kinds of instruments were introduced was to take the contingent liability of a bank failure off the government’s balance sheet and put it in the hands of professional investors. But with more than half of AT1 capital instruments held by retail investors, any bank failure would still hit mums and dads,” says Mr Mirenzi.
Retail investors consider AT1 instruments attractive given their tax credits that reduce personal income tax liability. Australian investors also have little experience with bank crises and often consider big lenders a safe investment bet.
Demand from this inexperienced investor base has spiked and helped keep a lid on yields, creating more favourable issuance conditions for the country’s banks.
Disconnect in value
According to Jenna Labib, head of sales at IAM Capital Markets in Sydney, this has led to a disconnect in value between the retail and institutional markets regarding bank-issued capital instruments.
“Retail investors are being shown new bank hybrid securities that are paying yields that are similar — or even below — bonds that have a higher rating or higher place in the capital stack, highlighting the disconnect in value between retail and institutional markets,” she says.
Ms Labib compares two transactions from August to highlight the point: National Australia Bank’s issuance of A$1.25bn of listed hybrids priced at 280 basis points above the bank bill swap rate with a seven-year call date and Lloyd’s Australian dollar Tier 2 bond callable in five years and priced at 290 basis points.
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The UK bank’s debut Australian issuance of a Tier 2 bond — representing a step up in the capital structure — and with a shorter tenor generated a more attractive return relative to the listed hybrid.
“Part of this is certainly because Lloyds is a non-Australian company, so when accessing the Australian market, it needs to pay a larger new issue premium to attract investors, but this still shows the disconnect,” says Ms Labib.
As such, Apra’s discussion paper represents a first step in what could be a broader push to recalibrate AT1 investment. “Apra is exploring ways to potentially shift the investor base to global institutions rather than mum and dad investors,” says Ms Labib.
Apra is seeking industry feedback on its proposed changes until November 2023. A full consultation is expected to occur in 2024 before final regulatory changes could be imposed later in the year.
