Tier 2 dynamics mean proposed Australian phase-out of AT1 securities ‘manageable’

Australia could become the first jurisdiction to phase out AT1 for banks, after the Australian Prudential Regulation Authority (APRA) on 10 September published a proposal to do so from 1 January 2027 to 2032 that could see some A$35bn of incremental Tier 2 issuance in the coming years.

The move — which kicked off a two month consultation period — came after the Australian regulator in September 2023 floated a reduction in “reliance on AT1” or large scale modifications to the AT1 structure, including materially increasing the trigger levels. The country’s four large banks have around A$39bn (€24bn, US$26bn) of such issuance outstanding.

“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,” said John Lonsdale, chair of APRA.

“These risks are heightened in the Australian context due to the unusually high proportion of AT1 held by retail investors.”

While the total amount of regulatory capital banks would be required to hold would remain unchanged under the proposed approach, large, internationally active banks would be able to replace the 1.5% AT1 bucket with 1.25% Tier 2 and 0.25% Common Equity Tier 1 capital.

Advanced bank requirements for CET1 would rise 0.25% to 10.5%, and Standardised banks’ remain at 8.0%. Smaller banks would be able to fully replace AT1 with Tier 2, upon a reduction in Tier 1 requirements.

After 2027, existing AT1 instruments will be eligible as Tier 2 capital until their first scheduled call date.

APRA expects the volume of Tier 2 funding needed to replace AT1 over the next several years to be around A$35bn. Its base case puts the estimated funding cost — stemming from a potential repricing of Tier 2 instruments without AT1 in the capital structure — at A$70m for Advanced banks.

Although Australian Tier 2s widened on news of APRA’s proposals, with some knee-jerk selling, they are only expected to be slightly negative for the asset class over the medium to long term, according to Daniel Dela Cruz, head of debt capital markets, Australia and New Zealand for Crédit Agricole CIB, with the transition very manageable.

“It will be interesting to see where the circa A$40bn of AT1 liquidity goes once they are called,” he said. “Most of the domestic investors in these securities consider them ‘fixed income’, as they are already exposed to bank equity, and so a good portion of it could well migrate to ETF funds that invest in Tier 2 bonds to continue to chase yield.

“Meanwhile, other domestic investors in these securities who take advantage of the ‘franking credits’ will move to other alternative products or buy more bank equity.”

Dela Cruz notes that Australian banks enjoy healthy demand for their Tier 2 in offshore markets, particularly euros and US dollars, where they are appreciated as low beta, safe haven product and offer a pick-up over senior (non-preferred) paper. He points to a US$1.25bn 11 non-call 10 Tier 2 for ANZ on 23 September that was tightened from the US Treasuries plus 175bp area to 147bp after books peaked at around US$5.5bn — having been recently upgraded, the notes are rated single-A by all the bank’s three rating agencies.

However, a conclusive verdict will only be possible once the new regime is finalised.

“Most investors are still comfortable with the instrument and see very minimal call risk in the new regime,” added Dela Cruz, “although others warned of further price reaction if the proposal is confirmed with more details.”

Outstanding AT1s have benefited from the news, while a A$800m floater perp for ANZ Holdings New Zealand printed the day after APRA’s announcement traded up a point on the day of launch.

“The proposals are positive for AT1 from a technical perspective,” said Dela Cruz, “and mean a much lower risk of non-call, even if this was already negligible.”

Australian banks meanwhile generate very strong capital from their earnings and remain well above APRA minimum requirements, meaning the 0.25% increase in CET1 requirement should not be problematic, he notes.

The revised Australian capital framework also remains more conservative than Basel requirements.

Moody’s said the proposals are neutral for bank capital adequacy but positive for banking system stability because they promote a simpler resolution regime that would limit the severity of losses for investors in a bank resolution.

“In APRA’s discussion paper, it noted banks’ potential reticence to suspend AT1 securities distributions and the complexity of multiple stakeholders as potential hurdles to the effectiveness and timeliness of bank resolution,” the rating agency said.

“Additionally, contagion risk is heightened in Australia because these securities have a high volume of retail investors who may be less equipped to absorb losses.”

Fitch said few countries are likely to follow the Australian example, unless the Basel Committee on Banking Supervision were to issue a recommendation. The committee is nonetheless just one of many looking into the role of AT1.

“While most investors do not expect other regions to follow with similar framework,” said Dela Cruz, “one investor in particular noted that what APRA proposed was indeed a wake-up call — people need to take a step back and reevaluate AT1 as an effective loss absorption instrument.”

Insurance companies and their AT1 instruments are not affected as their position in the capital regime will be retained, APRA confirmed.

Insurers’ ability to continue to issue AT1, while banks cannot, should make them one of the biggest beneficiaries of the move, said Dela Cruz.