Phasing out bank AT1 capital instruments (Capital Notes): a significant development from APRA

The Australian Prudential Regulation Authority (APRA) released a discussion paper on 10 September 2024 (Discussion Paper) outlining its proposal to phase out the use of AT1 capital instruments by banks for their capital adequacy requirements in favour of cheaper, more reliable and more effective forms of capital.

The proposal represents a significant shift away from the accepted regulatory approach to bank failure following the global financial crisis (GFC) in 2008. It is a decision which may see Australia become the first jurisdiction to phase out AT1 instruments. APRA’s view is that simplifying the capital framework for banks will strengthen the crisis preparedness of the Australian financial system.

The Discussion Paper has been eagerly anticipated following a comprehensive consultation process where APRA sought feedback on improvements with regards to the effectiveness of AT1 in the unlikely event of an Australian bank crisis. The consultation process was undertaken in response to the instability in the international banking system following bank failures in Europe and the US in 2023.

While the effectiveness of AT1 has not been put to the test domestically, the offshore failures highlighted the possibility that AT1 may not be fit for purpose.

The purpose of AT1

AT1 capital instruments were introduced as a part of the post-GFC Basel III reforms to help support bank balance sheets and provide protection against the need for governments to step in and prevent bank failures. AT1 capital is deeply subordinated (with only equity ranking behind it to absorb losses) and is contractually available to be called upon when the bank’s equity falls below a certain threshold – meaning that holders of AT1 capital instruments may be “bailed in” as shareholders.

AT1 instruments have two main functions, first, to absorb losses in times of stress (providing stability so that a bank can remain a going concern), and secondly, to provide capital to support a bank’s resolution at the point of failure.

APRA’s view is that, in practice, AT1 capital instruments are not fulfilling those functions. The international experience seems to indicate that AT1 capital instruments absorb losses only at a very late stage in a bank’s crisis and are difficult to utilise to support resolution without complexity, contagion and litigation risk.

Policy reform following offshore bank failures in 2023

During the first half of 2024, APRA reviewed feedback received during the consultation process and identified three possible options for policy reform, including (i) maintaining the status quo, (ii) redesigning AT1 to ensure effective operation, or (iii) replacing AT1 with other existing, more reliable forms of capital.

Ultimately, APRA has reached the view that the best way forward is to simplify the framework by phasing out AT1. APRA has posited that there are certain design features and market characteristics which impede the effective use of AT1 in Australia, including because of the fact that a material proportion of AT1 is held by domestic retail investors. AT1 may not offer any advantage in resolution as compared with Tier 2 capital instruments and may in fact create further complications through the investor base. While APRA has considered options to improve AT1 to address these issues, the view is that these options are likely to be more complex and costly to implement.

APRA is proposing to replace AT1 with cheaper and more reliable forms of capital that would absorb losses more effectively in times of stress.

At a high level, APRA’s current proposal is as follows:

• Large, internationally active banks would be able to replace 1.5 per cent AT1 with 1.25 per cent Tier 2 and 0.25 per cent Common Equity Tier 1 (CET1) capital; and
  
  
• Smaller banks would be able to fully replace AT1 with Tier 2, with a removal of Tier 1 requirements and no proposed changes to Total Capital requirements.

APRA’s view is that a simpler capital framework for banks will not only improve the effectiveness of bank capital in a crisis but will also bolster confidence in the safety of deposits at such times. Further benefits are expected to include reduced compliance costs as well as improving proportionality with a simpler approach and lower capital requirements for smaller domestic banks vis-à-vis larger banks.

Next steps

For existing investors, APRA does not foresee an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates. APRA is not currently proposing changes to AT1 capital requirements for insurers. The plan is to commence the transition from 1 January 2027, with all current AT1 capital instruments on issue expected to be replaced by 2032.

APRA is seeking feedback from market participants and stakeholders on the conceptual policy framework outlined in the Discussion Paper. Written submissions should be provided to APRA by 8 November 2024. APRA will then provide an update on the consultation process in late 2024 and formally consult on changes to prudential standards in 2025.

APRA’s plans to phase out AT1 capital represents a significant change to bank capital structures in Australia. All banks will need to consider the impact of this shift. Investors in AT1 capital will need to find other instruments to invest in. There is a lot to consider and a number of stakeholders who will need to be involved.