The Australian Prudential Regulation Authority (APRA) has begun exploring options to improve the effectiveness of Additional Tier 1 (AT1) capital instruments for use in a potential bank stress scenario.
AT1 capital instruments, often referred to as “hybrid” bonds, are one of three types of capital that banks can hold to support their resilience and protect depositors.1
The purpose of AT1 is to stabilise a bank by absorbing losses during a period of severe stress or to support an orderly resolution in the unlikely event of a failure. In such circumstances, a bank could decline to pay discretionary coupons to AT1 investors,2 convert the instruments to equity or write them off.
Executive Board Member Therese McCarthy Hockey said APRA is concerned that AT1 capital instruments would not operate as originally intended due to certain design features and market practices.
“Australia’s banking system is one of the strongest and most resilient in the world, but we need to stay alert to potential risks to that stability.
“AT1 are critical instruments designed to absorb losses to stabilise a bank before it reaches a crisis scenario or support bank resolution if it gets to that. However, recent episodes of banking stress overseas highlighted that AT1 only absorbs losses at a very late stage of a crisis – in the resolution phase.
“The Australian market for AT1 is also unusual by global standards, with more than half the bonds held by small retail investors. Converting their investments into equity or writing them off could undermine confidence in the financial system and impact the stability of other institutions – a complication that risks impeding the speed of decision-making in a crisis.
“Given the Australian banking sector’s reliance on AT1 – and noting how rapidly contagion spread across international banks earlier this year – APRA wants to start exploring how we can make sure this form of capital functions as intended should it be required,” Ms McCarthy Hockey said.
In a discussion paper released today, APRA has outlined the challenges of using AT1 in an Australian context and called for feedback on a range of potential options to overcome them.
In addition to written submissions, APRA will hold discussions with industry on these options this year. After considering this feedback, APRA plans to formally consult on any proposed changes to prudential standards or guidance next year.
The discussion paper is available on the APRA website at:.
Footnotes
1 The other two are Common Equity Tier 1 (CET1) Capital and Tier 2 Capital.
2 Akin to dividends for shares.
