APRA has proposed an increase in capital for the four major banks. The announcement has been met with a variety of asset price responses, depending on where each asset class sits in the capital structure. With more supply of Tier 2 probable, yields on existing securities have widened and prices lowered. For those investors looking to add investment-grade financials to their portfolio mix, we continue to prefer regional bank and general insurance issuers.
Background
For a number of years, regulators around the world have been instructing globally systemically important banks (G-SIBs) to increase the amount of total loss absorbing capacity (TLAC) to ensure they can continue to function without threatening financial market stability or requiring further taxpayer support, particularly during periods of financial stress. Minimum TLAC requirements are in addition to minimum regulatory capital requirements, but qualifying capital may count towards both requirements, subject to limits.
No Australian owned banks are on the current list of 30 G-SIB’s. This isn’t a surprise given the domestic focus of the four major banks--ANZ, CBA, NAB, and WBC--who are nevertheless viewed as domestic systemically important banks (D-SIBs). The Australian Prudential Regulatory Authority (APRA) generally applies the requirements imposed on G-SIBs to Australia’s four D-SIBs.
Overview of the proposal
In a discussion paper released on 8 November 2018, APRA proposed increasing risk weighted assets (RWA) by four to five percentage points for the four major banks. They would have four years to meet the higher capital requirement. APRA expects the banks to satisfy this requirement predominantly through the issuance of Tier 2 capital (see Figure 1). Tier 2 capital is the cheapest form of loss absorbing capital currently available to the major banks. For now, we assume the local banks are unlikely to follow the overseas lead by some European banks to issue 10 year bullet maturity Tier 2’s, instead opting for the current ‘ten year, non call five’ structures.
For other banks and alike, APRA did not lay out any additional loss absorbency requirements, although for some complex banks, it noted additional loss absorbency may be required.
Figure 1: Proposed change to the major banks’ capital structures – as a percentage of RWA
Source: APRA
^Capital conservation buffer.
*Capital surplus of 3% is generally higher than the level D-SIBs may normally maintain, as they have acted in anticipation of changes to the capital adequacy framework as a result of the ‘unquestionably strong’ capital benchmarks. APRA expects the D-SIBs to continue to maintain a normal capital surplus in excess of regulatory capital requirements once such changes are implemented.
In opting for an increase in TLAC through the issuance of Tier 2 capital, APRA has clearly exhibited a preference for a clean approach consistent with Australia’s existing pool of available capital.
Australia has almost always operated with a current account deficit (CAD) (i.e., the value of goods and services imported exceeds the value of goods and services exported), although it wasn’t until the 1980’s that these deficits were associated with a build up of foreign debt (borrowings)[1]. Australia’s banking system, and in particular, the major banks, are a primary conduit in which the country finances its CAD, much of it in the form of senior unsecured debt.
In our opinion, the prospect of a new type of senior debt that features loss absorbency, known as non preferred senior debt, similar to that issued in some parts of Europe, may have had unintended consequences for the perceived security of senior unsecured debt, and as such, leading to a potentially broad based increase in the cost of funding. Indeed, APRA has estimated its proposal would increase the cost of funds for the major banks by an amount less than 5 basis points in aggregate.
On the back of the APRA proposal, the four major banks released an estimate of the amount of capital needed (see Figure 2). The fact that each bank has disclosed the quantum and quality of capital required suggests the proposal is largely a formality, in our view.
Figure 2: Additional TLAC per major bank (AUDbn)
Credit rating impact
If the major banks meet the increased capital requirement through the issue of Tier 2 subordinated debt, as is generally expected, the higher capital levels are unlikely to result in higher credit ratings. S&P generally doesn’t incorporate Tier 2 subordinated debt in its capital component for bank credit ratings.
While Moody’s and Fitch said the developments would be credit positive, given they have stable outlooks, we expect no change.
S&P, the only rating agency with a negative outlook on the credit ratings for the major banks, has suggested the proposal by APRA may reduce any burden on the Australian government to provide financial assistance to banks in a stress scenario. S&P currently incorporates three notches of government support into the issuer credit ratings for the four major banks. S&P has also indicated that if there are no further developments that suggested a weakening in the likelihood of government support, the rating agency would expect to revise the outlook to stable. Given the significant reliance on the major banks as a funding mechanism for Australia’s CAD, which is somewhat unique to Australia, this would represent our base case expectation.
Market response and outlook
The announced proposal has been met with a variety of asset price responses, depending on where each asset class sits in the capital structure. Equity prices improved as the prospect of further dilution appeared unlikely. Similarly, the price of senior unsecured also firmed in response to the expected increase in loss absorbing capacity subordinated to (senior unsecured) within the capital structure. Senior unsecured is also likely to respond favourably to reduced supply, all else being equal with the increase in Tier 2 likely to mean a corresponding decrease in senior unsecured debt issuance, while the increasing likelihood of S&P revising the rating outlook to stable may also be a factor.
The prospect of increased supply in Tier 2 debt has seen prices fall and yields rise for financials in general, but more so for major banks (see Figure 3). Regional banks were off modestly. Insurance in general fell too, although the response was likely to be influenced somewhat by AMP issuing around the same time at a considerable margin (3M BBSW+2.75%).
Figure 3: Tier 2 movements in relative value
The amount of new capital to be raised is around AUD75bn, themid point of the estimates , or just under AUD19bn per year over the next four years. This compares with around AUD36bn in Tier 2 capital currently outstanding for the four major banks, with an average of around AUD7bn maturing each year over the next four years. The significant increase in supply is likely to see spreads widen on both existing and new issues more generally, particularly for major bank debt.
The general market practice for Tier 2 notes is to call five years prior to maturity and replace with a similar instrument. We see little change in this practice, as the benefit of Tier 2 from a financials’ regulatory capital perspective starts to fall away from the date falling five years before their maturity. For investors holding to call, movements in price may not be a significant factor in their investment decision.
On this basis, for those looking to add investment grade financials to their portfolio mix, we continue to prefer less frequent issuers, including regional bank and insurers. These are generally issued at a premium of between 50bps-100bps to the major banks. The difference in credit risk is modest and usually limited to one notch, and in some instances, particularly insurance, the credit risk is enhanced. While liquidity risk is likely to be higher, issuers are generally well known and risk of write down or conversion is very low, in our opinion.
For more information read our Credit research report (FIIG login required) - Tier 2 Financials