APRA switches off AT1s

In a somewhat surprising announcement, on Wednesday the Australian Prudential Regulation Authority (APRA) released a discussion paper outlining a move towards “more reliable forms of capital”, headlined by a proposed phasing out of Additional Tier 1 (AT1) capital instruments by 1 January 2027 (with all current AT1 bonds on issue expected to be replaced by 2032). The proposed shift from AT1s to other forms of capital raises questions around the impact on funding costs and whether APRA’s assessment of the potential increase will hold true.

As market participants would be aware, AT1s have traditionally been viewed as the last bulwark of bank liquidity and as a key regulatory capital requirement; deeply subordinated instruments designed to absorb losses in crisis provide a stable source of liquidity and capital to support bank resolution, and to avoid public facing failures and bailouts. A more effective capital framework for a crisis puts forward a range of reasons for the shift, arguing that AT1s’ structural and practical complexity, potential for legal challenge, and contagion risk present an unacceptable risk to the market in light of the ‘cheaper [and] more reliable alternatives’ that could otherwise be used by market participants.

The proposal is as follows:

• 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 Common Equity Tier 1 (CET1) capital.
• Smaller banks would be able to fully replace AT1 with Common Equity Tier 2 capital (CET2), with a reduction in Tier 1 requirements.

This decision follows a consultation process begun by APRA in early 2023 following the high profile failures of banks in the US and EU. That ‘international experience’ seems to have guided APRA’s perspective that ‘a simpler capital framework… would enable banks to more quickly and confidently use their capital buffers in a crisis scenario’, together with ‘strengthening the proportionality of the prudential framework by embedding a simpler approach to capital requirements for small and mid-size banks’.

The next two months – which APRA will spend taking submissions on the proposal during a ‘discussion period’ – will be revealing as to the market’s reaction to this announcement (both in terms of the issuers of these types of instruments, and the Australian investor base, which, somewhat unique to the market for these types of instruments, includes retail investors). Although APRA has assured market participants that it does not envision ‘an immediate impact’, and ‘is not proposing changes to AT1 settings for insurers’, we believe reactions and next steps should be monitored, as this step appears out of keeping with global trends. Perhaps unsurprisingly, the price of many Australian issuer AT1s have trended lower since APRA’s announcement.

In the EU, the Basel Committee on Banking Supervision held a series of meetings with stakeholders and regulators at the European Banking Authority in March, seeking views on how well AT1s performed during 2023, with a particular focus on the collapse of Credit Suisse, any prospective changes to the investors’ views on instrument risk, and whether banks were changing terms on AT1s. The Committee said it was carrying out ‘analytical work based on empirical evidence to assess whether specific features of the Basel Framework performed as intended during the turmoil’, but made specifically clear that it was ‘not currently planning to phase out AT1s’.

Indeed, there are fresh signs of recovery in the AT1 market globally – in April of this year, Lloyd’s (Britian’s biggest domestic bank) announced that it would repay an AT1 bond, following Credit Suisse’s announcement in the same month that it would redeem a 1.25 billion euro AT1. This sentiment appears to run contrary to the fears raised by some European regulators that a lack of liquidity and soaring yields would make it difficult to market new bonds; appearing to endorse the Committee’s decision. This optimism isn’t limited to Europe; the Royal Bank of Canada announced the offering of US$1.0 billion of non-viability contingent capital LRCNs (the Canadian equivalent of AT1s), registered with the U.S SEC.

APRA seems to consider Australia, with its heavy concentration of retail investors in the AT1 asset class, as anomalous in the context of the global market for these instruments, and see the cost to the market as outweighed by the potential for protecting that vulnerable class of creditor. Australian AT1s though are not necessarily the same as those instruments issued in offshore markets. Rather, Australian AT1s tend to be higher rated, investment grade instruments (issued by comparatively higher rated Australian issuers), with reasonable levels of liquidity (and trade on the ASX). Unlike the multi-faceted business of Credit Suisse at the time of its recent AT1 wipe out, Australian issuers tend to have more focussed business models.

From a practical perspective, the real impact here for institutions is potential changes to costs of funding – Australia’s big four banks each hold AT1 bonds equal to at least 1.5% of their risk-weighted assets, and APRA’s view is that the trade to CET1/CET2 will yield a ‘relatively low’ increase in funding costs for the ‘advanced banks’ – working from a figure of $70 million as a base case. It remains to be seen if this projection will hold true as the regulator works through the discussion period; NRF and our global team of capital markets specialists are continuing to review the proposed changes and will publish additional updates as more information becomes available.