Australia Wants Banks to Phase Out AT1 Bonds

As part of its plans to the capital framework for banks in relation to hybrid instruments to improve the effectiveness of bank capital in a crisis, the Australian Prudential Regulation Authority (APRA) on Tuesday wanted the banks to phase out the use of AT1 capital instruments and replace them with cheaper and more reliable forms of capital which can absorb losses more effectively in times of stress.

The proposed changes, outlined in a discussion paper released on Tuesday, seek to support financial system stability at times of crisis with simpler and more certain resolution of banks in the unlikely event of failure. They are also aimed at reinforcing confidence in the safety of deposits at times of stress.

The total amount of regulatory capital that APRA requires banks to hold would remain unchanged and banks would remain ‘unquestionably strong,’ APRA said.

The proposed changes draw on the lessons of last year’s global banking turmoil where several US and European banks either failed or needed to be resolved in short succession, with a number of governments having to intervene to minimise the risk of contagion and financial system instability.

Tuesday’s announcement follows an extensive consultation process that began with the release of a discussion paper last September asking for feedback on ideas to improve the effectiveness of AT1 for use in a potential bank stress scenario.

After receiving feedback from 26 submissions and more than 40 engagements, APRA identified three potential options: maintaining the status quo, redesigning AT1 to make it operate more effectively when required, or replacing AT1 with other existing, more reliable forms of capital.

Right Settings Needed

APRA’s Chair John Lonsdale said that it was essential to have the right settings in place to protect depositors and financial system stability in the unlikely event of a bank failure.

He said that the purpose of AT1 was 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 did 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, he said.

Replacing AT1 with more reliable forms of capital will enable banks to more quickly and confidently use their capital buffers in a crisis scenario and is expected to reduce compliance costs for banks.

“It will also strengthen the proportionality of the prudential framework by embedding a simpler approach to capital requirements for small and mid-size banks compared to the new requirements for large banks,” Lonsdale said.

Under APRA’s proposed approach, large, internationally active banks would be able to replace 1.5% AT1 with 1.25% Tier 2 and 0.25% Common Equity Tier 1 (CET1) capital and smaller banks would be able to fully replace AT1 with Tier 2, with a reduction in Tier 1 requirements.

APRA has proposed commencing the transition to the simpler capital framework from 1 January 2027, with all current AT1 on issue expected to be replaced by 2032.

APRA’s intention is for an orderly transition path with changes implemented over time. For existing investors, APRA does not envision an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates. APRA is not proposing changes to AT1 settings for insurers.