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Little to fear from APRA's hybrids review

Banking regulators have a real dilemma: there is a choice between safety versus effectiveness. APRA could make the system completely safe for depositors, with 25% equity levels and dividends only payable when profits reach a certain level. However, if they did that, they wouldn’t have a banking sector to regulate as the cost of banking products would be prohibitive and/or no investor would give banks capital because there would be no prospect of decent returns. Banking type activities would migrate to the non-bank sector with all the potential issues that come from non-regulated finance sectors blowing up. If they went to the other extreme and let banks operate with very little capital and limited regulation, you get lots of profitable banks and regular banking crisis (see GFC experience).

A banking regulator must try and walk that tightrope. They tend to safety because there is enough evidence that a systemic banking crisis results in GDP falls of 25%. But a risk-free banking system has the same economic result: bad stuff just happens in a different way.

This is where we think APRA is with their call for comment in September regarding AT1. It is a largely subjective trade off, so we think it’s worth discussing.

No loss for existing hybrid holders

APRA’s call for comment has finished on November 15, and they will release the results in early/mid 2024. Whatever their decision, there should be no loss for existing hybrids. The table below shows a summary of potential APRA decisions and our view of what it might mean for existing hybrids.

Why does APRA object to hybrids?

Both APRA and ASIC have been wary of retail investor exposure to hybrids for the last decade. We don’t think many of the arguments stand up to evidence or discussion, but because they get repeated so often, some of them have gained the status of semi truth. There seems to be a range of arguments from both the discussion paper and the AFR articles in the week after.

This year was about liquidity crisis not solvency events

  • (from APRA) AT1 was only used when recent international banks (SVB? Credit Suisse?) had collapsed rather than providing capital support earlier in the crisis.

We disagree with APRA’s interpretation of these events.

SVB was clearly a liquidity event rather than a solvency event. It went broke in the space of less than a month after concerns become apparent. The final liquidity run was just 2 days. Converting an AT1 in that month would not have changed the click induced bank run. Arguably, one of the catalysts for the liquidity event was the recognition that SVB had enormous unrealised losses on securities (due to higher interest rates). If SVB was subject to Basel 3 regulation (or Australian Basel 3 regulation), those unrealised losses would have been deducted from equity levels, and SVB would have been in breach of its capital levels. It would have been required to convert hybrids to equity or raise new equity. If that was the case AT1 would have done its job, but we will never know.

Credit Suisse. For the past 10 years Credit Suisse has been a really bad, but still solvent bank. It was solvent in February 2023, one month before collapse. Its average RoE for the last decade is around 3% and there were continual stupid events. Despite that, it has been operating with 13% CET1 levels over that period, which is above Australian bank levels. Prior to February 2023, it had been able to raise debt and AT1 and Tier 2 capital relatively easily and it had an investment grade rating. This all changed in February/March when deposits disappeared, and the Swiss authorities acted. Bagehot, who wrote the bible on central banking believed “to avert panic, central banks should lend early and freely (without limit) to solvent firms against good collateral and at high rates”. The Swiss forgot that (or never learned), and they shot-gunned a marriage to UBS which involved the wiping out of CS AT1’s. As it turns out UBS paid not much for $57B USD of net assets and the only legitimate post acquisition write offs were about $2.3B of asset/goodwill write downs and $4.5B of regulatory costs. The assets were OK. This was a solvent (bad) bank finished off by a liquidity run. Converting AT1 in 2022 or earlier would not have altered the situation.

Too much retail involvement?

  • (from APRA) Australia is an international outlier due to the level of AT1 held by retail investors

And? Australia is also an international outlier in the extent to which retail owns the ordinary equity of its financial system. Direct retail and SMSF probably own more than 40% of bank equity. The major banks have a capitalisation of $400 billion. Hybrids have a market capitalisation of $42 billion. If APRA is worried about the effect of retail ownership of bank capital instruments, bank equity will fall further and faster than hybrids and should create more problems of that kind. It’s hard for us to comprehend APRAs view that it is worried about ‘unsophisticated’ or ‘unaware’ investors investing in hybrids. Since 2021, only ‘wholesale’ investors can purchase hybrids at new issues. These investors almost all use financial advisers, who themselves are licenced and are required to select appropriate investments. Most financial advisers have approved product lists and probably have access to expert/independent advice. We can’t see where the concept of this “knowledge vacuum” comes from.

Clearly, non-wholesale/non-advised investors can buy hybrids on the secondary market. If we look at the 3 largest non-advice broking platforms (Commsec, CMC, Open Markets), they account for around 10% of turnover of all hybrids. All the other turnover is via brokers that offer advice. We think that given the warnings about hybrids, the experience of hybrids going to $0 (Axess, Virgin, Allco, Babcock and Brown etc), and the small number of investors who haven’t received advice, the problems of retail unadvised ownership are not material. We’re not sure that wholesale changes to protect 10% of a $42 billion segment is an example of good policy.

  • (from APRA/Media) Problems of banks having to compensate retail investors who own hybrids

In their paper APRA cites examples of Spain and Italy where banks that defaulted/reconstructed had to compensate investors. In at least some of these cases, the banks had offered hybrid type securities to customers alongside deposits. Customers walked into the bank and were offered a deposit or a higher yielding hybrid, without the risks being explained. Unsurprisingly, some opted for the hybrid. When the bank was restructured the hybrid holders suffered losses. The banks had to compensate the investors due to the banks explicit or implicit mis-selling. It’s a little disingenuous for APRA to cite these events as a comparison to Australia. Here banks have no role in investors buying hybrids. There have been no shareholder offers since 2021 and any investment in hybrids is via a financial adviser or via a broking platform. It is difficult to see how the banks would be required to compensate investors as they did in Spain and Italy. The banks’ and APRA’s response would be “go and sue your advisor“. There were also concerns about litigation from upset investors and some speculation that it would be worse from retail investors. It’s not obvious these concerns are valid. Apparently, there were 1000 lawsuits regarding the bail in/reconstruction of the Spanish Bank Popular which was shuttered in 2017. None have succeeded.

Banks won’t stop dividends

  • (from APRA) Banks are reluctant to stop AT1 distributions and hybrids haven’t been converted early enough

APRA notes that Credit Suisse didn’t cancel AT1 payments despite incurring losses and facing “uncertain profitability outlook” (we’re not sure when any profitability outlook is “certain”). Let’s start with the observation that hybrid distributions must be paid if the bank pays dividends on the ordinary shares (fair enough). Let’s also note that Australian banks have consistently been viable enough to pay dividends (Westpac has paid an annual dividend since 1817). As per APS 111, banks can pay dividends provided they have an adequate process around capital and are above the required capital buffers. There is a specific waterfall about how much capital they can distribute depending on their equity levels. APRA’s issues about banks paying AT1 distributions are entirely their own making. If APRA is sufficiently concerned about banks making hybrid capital distributions, they can simply instruct banks to stop them. Dividend payment or not does not relate to the structure of AT1 instruments or their ownership. But this is not a consequence free exercise. ANZ lost a lot of money in 1992 (but still paid a dividend). Should APRA have kvetched about banking system capital and exercised its discretion to halt dividends (and hybrid distributions)? As it turns out the directors were right to continue paying dividends. Two years later the RoE hit 18%. If APRA exercised its discretion (and was wrong), investors would have added an APRA risk premium to capital which would have resulted in more costly and less access to capital.

Trigger levels increasing

Under current regulations, hybrids are automatically converted to equity if CET1 levels reach 5.125%. We think that APRA’s view that this is too low for “going concern” capital is valid. If a bank reaches 5.125%, it is a “gone concern”. APRA’s last stress test had the usual dire scenarios (10% unemployment, house prices falling 33%, no equity raisings), but apparently no bank breached the 5.125% trigger level. If those stress test conditions did occur, banks should be raising equity or converting hybrids. If (when!) APRA makes that change, new hybrids will be issued with a c7% conversion trigger. Existing hybrids will retain the 5.125% trigger. We think that pricing of new hybrids will be relatively unaffected in those circumstances. Under current documentation, investors receive $100 worth of shares provided that the share price at the time of conversion is greater than 20% of the issue price VWAP. We find it hard to see bank share prices falling by 80% for a bank which has a mild capital shortage and is reasonably profitable. It’s a different story for equity, which gets diluted pretty heavily if this happens.

Why APRA shouldn’t make wholesale changes

We noted before that regulatory policy is a trade-off between safety and effectiveness. By any standards, APRA is one of the most conservative regulators in the world. The US regulator is reluctant to implement standard Basel 3 because it is anti-economic. Australia’s version of Basel 3 is even more restrictive. Is APRA too conservative? If you ask a new business owner who can’t get bank finance and has to use non-banks or a credit card, APRA probably is too conservative. More concretely, locking retail out of providing bank capital will lead to higher cost of capital and less access to capital.

What eventually happens?

Our inkling is that there will be little change, due partly to the enormous changes that are needed to create a viable institutional market. We can’t see any banks being able to issue to institutions until the ATO allows banks to issue unfranked bank capital instruments. Unless APRA is able to convince the ATO to change its long-held rules on franking of equity instruments within the next few months, their early/mid 2024 response will have to be no material changes to the status quo. In addition, there has been a lack of precautionary bank hybrid issuance in the 2 months since the paper was published.

Conflict of interest statement: we manage hybrid funds. Changes to market structure will affect us but if retail is locked out of direct ownership of hybrids, an unknown portion of investments will transfer to managed funds such as EHF1. Arguably we would end up managing more funds.


Campbell Dawson is Managing Director of Elstree Investment Management, a boutique fixed income fund manager. This article is general information and does not consider the circumstances of any individual investor. Financial advice should be sought before acting on any opinion in this article. Elstree's listed hybrid fund trades under ticker EHF1.


John Abernethy
December 03, 2023

Thank you Campbell,

When I started in funds management hybrids ( other than convertible notes) did not exist in the capital structure of banks.

The creation of hybrids and AT1s has emerged from financial engineers ( investment banks and bank CFOs) sanctioned by bank regulators ( APRA and Treasury) and importantly supported by the ATO ( whom has allowed franking to be attached to the distributions).

The franking is allowed even though the hybrids are not issued as permanent capital. The hybrids are issued with equity risk but they have a term. It is the equity risk factor that seemingly supports the ATO allow for franking to be attached. The ATO support is crucial and has not been contested by the government.

I make the point about the ATO because it has made decisions ( for example allowing dividend washing through the sharemarket or off market concocted buybacks) that have sanctioned dubious tax minimisation schemes.

Once franking is attached to a hybrid then super funds ( particularly SMSFs in pension mode) are attracted.

In my view a hybrid review by APRA is highly desirable and what is more desirable is an outcome which creates a proper hybrid security, that is appropriately identified as permanent capital or a true secured loan to the bank, and which appropriately compensates the investor for the risk they are taking - with that risk being clearly defined.

December 04, 2023

This also suggests that the review should probably be performed by Treasury and consider AT1 hybrids, including the appropriateness of a these instruments having franking attached.

The apparent concern for retail investors is an issue for ASIC (acknowledging they do appear to be working together on the topic).

Also the desire for a more diversified investor base appears slightly misplaced. If retail investors leave the market then the cost of these instruments would logically increase, since those other investors have not buying as much at available prices. Diversification of a deposit base is important however hybrids (obviously) cannot be cashed in by their holders.

Campbell Dawson
December 05, 2023

Hi John
Most AT1/Hybrid securites look the same around the world due to Basel 3 and the need to have roughly equivalent banking capital structures and consistent instruments. It would be hard to see APRA walking away from Basel 3 consistency, so I suspect we are stuck with AT1 formats for a while yet.
In Europe they used to be called CoCo's (contingent capital) which is a good description of how they should operate; when everything is fine, they look like debt, but if the bank gets into enough trouble they become equity ie they turn into perpetuals with no repayment date and/or there are no distributions (and no accumullation either) and/or get converted into equity.
So, theoretically, they do provide permanent capital provided the directors or APRA act appropriately.
Advanced tax planning is a far too dark art for me, but it is interesting to note that no bank has been (yet) able to issue a non franked AT1, which we think is due to the ATOs stance on franking of equity instruments
Thanks for your response. We will all be waiting and seeing what APRA does

December 01, 2023

Contrary to the author's view, as a boutique fixed income fund manager, if one is a retiree, a SMSF trustee or any small retail investor wanting to diversify into hybrids, there is indeed much to fear from APRA's hybrids review. The discussion paper contemplates various options, including raising the minimum hybrid purchase, eg to $500,000. That will certainly have a negative impact on small retail investors.

From the discussion paper:
"3. Participation in AT1
APRA could seek to reduce the risks resulting from the high level of retail ownership by amending the eligibility criteria for AT1 to include conditions on the investor base. This approach would align with international practice that restricts retail ownership of AT1. It would diversify the investor base away from domestic retail investors.
There is a range of ways these conditions could be defined including, for example, by requiring minimum denominations for parcel sizes in which AT1 capital could be sold to effectively restrict participation to wholesale investors.
Footnote 21: Denominations prescribe the minimum parcel size that an investor could hold in that security. This would represent the minimum parcel size that the AT1 Capital instrument could be broken down to and therefore the minimum investment required to purchase the security (e.g. $500,000)."

Implementing Option 3 to make a minimum hybrid investment $500,000 is designed to deliberately exclude small retail investors from direct investments in the hybrid market. This will disadvanatge small retail investors, but benefit boutique fixed income fund managers.

Small retail investors should make their own submissions to APRA to ensure our interests are protected and that the inquiry does not just hear the views of fund managers. Contact details for submissions are at the end of the discussion paper.

November 30, 2023

I am an "unsophisticated" retail investor who has used bank hybrids issued by the Big 4 for many years as a (small) part of my portfolio. The returns from these have been valuable and they are an important part of the diversity of my portfolio. I understand that there are risks of loss of capital associated with these instruments, but I also think I have a good sense of the magnitude of that risk - particularly compared with the risks associated with investing in ordinary shares of the Big 4 (which I also own).
APRA should by all means publish warnings that highlight investment risks - but then get out of the way and let us "unsophisticated" investors get on with managing our own investments!

November 30, 2023

I agree with Peter totally. If I already hold a bank hybrid, even as an 'unsophisticated' investor I should be able to roll over that investment when a replacement hybrid is offered.

November 30, 2023

I think most of this is correct but the idea that financial advisers let alone "sophisticated" investors understand how hybrids work, in what circumstance they would convert to equity, or how to price them is absolutely laughable. There is next to no understanding of this by financial advisers and I seriously doubt that more than a handful of financial planning firms have any idea of how to price these complicated instruments, if that many. And the vast majority of "sophisticated" or retail investors buying these on the secondary market could not tell you any of the above if their life depended on it.

That doesn't mean that they're not a viable part of the overall portfolio for clients, but it's based on blind trust not actual understanding. So if any of the hybrids ever default, it will be lawsuits galore, which the regulator is presumably keen to avoid, along with the losses were this to be the case.

December 02, 2023

Well said. The Credit Suisse AT1 Wipeout also caught a fair number of more sophisticated institutional investors along with the retail investors.

Mark B
December 03, 2023

I agree, that's no doubt true. However, I would suggest that a significant number of investors buying shares are also not completely aware of all the risks facing the companies that they are investing into and whether prices accurately reflect that risk. How many of these hybrids have gone south versus the number that have listed? Maybe the risk is indeed worth it for us "non-sophisticated" investors.


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