Australia proposes banks phase out AT1 bonds following Credit Suisse collapse

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Australia’s banking regulator has proposed that banks phase out the use of additional Tier 1 bonds to meet capital requirements, underscoring concerns about the loss-absorbing instruments after the failure of Credit Suisse last year.

Australia’s prudential regulator said on Tuesday that banks should try to replace AT1 bonds – which are contingent convertible securities designed to absorb losses – with “cheaper and more reliable forms of capital” by 2032.

The regulator has opened a two-month consultation on the move. The proposal represents a significant shift from an approach to bank failure regulation following the 2008 financial crisis.

The AT1 bonds, which can be called when banks’ equity falls below a certain threshold, were part of a push to shore up bank balance sheets and avoid taxpayer bailouts.

But the market, which was worth about $260 billion globally last year, has become a source of volatility, with falling AT1 bond prices raising expectations of distress at the corresponding bank and the bonds sparking legal controversy during the actual default.

Last year, $17 billion of bonds were wiped out during the collapse of Credit Suisse, prompting lawsuits from investors against the Swiss regulator. Bonds, which sit above equity in a bank’s capital structure, have been treated more harshly.

John Lonsdale, chairman of Apra, said the purpose of AT1 bonds is to stabilize a bank so it can continue to operate in times of stress and prevent a disorderly failure.

“Unfortunately, international experience has shown that AT1 does not fulfill this function in a crisis situation due to the complexity of its use, the potential for legal challenges and the risk of causing contagion,” he said.

Apra last year launched a review of the use of AT1 bonds, following the collapse of Credit Suisse and Silicon Valley Bank, to better protect the financial stability of Australia’s banking system.

It reviewed the liquidity and effectiveness of AT1 and opted to push for the phasing out of hybrid bonds, proposing that they be replaced by a mix of equity and Tier 2 bonds, a less risky instrument that can also be issued to meet regulatory requirements.

The regulator said the risk was heightened in Australia because of what it said was an “unusually high proportion” of AT1 bonds held by retail investors. This has made the country an “outlier” compared to markets such as Britain, which banned the sale of hybrid bank bonds to retail investors almost a decade ago.

Hybrid bonds have proved popular with Australian investors in recent years due to the relatively higher yield they offer. Apra said retail investors could account for 20-30% of the outstanding AT1 bonds listed on the Australian Securities Exchange.

The Australian Banking Association, a trade body for the banking industry, said it would continue to discuss the move with the regulator.

“This would represent a significant change in a bank’s capital structure. Banks will now carefully consider the implications of Apra’s proposal, balancing any changes to capital costs as well as the impact on capital markets and investors,” it said in a statement.

Brendan Sproules, an analyst at Citi, said the switch from AT1 bonds would be “relatively ambiguous” for investors in the country’s banks, with most of the costs absorbed during the phase-out period.

He added that the bigger impact would be on retail investors with exposure to hybrid bonds, who would have to allocate their capital elsewhere.