By guest contributor Ken Atchison, founder of Atchison Consultants
The Australian Prudential Regulation Authority (APRA) has responsibility for ensuring financial system stability in Australia. Banks are the primary participants in the financial system and the effectiveness of capital instruments issued by financial institutions are reviewed and revised by APRA.
APRA has proposed changes to the capital framework for banks in relation to the treatment of hybrid securities for capital adequacy purposes. The proposal will be subject to input from the financial market participants over the next two months but APRA’s current intention is to begin the transition in 2027 and complete it by 2032.
Hybrid securities can take several forms but the most commonly issued hybrid listed on the ASX can be described as floating rate bonds which pays distributions on a discretionary basis. They are seen as mix of equity and debt and they are defined as Additional Tier 1 (AT1) capital for the purposes of capital adequacy regulations.
APRA states “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 ATI held by retail investors.” The “function” refers to AT1 as being a form of capital which would absorb losses in times of stress.
APRA’s proposal is that large banks gradually replace AT1 securities with Common Equity Tier 1 securities (shares) and Tier 2 securities (bonds which can be converted into equity in times of financial stress). Smaller banks would be allowed to replace AT1 securities with Tier 2 securities alone. The market value of AT1 securities is currently around $43 billion.
APRA’s concerns seem to centre on two issues. The first is their apparent belief one form of equity capital is better than another, a contentious proposition at best. The second concern is the effect on the sentiment of retail investors and the financial system as a whole.
Retail investors are very active in the Australian share market which has an aggregate market capitalisation of approximately $2.7 trillion. Analysis of shares of individual companies may be very complex, certainly more so the analysis of hybrid securities. Complexity arises from uncertainty about management of the business of individual listed companies, including profitability, dividends, finances and the share prices which vary significantly and constantly. Retail investors, often with advice, are capable of this analysis.
Whether retail investors are capable of understanding the structure of hybrids is debatable. However, the role of the Australian Securities and Investment Commission (ASIC) includes ensuring that securities issuance meets appropriate disclosure standards. Retail investors have demonstrated that they understand these securities to the extent they represent are a significant proportion of the ownership of the $43 billion market.
One can understand their interest. The performance of the Elstree Enhanced Income Fund in the 5 years to August 2024 has been 5.35% per annum or 6.5% per annum after franking credits. This compares favourably with the Bloomberg Ausbond Bank Bill Index return of 1.75% per annum over the same period. The Elstree Fund is an actively managed portfolio of hybrid securities and is a clear indicator of the attraction of hybrid investments for investors.
Hybrid securities are held in individual portfolios, self-managed superannuation funds and family trusts. Whether the retail investor would invest in replacement capital securities is unknown. Pure equity in banks has quite different attributes when compared with hybrids while Tier 2 securities offer a lower return as they are higher in the capital stack. A combination of alternative securities does not necessarily equate with AT1 securities and the ability of retail investors to manage such a combination is dubious from a cost perspective. A potential loss of capital for banks sourced from retail investors through this change is likely.
All things being equal, the phasing out of hybrids will reduce Tier 1 capital of banks. AT1 capital is a form of equity capital which is the core in capital adequacy measures in the capital stack of banks. Removing hybrids will weaken the capital base of banks which seems counter to the role of APRA in ensuring the stability of the financial sector. Sourcing Tier 1 capital for the financial institutions from retail investors has enhanced banks’ capital structures and financial stability.
It is of concern if the motivation for APRA’s intended plan is about the skills required in APRA to manage a financial crisis. Hybrids or equivalent are a recognised component of capital adequacy of banks in the criteria in the international framework set out in Basel 4. Regulators globally recognise the attributes of hybrids or equivalent securities.
Perhaps what is of greater concern is the absence of the Treasurer in this discussion. It would be expected that this public policy matter would involve the responsible minister in the Federal government. Potentially removing a segment of the investable universe currently available for individuals does matter.