The design of hybrid securities issued by Australian banks may be about to change, with the Australian Prudential Regulation Authority saying it is concerned some current product features and market practices “create significant challenges or potentially undermine” the effectiveness of additional tier 1 capital in absorbing loss.
Changes up for discussion include restricting retail investor access to hybrids, changing distribution and loss absorbency rules and reducing the level of hybrid capital in a bank’s minimum regulatory capital.
APRA has released a discussion paper that looks at whether bank-issued AT1 securities, or hybrids, are fit for purpose.
AT1 capital was introduced after the financial crisis as a form of capital that can absorb losses as part of early crisis intervention to restore a bank’s capital position.
It does this in two ways: by making distributions discretionary and non-cumulative, which reduces pressure on cash flow; and by requiring that AT1 securities be converted to ordinary shares when a loss absorption trigger is reached, thereby generating additional equity capital.
AT1 capital in the market, most of which has been issued by the big banks and Macquarie, is currently around A$42 billion. APRA estimates that more than 50 per cent of hybrids listed on the ASX are held by retail investors.
APRA has two concerns. First, its observation from overseas experience is that rather than acting to stabilise a bank as a going concern in stress, AT1 tends to absorb losses at a very late stage in a crisis.
Secondly, the regulator is concerned that Australian banks are outliers internationally in their practice of selling a large part of their AT1 issuance to retail investors.
“This would make it particularly challenging to use AT1 to facilitate the recapitalisation of a bank in resolution, as APRA would be concerned that imposing losses on these investors would bring complexity, contagion risk and undermine confidence in the system in a crisis,” it said.
APRA’s proposals for enhancing AT1 include adjusting constraints on distributions to ensure that AT1 absorbs losses at an earlier stage, and adjusting the loss absorbency trigger to bring AT1 into play earlier.
The current level for bail-in of AT1 is set at a common equity tier 1 ratio of 5.125 per cent, compared with the CET1 target of 11 per cent. This means a bank would need to sustain losses that deplete more than half its capital before the trigger is reached.
“As demonstrated by the speed of crisis events overseas, AT1 would need to be used more quickly than this to be effective in a going concern scenario,” APRA said.
Another option is to reduce the level of AT1 capital in a bank’s minimum regulatory capital requirement or cap the maximum amount of capital that is eligible to be counted as AT1.
APRA is also looking at imposing investor eligibility criteria to restrict retail investor ownership.
“This approach would align with international practice that restricts retail ownership of AT1. It would diversify the investor base away from domestic retail investors, reducing contagion risk in the Australian financial system.”