After repeated scandals and questionable strategic decisions, in March 2023, the 170-year-old Credit Suisse, a pillar of the much-vaunted Switzerland’s banking system, was on the cusp of failure. To avert financial crisis, the Swiss National Bank intervened. Credit Suisse was ushered into the reluctant arms of UBS in a shotgun wedding. Through this process, AT1 investors controversially suffered loss of capital while lower ranked common shareholders where left whole (the precipitous fall in Credit Suisse’s share price notwithstanding).
Following these events and some internal regulatory soul-searching, APRA has released a discussion paper titled “Enhancing Bank Resilience: Additional Tier 1 Capital in Australia”. The bank regulator is reassessing whether AT1 in its current form is fit for purpose, which is to absorb bank losses in stress scenarios and provide capital to support bank resolution at the point of failure.
AT1 securities are a form of “contingent-convertible" bonds created after the global financial crisis to prevent the need for government-funded bail-outs of precarious banks. AT1 bonds are designed to convert into equity when a lender runs into trouble.
In reviewing AT1 in the context of its intended purpose – i.e. “to avoid the use of public money and safeguard depositor funds”, the regulator recognised that in its current form “certain design features and market practices that would create significant challenges, or potentially undermine, the effectiveness of AT1 in Australia,” (APRA).
On the table for review is the design, role and investor base of AT1. As AT1 securities are popular with retail investors, the outcome of this review has potential implications for the structure of such securities, and importantly their ongoing access to AT1. At this juncture, it is worth highlighting that in most jurisdictions, only sophisticated investors are allowed to invest directly in AT1. Australia is an outlier by allowing retail access.
Key Considerations
The tone of APRA’s discussion paper signals several potential changes are on the table. On the design side, two core areas stand out. Namely the coupon and when they can be paid and when they should be cancelled, and then beyond that conversion triggers, that is when AT1 should be converted or written off. I’ll touch on these in turn below:
Unlike tier 2 coupons, which are contractual and non-discretionary, AT1 coupons are discretionary. Nevertheless, there is an expectation by investors (and issuers to some degree) that coupons will always be paid. Accordingly, APRA fear banks won’t be willing to cancel coupons as required for fear of contagion risk. Consequently, APRA will look to implement constraints around distributions, with likely more prescriptive and granular conditions around when a coupon can be paid, to ensure banks are willing and able to halt coupons when necessary. If this goes ahead, it should increase the risk premium investors demand as the risk of non-payment of coupon has risen. Obviously, the cost to banks will also rise.
Next, we look at conversion triggers. Under the current AT1 framework, conversion (into equity) or write off of AT1 capital in a stress situation would be triggered when CET1 falls to 5.125%. This level was set when CET1 regulatory requirements were around 7.5% - 8.5% for the major banks vs now where the requirement is much higher, around 11.0% - 11.5%. Accordingly, in a bid to have AT1 loss absorption triggered sooner in a rising stress scenario, APRA have signalled that perhaps a more appropriate conversion trigger is 7.00%. Again, investors should demand a higher risk premium with such a change.
Another consideration for AT1, what is its role and is there an alternative capital that can fulfil that role more effectively? At present, the minimum level of tier 1 capital a bank must hold is 6.0% (excluding capital buffers and additional loss absorbing capacity requirements), of which 4.5% must be met with CET1, or common equity. The balance of 1.5% is generally met with AT1. Australian banks hold more AT1 capital compared to international peers despite the 1.5% being on par with global standards. APRA suggest this is likely the result of AT1 being listed and the high proportion of retail investors – that is, it tends to be cheaper for banks than common equity. In some research released recently, WBC calculated the four majors held $9.4bn of excess AT1 (vs regulatory requirements). A possible solution is to cap the level of AT1 that qualifies as capital. Result is less issuance of AT1.
Lastly, who is the investor base for Australian bank AT1, and are they appropriate holders given the intended purpose of AT1 capital. Of the A$40bn or so of outstanding AT1 capital on issuance by Australian banks, 53% is held by ‘retail’ or ‘smaller’ investors. Per APRA’s discussion paper…”Australia is an outlier internationally with a large proportion of AT1 held by domestic 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.” This concern is amplified by Australia’s relatively concentrated banking system.
In a former life, as Head of Credit Strategy at CBA, I often travelled to the US and Europe to provide views and analysis on Australian companies issuing into offshore markets. Being the biggest cohort here, the banks took up the bulk of my time. And within these discussions with offshore investors, a common theme was their utter surprise that Australian AT1 was predominantly a retail market. Long story short, APRA might restrict direct retail access to AT1 securities.
Other Considerations
There are various other considerations, but an important one that wasn’t really touched on in APRA’s discussion paper is deductibility. And here I’ll borrow some words from WBC, who commented on the matter recently…”one approach APRA may consider is changing the tax treatment of AT1 securities to be debt rather than equity capital as is the case in offshore jurisdictions. From an investor perspective, this would make AT1 similar to Tier 2 (APRA appear content with T2). Market access outside the listed space, particularly offshore, would improve providing added diversification to the investor base and seeing a natural down weighting of AUD AT1 supply. From a bank perspective the distribution impact is largely neutral (deductible interest vs non-deductible interest, but franked distribution), however pricing will clearly be impacted by market pricing differentials.”
Impact on Mutual Limited
Mutual Credit Fund (‘MCF’) and Mutual High Yield Fund (‘MHYF’) both have capacity to hold AT1 securities, however, here and now the two funds don’t. The risk-vs-return dynamics of the asset class in its current state is not attractive. Notwithstanding, as a firm we are experienced with AT1 as we have private clients who are active holders.
Applications for submissions close in November 15th. They’ll then take time to digest it all. Likely a 2024 story.
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