Summary: APRA plans to go ahead with phase-out of capital notes by banks; transition to begin 2027.
In September 2023, APRA flagged its disdain for Additional Tier 1 (AT1) securities, a type of hybrid security which had its origins in fixed-rate converting preference shares first issued in the 1990s. The move came after a high profile Swiss bank came under intense financial pressure in March 2023 and regulators felt forced to intervene.
At the time, APRA stated it was proposing “changes to the capital framework for banks in relation to hybrid instruments to simplify and improve the effectiveness of bank capital in a crisis.” However, it seems APRA’s bigger concern was the effect of retail investor confidence in the wider financial system should a loss arise from holding this type of security.
“The Australian market for AT1 is also unusual by global standards, with more than half the bonds held by small retail investors. 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.”
After a year of discussions with various interested parties, APRA has now announced it is planning to change the capital requirements of banks institutions, but not insurers, which come under its purview in order to make the use of AT1 securities by banks less attractive.
“APRA is proposing that banks phase out the use of AT1 capital instruments, often called hybrid bonds, and replace them with cheaper and more reliable forms of capital that would absorb losses more effectively in times of stress. The total amount of regulatory capital that APRA requires banks to hold would remain unchanged and banks would remain ‘unquestionably strong’.”
In short, APRA proposes phasing out the use of AT1 securities as eligible bank capital, thereby notionally reducing a bank’s ability to lend unless it replaces it with some other type of eligible capital.
APRA is seeking to have banks replace AT1 securities with “Tier 2” securities, which are essentially bonds which can be converted into ordinary shares in times of financial stress, and Common Equity Tier 1 securities, which are either ordinary shares or preference shares. It plans to begin the transition from the start of 2027 and complete the process by 2032.
APRA’s proposal is not set in stone at this point and the regulator will hold discussions with interested parties for the next two months. However, given the similarity between its statements from last year and its most recent announcement, investors should probably start planning for an ASX market with substantially fewer capital notes on issue.
APRA’s statements raise several questions. Why have Australian banks favoured issuing capital notes instead of other forms of capital such as Tier 2 bonds over the past decade? Banks are not generally known for their generosity and if there were indeed “cheaper and more reliable forms of capital”, why were they consistently issuing AT1 securities? Also, why are Tier 2 debt instruments, a form of temporary capital for banks, any better than AT1 instruments, another form of temporary capital?