The Australian Prudential Regulation Authority (APRA) has issued a discussion paper outlining the challenges of using Additional Tier 1 (AT1) capital instruments in a potential bank stress scenario and calling for feedback on a range of potential options to overcome them.

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.

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, convert the instruments to equity or write them off (also called “bail-in”).

Prudential Standard APS 110 Capital Adequacy (APS 110) sets out the minimum capital requirements for banks.

The minimum level of Tier 1 required to be held by a bank is 6.0 per cent of Risk Weighted Assets (RWAs), of which 4.5 per cent must be met in Common Equity Tier 1 (CET1) capital, such as ordinary shares; the remaining 1.5 per cent is generally met with AT1. Specific criteria for capital instruments to qualify as AT1 are set out in Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111).

APRA is concerned that the challenges of using AT1 to absorb losses to stabilise a bank in the early stages of a crisis are likely to be more acute in Australia, for several reasons:

• investor expectations that distributions continue to be made in stress is likely to be strong, given the lack of crisis experience which has resulted in no AT1 distributions ever being missed;
• there can be a perception that AT1 operates more like debt instruments and therefore would not absorb losses early in stress. For example, APRA has been concerned that Australian banks have been under market pressure to treat AT1 as fixed term and call these instruments even when it is uneconomic to do so; and
• the low trigger level for bail-in of AT1, which is set uniformly at a CET1 ratio of 5.125 per cent of RWAs, in contrast to market practice in some other jurisdictions.

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.

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