David Murray released the much anticipated final report of the Financial System Inquiry (FSI) on Sunday. There were 44 recommendations to make substantial changes to Australia’s financial system to:
- Improve resilience
- Reduce the requirement for regulatory intervention
- Increase the value of the superannuation system
- Improve consumer outcomes and increase innovation
Many of these, if implemented, will impact the banks’ business models going forward and have implications for bank investors’ risk and return. The impact on investors will vary across the capital structure with senior bond, subordinated debt (Tier 2) and hybrids (Alternate Tier 1) the likely winners while equity returns will diminish.
In this Wire article, we focus on the recommendations that seek to address the resilience of our financial markets and specifically the FSI’s approach to removing the “too big to fail” implicit guarantee our Big 4 banks enjoy. How does this impact the capital structure of the banks? What does it mean for investors in bonds? Hybrids? Sub debt?
Firstly, the FSI has made the following three key recommendations relating to the banks to reduce the probability and cost of failure:
- Increase capital levels so capital ratios are unquestionably strong; this requires the major banks to raise capital so they are in the top quartile globally. This has been estimated to require around 2.2% or $20bn1 of primarily common equity capital T1 (CET1)2.
- Increase the risk weightings of housing mortgages for the major banks from 18% to 25-30%. This will remove the advantage enjoyed by the major banks and will increase capital requirements for residential mortgages.
- Implement a loss absorbing and recapitalisation capacity framework in line with the emerging global framework. This is a minimum capital base that can absorb losses in time of financial distress (see diagram below). Currently this includes equity (CET1) and subordinated debt (T2) and hybrids (AT1) that contain capital triggers or bail in clauses3. The inquiry raises the potential for another layer of debt above T2 and below senior debt that could also have bail in clauses.
The diagram below is from the FSI report and demonstrates the capital structure, capital ratios and the loss absorption capacity framework.
If the key FSI recommendations are accepted, the banks will need to meet higher capital ratios combined with higher risk weightings on residential mortgages. It is estimated that the major four banks will need to raise between $20-35bn of new capital. This will be primary CET1 but depending on APRA and global trends could include other loss absorbing capital (AT1, T2 and “bail in” senior debt).
For existing investors in the major banks’ capital structure here is the likely impact:
- Senior debt: the requirement to hold more subordinated capital in the form of CET1 and potentially T2 and hybrids provides further buffer for senior debt holders. This is a positive for credit and improves bond holders’ position. The only caveat here is the possibility of a downgrade in credit rating. The banks enjoy a two notch upgrade due to the implicit government guarantee which will be reviewed as part of this process.
- Subordinated debt (T2): net a positive even though the mix of new capital required is yet to be determined, the FSI has recommended CET1 as the primary source of new capital. This provides an increased buffer for subordinated debt holders and is positive for the credit. However, the ultimate capital mix is at the discretion of APRA and should it decide to allow T2 and T1 in place of CET1 then this increased supply may put pressure on credit spreads.
- Hybrids (AT1): net a positive as, even though the mix of new capital required is yet to be determined, the FSI has recommended CET1 as the primary source of new capital. This provides an increased buffer for hybrid holders and is positive for the credit. However, the ultimate capital mix is at the discretion of APRA and should it decide to allow T2 and T1 in place of CET1 then this increased supply may put pressure of credit spreads.
- Equity: the requirement to hold higher levels of CET1 and higher levels of capital against home loans will result in lower returns on equity. Over time this may impact on the banks’ ability to pay out increasing dividends.
The key caveat to the above analysis is that the FSI recommendations are exactly that, recommendations. We now have to wait and see what the government decides to take up and turn into legislation or APRA policy. The FSI provides a framework for a stronger and more resilient financial system that encourages competition so you can bet there will be plenty of lobbying to get aspects watered down/ignored.
1 FSI states the plausible range for CET1 is 10-11.6% versus the 75th percentile cut off of 12.2% and analysts estimate this at $20bn of additional capital (AFR 8 December) 2 FSI has recommended APRA determine the mix between CET1 which is ordinary equity and total capital which also includes T2 and AT1
3 Securities convert into equity or get written off where APRA determines the bank is non-viable
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