APRA goes loco on CoCo, sounding the death knell for bank hybrids

The Australian Prudential Regulation Authority plans to shut down the market for a type of bank security that has been highly attractive to the country’s retail investors for more than a decade.

Last week, APRA said it has proposed to phase out the use of AT1 capital instruments (additional tier one capital or hybrid bonds) and replace them with cheaper and more reliable forms of capital that would absorb losses more effectively in times of financial stress.

Those “capital instruments” are hybrid securities issued by banks, which are listed on the ASX and deliver high-yield franked income to investors. There is roughly $40 billion worth of those bonds on the ASX, with the financial watchdog estimating between 20 per cent and 30 per cent of them ($8 billion to $12 billion) are held by retail investors.

APRA chair John Lonsdale: The financial regulator has decided to end hybrid securities.Credit: Louise Kennerley

The hybrids, sometimes also known as “CoCo” (contingent convertible) bonds, were a response to the 2008 financial crisis and the massive taxpayer-funded bank bailouts it prompted in Europe, the UK and the US.

Regulators decided the banks needed to hold more loss-absorbing capital and came up with what appeared to be a very clever idea – debt that could be forcibly converted to equity in the event of a bank crisis.

This “bail-in” capital would be forced to convert to equity if certain trigger events, generally related to capital levels, occurred.

The securities proved very popular, with more than $US275 billion ($408 billion) of them issued globally from early last decade. They have proven particularly attractive to Australian retail investors since being first issued here in 2013 because they generate franked income. Australia is an outlier in terms of the degree of retail investment in these bonds.

For the banks, CoCos are cheaper than pure equity, but are treated by regulators as quasi-equity because they rank behind more conventional forms of debt. The securities are only redeemable at the issuing bank’s option.

When hybrids first came out, there was a minority view that they might prove less effective in a crisis than generally thought and might even contribute to a crisis if, at the first sign of bank stress, investors begin dumping them to avoid forced conversion into equity.

The first real-world test of the securities came last year, when Credit Suisse suffered a liquidity crisis as depositors and bond holders scrambled for the exits.

The Swiss authorities, panicked at the prospect that one of their two global banks might fail, hastily arranged a forced merger with Credit Suisse’s great domestic rival UBS.

They offered hundreds of billions of dollars in liquidity support, cover for writedowns, litigation and restructuring costs, indemnity for losses and the write-off, rather than conversion, of all $US17.3 billion worth of Credit Suisse’s CoCo bonds.

Perversely, given that bondholders are supposed to rank ahead of shareholders, they also offered Credit Suisse shareholders $US3.25 billion of equity in the merger-expanded UBS.

There was momentary panic in the market for AT1 bonds, with regulators elsewhere rushing to reassure investors until it was recognised that the Credit Suisse predicament appeared unique. The prospectus for the issuance of the bank’s hybrids gave the bank the discretion to “zero” their value if it were deemed essential to prevent its insolvency.

Trading and issuance of CoCo’s quickly got back to normal.

The Credit Suisse experience, however, prompted APRA – regarded as one of the more conservative prudential regulators in the world – to reappraise its attitude towards hybrids.

The proposed phasing out of the bonds, it said last week, drew on the lessons of last year’s banking turmoil, where US and European banks either failed or needed to be “resolved” quickly, with governments intervening to minimise the risks of contagion and systemic instability. In the US, a number of regional banks failed or had to be merged.

APRA released a discussion paper on the bonds last year and said it had looked at three options. It could have maintained the status quo; redesigned the securities; or replaced them with more reliable forms of capital. It has chosen the latter.

At the moment, forced conversions of Australian hybrids would occur if the banks’ ordinary regulatory capital ratio falls below 5.125 per cent of risk-weighted assets.

What is a hybrid?

Hybrid securities, as the name suggests, have characteristics of both debt (bonds) and equity (shares).

Also known as contingent convertible bonds (CoCos), hybrids are listed on the ASX and pay franked income to investors - which can make them attractive from a tax perspective.

If the bank faces severe stress, it can decide not to pay income to hybrid investors, or to convert hybrids to shares.

With international experience demonstrating that banks with higher trigger points have still failed, that wasn’t a sensible option, and the regulator is clearly uncomfortable with the status quo.

So, APRA plans to phase out the hybrids by 2032, which is the last date at which any of the banks can force redemption, and replace them within its capital adequacy requirements with a mix of more common equity and subordinated debt, with a lot more subordinated debt (an additional 1.25 per cent of risk-weighted assets) than equity (0.25 per cent).

The changes will come at a significant cost for the four major banks. APRA’s base case is that it will add $70 million a year to their funding costs, but that it could add as much as $260 million. Smaller banks could modestly lower their funding costs.

By replacing quasi-equity that can only be called by the issuing bank with proportionately more debt than equity, the debt levels of the major banks would also increase, which doesn’t necessarily fit with the ambition that led to the creation of the hybrids – increasing banks’ capacity to absorb losses by forcibly converting debt that can only be redeemed by the issuer to equity.

Substituting the bonds with pure equity, as some in the sector have argued, might have been a cleaner (albeit more expensive in terms of banks’ cost of capital and shareholder returns) option.

It would be simpler and less likely to produce the unintended consequences feared at the outset, and which Credit Suisse’s implosion demonstrated.

APRA describes its plan as “proposed” changes to its prudential framework for banks, which implies that the phasing out of the hybrids isn’t a done deal yet. It has invited submissions from the industry and other interested parties, with a deadline of November 8 and final consultations on the specific changes it plans next year.

If securities designed to help resolve a banking crisis, or at least provide breathing space for regulators to sort things out, might fail to perform as designed and could contribute to the momentum of a crisis, then they are more of threat than a safeguard.

In Australia, with its unusually high proportion by global standards of retail investors – self-managed super fund investors and retirees – exposed to the hybrids and representing a political force that might complicate efforts to resolve or ameliorate a bank crisis by bailing the hybrids in, there is another stream of complexity and risk.

Neither APRA nor its political masters would want to be blamed for imposing billions of dollars of losses on retirees, which might inhibit the ability of the securities to perform as designed in a future crisis.

It is understandable that APRA would take a close look at hybrids after the events offshore last year, and its conclusion that they should be phased out is defensible.

Much of the focus of the next round of consultations may be less on whether they should be retained, but rather on what mix of capital should replace them.

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