Late last year APRA announced it was reviewing whether AT1 securities were fit for purpose as effective loss absorbing capital. A review that was triggered by the collapse of Credit Suisse earlier in 2023, and specifically the treatment of AT1 investors, who were wiped out, while equity investors were left whole. An outcome that contravened the natural order of all things’ regulatory capital. Recall, Australia is one of the only developed markets where AT1 securities are available to retail investors. In most similar jurisdictions, AT1 investing (direct) is restricted to wholesale investors. This retail presence in Australian markets represented an area of concern for APRA, specifically whether ADI’s had the intestinal fortitude to use AT1 for loss absorption as per its initial intended purpose should the proverbial hit the fan.
APRA has today announced it is proposing the phasing out of AT1 within bank capital stacks, replacing it mainly with Tier 2 capital (subordinated debt) and a smidge more CET1. The minimum prudential capital requirements remain unchanged, at 13.75%, just the composition has changed - simplified. The proposal is for existing 1.5% AT1 requirement to be replaced by 1.25% Tier 2 and 0.25% CET1 for large banks and all AT1 with Tier 2 for smaller banks. If implemented as proposed, the changes would be phased in from January 2027 through to 2032, when the last existing AT1 line is due to be called. Essentially, upcoming AT1 calls will be refinanced with Tier 2 as they roll off.
To maintain an orderly transition, APRA will not expect to approve regulatory calls on these instruments earlier than their documented call dates. Basically, existing AT1 securities will continue to do their thing before eventually rolling off, with the last few lines not due to be call for another 7 years yet. To this end, we note the price of ANZ’s Mar-24 issued AT1, has rallied +0.5% on the day, with traded volumes well below average. Similar for WBC’s Dec-23 issued AT1, up +0.8% on the day, with lower than usual volumes. Over the very near term, we perhaps see a better bid for AT1, but in time they’ll dwindle on the vine, posing longer term threats to hybrid funds and ETFs.
Tier 2 spreads in secondary markets are a smidge wider on the news, a basis point at worst, with minimal traded flows. The orderly transition process ensures there is plenty of time for banks to replace AT1 with Tier 2 without causing any undue stress on the market’s digestive capabilities. ADI’s have ramped up from just 2.0% Tier 2 to 6.5% as part of APRA’s ALAC requirements over the past five-plus years with spreads currently trading towards the tight end of historical ranges. Accordingly, I don't expect an additional 1.25% of Tier 2 by 2032 will materially weigh on spreads in the medium term. In dollar terms the volume of Tier 2 required by 2032 is estimated to be somewhere between $24bn and $26bn, which would see the Tier 2 market grow 20% by the completion of the phase out
APRA did raise the risk of a downgrade to Tier 2 securities from the rating agencies as the loss buffer normally provided by AT1 will disappear, and only been partially replaced by higher CET1. No word yet from the agencies, but this process will be a slow bleed, so I actually doubt any downgrade will be forthcoming. Having said that, if a downgrade eventuated, ratings would be back to where they were six-months ago.
Looking further afield, the move from APRA is positive for Mutual’s funds. More Tier 2 issuance increases the depth of our investment pool, and we would expect to capture some flows out of hybrid ETF’s as the investment universe disappears. Mutual’s fund invest extensively in bank debt securities, including senior bonds and Tier 2 paper. Following the announcement from APRA, some hybrid investors have talked up the prospect of listed Tier 2 issuance as an alternative for them, but I find this a naïve hope. APRA’s decision around AT1 is because they don’t want loss absorbing capital in the hands of retail investors. APRA has alluded to this by saying… “converting AT1 would impose losses on investors who may not be prepared to absorb those losses, potentially leading to contagion in the broader financial system, further undermining confidence in a crisis. This is heightened in Australia where retail investors, who are less equipped to absorb losses compared to wholesale investors, participate in the AT1 market.” While that references AT1, it’s hard to see how it’s not relevant for Tier 2 also.
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