Additional Tier 1 capital, once the hot new things, is to be eliminated from the capital structure of banks in Australia.
APRA proposes to replace Additional Tier 1 capital “with more reliable and effective forms of capital” in a manner highly advantageous to smaller banks in Australia.
“In APRA’s view, AT1 has not been shown to act effectively in a going concern scenario and does not offer advantages to Tier 2 in resolution; in fact, it has the potential to create additional complexities through the investor base” APRA said in a discussion paper ‘A more effective capital framework for a crisis.’
For insurers, APRA is not proposing any changes to capital instruments.
APRA said it concerns for AT1 “are less acute for insurers, and simplifying the capital framework involves different trade-offs, given the different nature of how stress may impact the insurance industry.”
APRA will monitor developments in the AT1 market for insurers and may review the approach to insurance capital instruments in due course.
The proposed approach is:
• Large, internationally active banks would be able to replace 1.5 per cent AT1 with 1.25 per cent Tier 2 and 0.25 per cent CET1 capital.
• Smaller banks would be able to fully replace AT1 with Tier 2, with a removal of Tier 1 requirements and no proposed changes to Total Capital requirements.
While AT1 has never been used in Australia to stabilise a bank, “international experience has shown that AT1 has not been effective in absorbing losses in stress and can complicate resolution” APRA said.
APRA’s 2023 Discussion Paper highlighted certain design features and market practices that would create significant challenges to, or potentially compromise, the effectiveness of AT1 in Australia.
Reflecting on the lessons learnt from the international banking turmoil of 2023, the Basel Committee on Banking Supervision noted that “there may be merit in further assessing the complexity, transparency and understanding of AT1.”
While AT1 has been designed to absorb losses prior to resolution, “this has been challenging in practice” APRA said:
• Discretionary distributions – distributions on AT1 are discretionary, meaning that banks under financial stress can cancel distributions to conserve capital. In theory, this would allow a bank to continue lending during tighter economic conditions. However, in practice, the market signalling effects from cancelling distributions are considered more detrimental than the minor benefit of additional financial support. This was observed internationally where Credit Suisse did not cancel distributions despite reporting losses over several consecutive quarters.
• Loss absorption trigger – APRA requires banks to include a loss absorption trigger in their AT1 capital instruments that requires banks to either convert them to shares or write them down when their CET1 ratios fall below 5.125 per cent. However, international experience has shown that banks have failed with CET1 ratios much higher than 5.125 per cent, making it unlikely the loss absorption trigger would be used in practice. With Australian major banks running CET1 ratios of higher than 11 per cent, they would have to deplete more than half of their CET1 capital base before reaching the trigger. While the loss absorption trigger could be increased, this could undermine recovery plan actions and the useability of capital buffers.
Advanced banks
There are currently six banks in Australia that have received APRA approval to use the Internal Ratings-based Approach to credit risk capital requirements (Advanced banks). Guided by the design principles outlined above, the proposed approach would:
• replace the existing 1.5 per cent AT1 with 0.25 per cent CET1 and 1.25 per cent Tier 2;
• increase the minimum CET1 requirement from 4.5 per cent to 6.0 per cent, but offset this increase by removing the Advanced portion of the capital conservation buffer of 1.25 per cent. The reason for this change is to maintain a minimum Tier 1 capital ratio of 6.0 per cent and a minimum 2.5 per cent CCB in line with the Basel minimum standards; and
• retain the total capital requirement plus CET1 buffer level of 13.75 per cent by increasing the minimum Total Capital ratio to 9.25 per cent as a result of the additional Tier 2.
Standardised banks
The design for banks using the Standardised Approach to credit risk capital requirements (Standardised banks) would mirror the Advanced changes, with further simplification:
• fully replace AT1 with Tier 2 capital; and
• remove the minimum Tier 1 Capital ratio.
APRA said it would “likely apply the following high-level transitional arrangements”:
• Changes to the minimum capital requirements and buffers would come into effect from 1 January 2027. This would include the increase to CET1 levels required of Advanced banks.
• From this date, existing AT1 instruments would be eligible to be included as Tier 2, until their first scheduled call date. All existing instruments would reach their first call date by 2032 at the latest.
• To maintain an orderly transition, APRA would not expect to approve regulatory calls of these instruments at an earlier date than the first call.
• APRA would also not expect to see banks increase AT1 from current levels or extend call dates beyond 2032 in advance of APRA confirming changes to prudential requirements.