Proposed hybrid capital regulations could deal blow to banks

APRA’s AT1 changes could result in lower bank valuations and even capital raisings, instead of cash surpluses being returned to shareholders.

Regulators are threatening the one positive thing going for banks: their high dividends and surplus capital positions, which were supposed to translate into capital distributions.

Some stockbrokers have highlighted the possibility that APRA’s plans to change the rules around Additional Tier 1 capital (AT1) could result in lower bank valuations and even capital raisings, instead of cash surpluses being returned to shareholders.

Additional Tier 1 capital or hybrid capital is issued by banks to absorb losses in a crisis, by suspending coupon payments or converting to equity.

But the regulator last week said certain characteristics of bank hybrids, which account for about 2 per cent of the big four’s capital bases, would create “significant challenges, or potentially undermine” their effectiveness in a banking crisis.

Instead of acting early to stabilise a bank in stress, recent experience overseas – notably in the Credit Suisse case – showed that AT1 absorbs losses only at a very late stage of the crisis.

In Australia, over half of the $38bn of outstanding AT1 securities issued by the major banks are held by retail investors. This is not the case in other markets, and is problematic because retail investors often consider hybrids similar to high yielding bank deposits and don’t understand the higher risks.

To fix this, the regulator spelled out three potential options, including redesigning their “constraints” on capital distributions and making their triggers for conversion to happen earlier to stabilise a bank in stress.

The second option would change the “level or mix” of regulatory capital requirements to reduce the level of hybrids banks can issue.

It is those two options that banking analysts at Morgan Stanley and E&P Capital think could increase the banks’ cost of capital, and they could even be required to raise core capital.

“The options flagged by APRA could increase the cost of new AT1 issues and/or require banks to hold more CET1 capital,” Morgan Stanley analysts told clients in a note.

The third option, which many in the market believe is most likely, would be to restrict who can invest in hybrids, by adding conditions that align with international practice.

That would still increase the costs of hybrids to banks, given a smaller investor base, which could lower their return on equity by about 0.5 percentage points.