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The future of bank hybrids is open to question

The Australian Prudential Regulation Authority (APRA) is currently undertaking a review of hybrid capital bonds (often referred to as 'bail-in bonds') issued by banks, with a focus on those known as Additional Tier 1 (AT1) instruments. This is hardly surprising since recent international experience (particularly the demise of Credit Suisse) has shown them not to work for the purpose for which they are designed. Their continued use, rather than just redesign of some of their features, is open to question.

Context to the review

Bail-in securities were introduced as part of the Basel 3 regulatory framework following the Global Financial Crisis, and introduced in Australia in 2013. AT1 securities are intended to provide the next line of protection, after common equity, against bank failure. This is meant to occur by them being 'bailed-in' to convert into equity should the bank’s equity capital base fall sufficiently for the bank to reach a point of “non-viability”.

APRA would make the decision to require the 'bail-in', but the exact features of what a bail-in would entail (exactly when, how many, and which of, the securities to be bailed-in) has been left purposely vague. Should a bail-in of all AT1 securities be insufficient to adequately recapitalize the bank, then another class of bail-in securities (Tier 2) would be bailed in.

It can be argued that the existence of bail-in securities (used to keep capital ratios above APRA-required levels) helps to reduce risk of depositor (or other creditor) runs by the psychological effect of them providing a larger buffer to absorb losses. But that could also be achieved by simply requiring higher levels of equity, and avoiding the question of whether a bail-in will work when it is implemented.

Problems with bail-in bonds

One reason for doubting the robustness of the bail-in approach is found by asking what happens when a bail-in occurs? The total capital (equity plus bail-in securities) ratio of the bank won’t be changed, just its composition.

So, the bank will likely need to issue new securities to increase its capital ratio - and what investors would want to subscribe to a new issue by a bank which has just been seen to be in difficulty? And larger depositors not covered by the Financial Claims Scheme will likely think it prudent to move their funds elsewhere.

Bail-in is meant, in theory, to enable the bank to continue operations, but in practice is more likely to sound the death-knell of the bank.

Other issues

There are further complications in the specific Australian situation. AT1 securities generally pay franked dividends, and have hence been attractive to Australian retail investors, and unattractive to foreign investors who do not value the franking credits.  The foreigners prefer the AT2 securities which pay unfranked distributions.

It is difficult (impossible) to imagine John Lonsdale (CEO of APRA) not consulting the Australian Treasurer before doing a bail-in of a bank’s AT1 securities. And it is even more difficult to imagine the Treasurer being willing to have Australian retail investor holders of AT1 securities being bailed-in while foreign investors holding Tier 2 hybrids are not bailed in. The politics would prevent the bail-in regime from operating in the way it is designed to.

One way to overcome that problem might be to preclude retail investors from the AT1 market. The introduction of Design and Distribution Obligations (DDOs) powers to ASIC has meant that retail investors are no longer generally able to participate in new issues of AT1’s. But, paradoxically, once issued, the AT1’s trade on the ASX and so are available to retail investors.

Given the difficulties in pricing the bail-in risk of these complex AT1 securities, and thus identifying their appropriate yield, it is also paradoxical that they should be available to retail investors who really cannot evaluate the risks. If nothing else, legislation to prevent AT1 securities from paying franked distributions could be expected to diminish retail investor interest.

There are numerous other problems with the bail-in approach – most particularly that it is unlikely to work! But the fundamental question which should be asked is why require these complicated bail-in securities as part of the bank’s capital base rather than simply having a higher required level of common equity. It is by no means apparent that replacing bail-in securities with common equity would substantially increase the overall cost of bank funding.

 

Kevin Davis is Emeritus Professor of Finance at The University of Melbourne. 

 

6 Comments
Michael
December 17, 2023

While APRA would clearly understand that the removal of franking would be attractive to the current Federal Government, the simple test for APRA on this question is whether they will make logically consistent decisions.

For example , why would retail investors be permitted to participate in the highly likely scenario of the issue of bank shares through an entitlement, before AT1's are bailed in, and for which the risks may also not be properly understood (as with AT1)?

Buy-side credit analyst
December 14, 2023

Professor, can you please work us through how "it is by no means apparent that replacing bail-in securities with common equity would substantially increase the overall cost of bank funding"? Big assertion that is not backed up with research (ironic).

T2 (not AT2 as you incorrectly stated) cost on weighted market cap average over the past 10 years for the Big Four is 3mBBSW +1.60%.
AT1 economic cost (franking included) over the same period for B4 is 3mBBSW +3.00%.
Average B4 bank dividend yield (franking included) over 10 years is ~7.75% (3mBBSW+6.00%).

Also interested to see the Professor's research on majority of our T2 securities being sold to offshore investors? Just one example I could quickly find but Suncorp's T2 issued in September had $2bn in demand of which 91% was Australian according to deal stats.

AT1 and T2 is not for everyone, but serve a purposes to banks, depositors, investors and regulators.

Jonathan
December 14, 2023

Hi Kevin, what do you mean by "recent international experience has shown them not to work for the purpose for which they are designed." For Credit Suisse, taxpayers and depositors were spared so arguably they did fulfil their primary purpose, to protect higher ranking creditors for losses.

Aussie HIFIRE
December 15, 2023

They are supposed to rank higher in the capital structure than ordinary shareholders, but in the case of Credit Suisse shareholders received a payout and those who held the hybrid securities did not. This is the subject of a lawsuit at the moment, but if you owned the hybrids and got zeroed whilst sharesholders got paid out you might not think that you were treated fairly.

Nic
December 18, 2023

The terms of the Credit Suisse hybrids specifically stated that they would be written off to nothing if the bank failed. The investors knew this. Any lawsuit by Credit Suisse investors is pointless. The only people complaining about the Credit Suisse outcome are people who didn't look at the terms. These structures are not issued in Australia and so are pointless to discuss in tandem.

SGN
December 14, 2023

Who are the majority holders of big bank Hybrids ?
They Australian investors and in my opinion are there because of Franking. Your suggestion " If nothing else, legislation to prevent AT1 securities from paying franked distributions could be expected to diminish retail investor interest."That will drive Australian Investors out of the market quick However how new hybrids can survive without Franking credit ? The cost for baks will go higher ?
Bank hybrids is one avenue where banks can utilise their franking credit ? and The reason to issue the Hybrids.

 

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