APRA may restrict bank hybrid issuance

Retail investors could be prevented from holding bank hybrid notes under one of three plans being weighed by the regulator.

Australian retail investors could be prevented from holding bank hybrid notes under a plan being weighed by the financial services regulator.

APRA on Thursday released a discussion paper under its review into so-called Additional Tier 1 bonds — currently valued at $40bn across Australia’s banks — following concerns prompted by this year’s international banking crisis.

One of three options considered by the regulator would see retail investors shut out of the market, for example by requiring minimum denominations for parcel sizes that would effectively restrict participation to wholesale investors.

Small retail investors currently hold around half the AT1 capital on issue by Australian banks.

Additional Tier 1 (AT1) capital refers to hybrid securities issued by banks, and designed to absorb losses when a lender runs into trouble, through the suspension of discretionary coupon payments or conversion to equity.

The regulator’s review intends to improve the ability of AT1 bonds to absorb losses and support a bank during times of financial stress.

It also suggests two alternate policy paths, including improving the design of AT1 bonds to ensure they can be used earlier to stabilise a bank in stress; or reducing reliance on AT1 by changing the level or mix of regulatory capital requirements for banks.

APRA executive board member Therese McCarthy Hockey said the regulator was concerned that AT1 bonds would not operate as intended due to “certain design features and market practices”.

“AT1 are critical instruments designed to absorb losses to stabilise a bank before it reaches a crisis scenario or support bank resolution if it gets to that,” she said.

“However, recent episodes of banking stress overseas highlighted that AT1 only absorbs losses at a very late stage of a crisis – in the resolution phase.

“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.”

AT1 bonds are one of three types of capital that banks hold to support their lending activities and reinforce their balance sheets during times of financial stress.

Owners of AT1 bonds – typically retail investors in the Australian market – have generally expected they would rank ahead of equity investors when a lender’s finances are tested.

However that theory was tested during the international banking crisis earlier this year.

As part of the emergency sale of Credit Suisse to UBS in June, Credit Suisse’s hybrids were wiped out, with their $US17bn value written down to zero.

The deal, co-ordinated by Swiss regulators, left hybrid holders with nothing, whereas holders of Credit Suisse equity got some UBS shares as part of the takeover.

It effectively reversed the usual hierarchy that exists for debt and equity securities.

The move spooked markets, as investors were left to consider whether the same could happen to their holdings of AT1 debt in other banks.

APRA has been promising a review into AT1 capital following the events surrounding the UBS-Credit Suisse tie-up.

Bank hybrid instruments are highly popular among Australians, particularly among self-managed super funds.

National Australia Bank recently completed a $1.25bn hybrid share offering, following Commonwealth Bank’s $1.55bn issue in May and ANZ’s $1bn raise in February.

The NAB prospectus for its capital notes ranks the hybrids ahead of equity. It says NAB must immediately convert all shares into equity if the bank hits severe financial difficulty. APRA would determine the conversion under a “non-viability trigger event”, a point likely to arise just ahead of the insolvency of the bank.

The regulator is calling plans to formally consult on any proposed changes to prudential standards or guidance next year.