Rethinking Bank Capital: Australia's Bold Move to Phase Out Risky AT1 Bonds

In a move that could reverberate across global financial markets, the Australian Prudential Regulation Authority (APRA) has announced plans to phase out the use of Additional Tier 1 (AT1) bonds as a form of bank capital. This decision comes in the wake of the 2023 banking turmoil, which saw the collapse of Credit Suisse and the subsequent write-off of billions in AT1 bonds, raising concerns about the reliability of these instruments during times of crisis.

Safeguarding the Future of Australian Banking

Addressing the Flaws of AT1 Bonds

APRA's proposal aims to replace the use of AT1 bonds with more stable and reliable forms of capital that can better absorb losses during a crisis. The regulatory body has identified several key issues with AT1 bonds, including their complexity, legal vulnerability, and the potential for market contagion. The Credit Suisse debacle has exposed the flaws in the mechanism that was intended to convert AT1 bonds to equity or write them off during times of financial distress, ultimately failing to prevent taxpayer-funded bailouts.

Transitioning to a Safer Capital Structure

Starting from January 1, 2027, Australian banks will begin phasing out their AT1 bonds, with the complete transition expected by 2032. APRA is encouraging major banks to substitute 1.5% of their risk-weighted assets currently held in AT1 bonds with 1.25% Tier 2 capital and 0.25% Common Equity Tier 1 (CET1) capital. Smaller lenders will also be given the flexibility to replace their AT1 instruments entirely with Tier 2 capital, which is seen as more reliable in a financial downturn.

Simplifying the Resolution Process

The aim of APRA's proposal is to simplify the resolution process for banks during times of financial instability, reduce legal risks, and, most importantly, protect retail investors—who hold a disproportionately large share of AT1 bonds in Australia. By transitioning to a more straightforward capital structure, the regulatory body hopes to ensure that banks remain financially resilient in the face of future crises.

Lessons from the Global Banking Turmoil

Australia's decision to phase out AT1 bonds draws from the lessons of the 2023 banking turmoil that saw several US and European banks face existential crises. Governments had to intervene quickly to prevent contagion, but the sheer complexity of AT1 bonds meant that their intended role as crisis buffers was not effectively realized. APRA Chair John Lonsdale noted that international experience shows AT1 bonds fail to stabilize banks as intended, largely due to their complexity and legal challenges.

Implications for Australia's Financial Sector

Australia's "Big Four" banks—Commonwealth Bank, Westpac, National Australia Bank (NAB), and ANZ—currently have around A$39 billion in AT1 bond issuance. The transition to Tier 2 capital and CET1 could save these banks nearly A$1 billion in interest payments, while also ensuring that they remain financially resilient in the face of future crises.For investors, particularly retail investors who hold a large portion of AT1 bonds, this transition provides a more secure form of capital in case of a downturn. However, there may be an initial increase in funding costs as banks adjust to the new regulatory environment.

A Global Shift in Banking Practices?

Australia's move to phase out AT1 bonds raises questions about whether other countries will follow suit, or if new forms of hybrid securities will emerge to fill the gap. The AT1 bond market is worth hundreds of billions of dollars globally, and banks have continued to issue new debt instruments even in the wake of Credit Suisse's collapse. As the world grapples with the lessons of the 2023 banking turmoil, APRA's decision could serve as a blueprint for other regulators seeking to strengthen the resilience of their financial systems.