Australian Banks Urged To Transition From AT1 Bonds To More Stable Capital Forms

The Australian Prudential Regulation Authority (APRA) has suggested that banks phase out the use of AT1 capital instruments (or hybrid bonds), in a bid to strengthen the bank capital requirements and reduce risk in the event of a crisis.

The APRA outlined the changes in a paper released Tuesday, which aimed to create a stable financial system by replacing the Additional Tier 1 bonds with low-priced, reliable forms of capital that would help banks endure losses if faced by a potential failure.

The total amount of regulatory capital that was mandatory for banks would, however, remain the same. It recommended the transition to a simpler capital framework from Jan. 1, 2027, with all current AT1 bonds expected to be replaced by 2032.

As of June 2023, Australian banks have a total of AU$40 billion worth of Additional Tier 1 (AT1) capital still outstanding.

APRA's suggestion came in the wake of Switzerland's financial regulator writing down Credit Suisse's AT1 bonds worth $17.24 billion to zero as part of the bank's rescue merger with UBS, in March 2023. The move had led to legal action by investors, who lost their money.

Since last September, the APRA had been discussing with various stakeholders the need to improve hybrid bonds, after last year's global banking turmoil led to several banks in the U.S. and Europe being severely affected. With a number of banks failing, the governments were forced to step in to prevent the risk of contagion and financial instability.

After the banking crisis, AT1s were considered to be the riskiest type of bank debt. They can make good money when banks are doing well, but can lose value if a bank is in trouble.

In Australia, each of the four major banks, Commonwealth Bank of Australia, Westpac Banking, National Australia Bank and ANZ Group, holds AT1 bonds equal to a minimum of 1.5% of their risk-weighted assets, The Straits Times reported.

"This would represent a significant change to a bank's capital structure," an Australian Banking Association spokesperson said, Reuters reported. "Banks will now carefully consider the implications of APRA's proposal, balancing any changes to costs of capital, as well as impacts on capital markets and investors."

Shares of all the four banks rose by 1% on Tuesday.

Under the APRA proposal, the banks could replace the AT1 bonds with 1.25% Tier 2 capital and 0.25% Common Equity Tier 1 capital, while the smaller lenders could replace AT1 with tier 2 instruments.

"The purpose of AT1 is to stabilise a bank so that it can continue to operate as a going concern during a period of stress, and support resolution with the capital that is needed to prevent a disorderly failure. Unfortunately, international experience has shown that AT1 does not fulfil this function in a crisis situation due to the complexity of using it, the potential for legal challenges and the risk of causing contagion. These risks are heightened in the Australian context due to the unusually high proportion of AT1 held by retail investors," APRA Chair John Lonsdale said.

The current investors would be excluded from immediate changes with the AT1 capital instruments still computing as regulatory capital until their first call dates.