APRA warns on hybrids amid search for higher yield

APRA has reminded investors seeking yield that hybrids are the “first lines of defence” for troubled banks.

Mr Byres said once APRA makes banks’ capital ratios “unquestionably strong”, it “won’t be downing tools”. Picture: Adam Yip.

The nation’s chief banking regulator has issued a stern reminder to thousands of investors piling into hybrid securities in the hunt for better yields, warning these are the “first lines of defence” that will be used to assist banks that run into serious financial trouble.

As the The Australian Prudential Regulation Authority works on a range of new banking rules to be unveiled in the next 12 months, chairman Wayne Byres today said increasing banks’ loss absorption and recapitalisation capacity — as recommended by the financial system inquiry — would “take some time to complete” due to the importance of getting the “policy settings right”.

But he reminded investors that “bail-in” securities were “not something completely new”, citing how hybrids issued by the banks can be written off, or converted to equity, if their capital ratio falls below 5.125 per cent.

He said these triggers were designed to provide breathing space so banks endured an orderly resolution, providing ongoing services to customers while new owners and management took control.

“Viewing these capital instruments as simply higher-yielding substitutes for vanilla fixed-interest investments, let alone deposits, is something to be counselled against, since from APRA’s perspective holders of these instruments are providing the important first lines of defence that we can call into action, in some instances even ahead of shareholders, to aid an orderly resolution,” Mr Byres said.

The comments come amid strong demand for hybrids in recent years as investors seek out higher yielding assets for income following the Reserve Bank’s cuts to the official cash rate to a record low 1.5 per cent, resulting in lower bank deposit rates for savers.

ANZ Bank last week upsized a hybrid capital raising to $1.3 billion after solid demand, pricing them at 4.7 per cent, plus the bank bill swap rate. It follows deals this year from Westpac and Commonwealth Bank as the hybrids market improved and term deposit rates fell.

The corporate regulator has also upped its focus on the hybrid market in recent years, concerned the securities had complex features that were often poorly understood by investors, including potentially long redemption time frames and capital losses on upfront investments.

In the speech on banking resilience at an Actuaries Institute in Sydney, Mr Byres said while making banks have more capital wasn’t the only requirement for a safe system, a “steady accumulation of capital remains a sensible course of action” for banks.

Higher capital lowers banks’ leverage and thus reduces returns to shareholders, making the issue one of the biggest headwinds for banks in recent years as the financial system inquiry and global regulatory bodies flagged requirements would further increase.

Mr Byres noted that once APRA defined and achieved making banks’ capital ratios “unquestionably strong” globally — as recommended by the Murray financial system inquiry — the regulator “won’t be downing tools”.

“’Unquestionably strong’ will never equate to ‘invincible’,” he said.

“With that in mind, we can think of two basic types of failure: orderly and disorderly.

“To the extent any failure can be regarded as a success, then an orderly exit from the industry in this fashion is what we should strive for. For example, a firm that identifies it is approaching non-viability or a strategic dead-end, and seeks to merge with a stronger and more viable entity (sometimes with a nudge along the way from APRA) is a far from uncommon event in the Australian financial system.

“To the extent such exits can be classed as failures, or at least near failures, they are often so orderly that no one notices them. Disorderly failures, on the other hand, are to be avoided.”

Mr Byres added that while Australia stacked up relatively well, there remains “a number of areas for improvement” to ensure failures would be orderly, such as beefing up the powers to intervene.