APRA proposes abolishing AT1 bank hybrids

This morning, APRA announced an intention to simplify the regulations regarding the way banks fund themselves, with more bonds and fewer hybrid instruments.

At present, banks use a combination of pure equity (known as CET1), hybrid instruments (like CBA PERLS, or NAB Capital Notes, collectively known as AT1 instruments) and subordinated bonds (known as Tier 2 instruments).  

APRA is proposing to phase out AT1 hybrid instruments and replace a bank’s capital requirements with more Tier 2 and CET1.

Following the experiences in the US in 2023, it has become clear that while the AT1 hybrid instruments appear on paper to provide protection to banks, they are overly complex and hard to use.

When a bank is in mild distress, many features of hybrids have protective effects that cannot, in practice, be used without creating dangerous signalling effects to the market. For example, a bank announcing that “we are under more financial pressure than is generally understood and so are exercising our right to delay coupons on our hybrids” would make the situation much worse, not better. As such, the ability to delay those coupons looks good on paper, but isn’t useful.

When a bank is in severe distress, time is of the essence. Complicated rights and processes that cannot be quickly activated are not fit for purpose. This is particularly true in Australia where the majority of the hybrids are owned by retail investors. That structural positioning would make it very hard (and perhaps politically difficult) to organise a quick write-down of hybrids to protect a bank, in the unlikely event that it is necessary.

Some of the provisions for AT1 hybrids are only accessible once a bank has failed. While outlining the rules for resolution does affect bank and investor behaviour prior to failure, the overarching idea is to prevent bank failures.

Finally, Australia was a relatively early mover on AT1 hybrids and other countries have not followed. As such, the large use of AT1 in Australia is out of step with global standards.

APRA is suggesting that the current requirement of 1.5% of risk-weighted assets to be issued as AT1 hybrids be abolished. Large banks would be asked to replace this with an extra 1.25% subordinated Tier 2 bonds, and an extra 0.25% of pure equity. Smaller banks would fully replace AT1 hybrids with Tier 2.

The APRA proposal is still in the discussion phase, with further comments requested by November 2024 and final actions not until 2025. Existing notes and hybrids will not be affected, so this will be a slow, incremental change over coming years.

Over time, the changes will see more Tier 2 subordinated bonds issued and will also likely see the risk in newly-issued subordinated bonds rise slightly, increasing their margins and yields.

Overall, we expect the new processes should be simpler and easier to understand, making for more efficient bond markets and greater opportunities for bond investors.