This week APRA released a consultation paper on how to ensure the major banks have sufficiently strong “total loss absorbing capacity” (TLAC), which has important consequences for investors in their securities.
It’s terrific news for the banks’ senior bonds, which are rallying in price, but highly uncertain for their subordinated debt, which may or may not be affected depending on what the final policy looks like.
Credit rating agencies cheered. Moody’s commented that the proposals would be “credit positive” and “strengthen bank balance sheets further, consistent with APRA’s target of making Australian banks ‘unquestionably strong'”.
Standard & Poor’s echoed these remarks, stating the proposal “should lead us to revise our outlooks on the systemically important Australian banks to ‘stable’ from ‘negative'”. This would reaffirm the major banks’ prized AA- credit ratings, which S&P initially put on negative outlook back in 2016 when it said it was thinking of downgrading the sovereign’s AAA rating.
After then Treasurer Scott Morrison shocked analysts by pulling off the miracle of returning the government’s budget to surplus years ahead of schedule, S&P removed its negative outlook on the AAA rating. Yet it said the major banks’ ratings would remain at risk of downgrade until it got visibility on APRA’s TLAC policy, which the regulator has provided.
APRA’s customised approach to TLAC can be summarised as follows. In contrast to peers overseas, it has not created a brand-new resolution regime given that its powers to take control of and wind up (or resuscitate) a failing bank were already exceptionally strong under Australia’s Banking Act, the 1950’s drafters of which have proved to be remarkably prescient.
Over time APRA has further enhanced this legislation to recognise its ability to recapitalise a bank by bailing its hybrids and subordinated bonds into equity, and through its little-known ability to impose losses on senior bonds through its asset-transfer powers.
The latter allow APRA to quickly assume control of a bank and sell off its assets at fair-market value to either a newly-created entity or another bank, leaving bondholders with the same proceeds they would receive in a slower-moving bankruptcy process.
These laws have no time limits and operate in almost exactly the same way as US regulations (specifically Title II of the Dodd-Frank Act), which enable the FDIC to impose losses on senior bonds not through bailing them into equity but rather by exposing them to losses via asset sales subject to a “creditor-no-worse-off” protection that is a fair market value test.
A major bank’s capital stack comprises of equity, hybrids, subordinated bonds, senior bonds and deposits. (Technically there are also super-senior secured bonds that subordinate depositors, called covered bonds.)
APRA can bail-in the hybrids and subordinated bonds, and impose losses on senior securities. For resolution purposes, this means that about 40 per cent of a major bank’s capital is available to serve as Aussie TLAC, which is different to the approach of regulators overseas that favour more explicit bail-in of senior bonds over the indirect approach of loss-absorption (with creditor protections against a regulator selling assets below fair market value).
So the key take-aways are that APRA is not proposing to radically change its resolution powers nor seeking to bail-in the major banks’ senior bonds, which is why S&P has said it will likely upgrade its ratings to AA- stable.
Now this is where it gets more complex.
What APRA has canvassed for consultation is an increase in the banks’ regulatory capital buffer by 4 per cent of their risk-weighted assets. The idea is that if the banks’ total current equity, additional tier 1 (AT1) hybrids and tier 2 (T2) subordinated bonds add up to about 15 per cent of their risk-weighted assets, APRA thinks that this number should be closer to 19 per cent by 2023.
If a bank blows up its core equity, which is about 11 per cent of risk-weighted assets, bailing in its hybrids and subordinated bonds will furnish starting equity of about 8 per cent. That makes theoretical sense, though there are wrinkles.
APRA has suggested the banks could raise the extra 4 per cent by issuing more T2 debt, which would equate to $60 billion to $80 billion of extra bonds over the next four years. The problem is that the global T2 debt market has shrunk dramatically as banks around the world have chosen instead to issue bail-in-able senior bonds, which are variously called “non-preferred senior” or “tier 3” (T3) securities. There is a large global market for T3 debt, which banks tap every day with greater portfolio limits generally approved for T3 than T2.
As long as APRA can bail all these instruments into equity, it should be indifferent whether banks issue T2 or non-preferred senior T3 bonds save for a modest trade-off associated with introducing another layer into the capital stack. And S&P says whether APRA chooses T2 or T3, it should not affect its view on the senior bond ratings.
The real question is what global investors are willing to fund: subordinated debt or non-preferred senior. I personally believe that in volatile market conditions, there is no way the major banks can fund up to $80 billion of T2 (and roll-over existing maturities), which would likely be more than the rest of the world combined. The only tractable solution is issuing higher-ranking non-preferred senior (or T3) bonds, and even that might be challenging.
Another option is that APRA sets a more realistic – say 1-2 per cent – target increase in regulatory capital by 2023, recognising that it can already impose losses on senior and does not, therefore, need to shoot the lights out on the quantum of bail-in-able capital. All of this will be presumably figured out during its consultation period.
While APRA might have copped criticism from the royal commission for not being tough enough when it comes to punishing banks for peripheral transgressions, judged on its core mission of protecting depositors from bank blow-ups, APRA has won a reputation for being the strictest (and most successful) regulator on the planet.
And under the leadership of its boss Wayne Byres, who this week was reappointed by Treasurer Josh Frydenberg for another term, APRA has massively upgraded the intensity of its prudential supervision activities.
If there was a risk APRA was too soft on the banks under Byres’ predecessors, which I have argued in the past, this has categorically not been the case under the man who previously led the notoriously tough Basel Committee on Banking Supervision.
Two of Byres’ signal accomplishments are worth highlighting. The first has been forcing the major banks to lift their first-loss equity reserves to among the highest levels of any large banks in the world to minimise the probability of savers (and taxpayers) suffering losses during the next crisis.
A second has been unwinding the mother of all housing bubbles via the application of a range of unprecedented controls on new lending, which has delivered the orderly correction in house prices observed since late 2017.
There was considerable resistance to the idea that the major banks’ should have to deleverage their balance sheets from 29 times their equity in 2013 to 19 times today, which Byres steamrolled.
Most doubted that APRA’s relentless efforts to lean against the burgeoning property boom between 2014 and 2017 would actually work, but they did.
The author is a portfolio manager with Coolabah Capital Investments, which invests in fixed-income securities including those discussed by this column.