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Australia’s banking regulator has proposed that banks phase out the use of additional tier 1 bonds to meet capital requirements, highlighting concerns over the loss-absorbing instruments after the failure of Credit Suisse last year.
The Australian Prudential Regulation Authority said on Tuesday that banks should seek to replace AT1 bonds — which are contingent convertible securities designed to absorb losses — with “cheaper and more reliable forms of capital” by 2032.
The regulator has opened a two-month consultation over the move. The proposal represents a significant shift away from a regulatory approach to bank failure following the 2008 financial crisis.
AT1 bonds, which can be called upon when bank equity falls below a certain threshold, were part of a push to shore up bank balance sheets and avoid taxpayer bailouts.
But the market, which was worth about $260bn globally last year, has become a source of volatility, with falls in AT1 bond prices raising expectations of distress at the corresponding bank and the bonds causing legal controversy during actual failure.
Last year, $17bn of the bonds were wiped out during the collapse of Credit Suisse, prompting lawsuits from investors against the Swiss regulator. The bonds, which rank above equity in a bank’s capital structure, were treated more harshly.
John Lonsdale, chair of Apra, said the purpose of AT1 bonds was to stabilise a bank so it could continue to operate during periods of stress and 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,” he said.
Apra launched a review of the use of AT1 bonds last year following the collapse of Credit Suisse and Silicon Valley Bank to better protect the financial stability of the Australian banking system.
It looked at liquidity and the effectiveness of AT1s and has opted to push to phase out the use of the hybrid bonds, proposing that they be replaced with a mixture of equity and tier 2 bonds, a less risky instrument that can also be issued to meet regulatory requirements.
The regulator said risk was heightened in Australia due to what it said was an “unusually high proportion” of AT1 bonds held by retail investors. That made the country an “outlier” compared with markets such as the UK, which banned the sale of hybrid bank bonds to retail investors almost a decade ago.
The hybrid bonds have proved popular with Australian investors in recent years because of the relatively higher yield offered. Apra said retail investors could account for 20-30 per cent of outstanding AT1 bonds listed on the Australian Securities Exchange.
The Australian Banking Association, a trade body for the banking industry, said it would continue to discuss the move with the regulator.
“This would represent a significant change to a bank’s capital structure. Banks will now carefully consider the implications of Apra’s proposal, balancing any changes to costs of capital, as well as impacts on the capital markets and investors,” it said in a statement.
Brendan Sproules, an analyst with Citi, said the switch away from AT1 bonds would be “relatively ambiguous” for investors in the country’s banks, with most of the costs absorbed over the phaseout period.
He added that the bigger impact would be on retail investors with exposure to hybrid bonds, who will have to allocate their capital elsewhere.