Phasing out Australian bank AT1 instruments would address unique systemic risks in the country. Domestic retail investors hold about half of such instruments, a concentration that may prove problematic in the event of a banking crisis. Nonetheless, S&P Global Ratings thinks a phaseout has the potential to weaken stand-alone credit standings for some Australian banks.

On Sept. 10, 2024, the Australian Prudential Regulation Authority (APRA) released a discussion paper that proposes to replace additional tier 1 (AT1) capital, predominantly with tier 2 (T2) instruments. If the regulator's proposal were implemented without offsetting actions, many Australian banks' going-concern loss-absorbing capital would weaken. Specifically so, if the AT1 instruments are predominantly replaced with T2 instruments, which can only absorb losses when a bank is no longer viable.

This would be unlikely to affect issuer credit ratings on most banks but could lead us to lower ratings on some T2 instruments, including those issued by the four major Australian banks. Moreover, ratings on their instruments currently classified as AT1 could face offsetting positive and negative pressures. Any rating actions would be subject to certainty in relation to APRA's proposed changes as well as banks' responses.

The proposed changes are significant. Not for the first time, APRA is potentially taking a different path to global regulators. For example, the major Australian banks have been required to hold a (sizable) Pillar 1 capital charge against interest rate risk in their banking books.

APRA's proposal is unlikely to be widely replicated. Although loss absorption for bank AT1s before non-viability can be complex in practice, the ambiguities also provide authorities with some flexibility, which would be lost if these instruments are replaced by T2 nondeferrable subordinated debt instruments. We believe that bank AT1 instruments can play a role in absorbing losses and conserving cash on a going-concern basis, and recapitalizing or resolving a bank that is no longer viable--both through the contractual terms and the powers that authorities have in a stress scenario.

A Uniquely Australian Solution

We believe the large domestic retail investor base in bank Australian AT1 securities is a key consideration in APRA's proposal to phase them out. It could undermine the authorities' ability to impose loss absorption by AT1 instruments when a bank is a going-concern. For example, although AT1 instruments are not deposit products, loss absorption by retail investors could still weaken their confidence as depositors in the banking system.

Furthermore, such risk could be amplified by the perceived similarity of the four major Australian banks, and their dominant collective share of the country's banking market.

A significant retail investor base could also create some political difficulties for the elected government in a loss-absorption scenario (see sidebar below). For example, the government may face social pressure to compensate retail investors after they bear any losses. We believe that the Australian government would try to strike a balance between reducing taxpayer burden and a severe disruption in the financial system and economy.

APRA's Proposal Is Unlikely To Be Widely Replicated

We consider it unlikely that APRA's proposal will spread to many other markets for several reasons:

• The systemic risks from the large domestic retail investor base in bank AT1 securities are unique to Australia. We do not see a similar risk in most other banking systems.
• Yes, going-concern loss absorption by bank AT1s can be complex in practice and involve uncertainties but the inherent ambiguities can still provide the authorities flexibility to effectively address a bank distress. The uncertainties emerge from the tension between the impact on AT1 investors versus the common shareholders as well as the shorter-to-medium-term adverse reactions of the investors and broader market participants if they were required to absorb losses. Past track record suggests that market participants are likely to move on following loss-absorption events notwithstanding an investor backlash in the short term. UBS, which took over Credit Suisse, is already able to issue new AT1 to investors.
• AT1 offers bank regulators a viable option to quickly recapitalize a bank facing distress. The write-down in 2023 of Credit Suisse's AT1 instruments demonstrated their function in recapitalizing or resolving a bank that is no longer viable--both through the contractual terms and the powers that authorities have in a stress scenario. The AT1 instruments therefore played the recapitalization role that regulators intended.
• Regulators in some other jurisdictions may focus on mechanisms to encourage loss-absorption by AT1 capital through coupon-deferrals early in bank stress.
• Other regulatory frameworks may not have room to phase out AT1 without replacing it substantially with common equity tier 1 (CET1). An entire replacement with CET1 could be expensive for banks and raise questions about their competitiveness versus peers in other jurisdictions that have lower CET1 requirements.

Global Regulators' Last Word On AT1 Still To Come

Banks' AT1 instruments have remained under regulatory scrutiny since March 2023, when the failure of Credit Suisse sparked turmoil in the sector. The heavy loss for Credit Suisse AT1 investors highlighted the risks associated with these instruments when banks fail. At the same time, the Credit Suisse AT1 write-downs also demonstrated AT1 instruments' function in recapitalizing or resolving a bank that is no longer viable--both through the contractual terms and the powers that governments have in a stress scenario.

The 2023 turmoil raised questions about the broader role of AT1 instruments. The APRA proposal is in line with our expectation of further regulatory discussion of whether AT1 instruments are playing a clear enough part in preventing or delaying a bank from getting to the point where it is no longer viable (see "The Role Of Bank AT1 Hybrid Capital One Year On From The 2023 Banking Turmoil," June 26, 2024).

We expect the discussions to be global. A key question is whether banks may be discouraged from using their AT1 instruments early enough in a stress scenario if they are concerned that this action could weaken market confidence in them. We believe that a key concern in the Australian context was the potential impact on a retail-heavy investor base and that this has substantially driven the nature of the APRA proposals. Most other countries do not have a similar exposure to retail investor base and therefore we expect a different regulatory angle.

Outside of Australia, we anticipate a greater regulatory focus on clarifying how AT1 instruments can absorb losses on a going-concern basis and on enhancing disclosure of instrument features. One potential tension is the relative position of AT1 capital versus common equity on a going-concern basis. This is because there are some situations before the point of bank nonviability when an AT1 investor could bear losses before, or to a greater extent than, common shareholders. We don't expect any abrupt changes in these countries as regulators weigh up the benefits and potential constraints of the existing AT1 framework.

Proposal Likely To Reduce Going-Concern Loss Absorbing Capital

Based on our framework, the proposal could result in weaker going-concern loss absorbing capital of the Australian banks that currently rely significantly on AT1. This is if the AT1 instruments are predominantly replaced with T2 instruments, which can only absorb losses when a bank is no longer viable.

In our latest annual publication comparing our risk-adjusted capital (RAC) ratios for world's top 200 banks, three of the four major Australian banks were in the top quartile, and the fourth one in the second quartile (see "Top 200 Banks: Capital Ratios Continue To Normalize After Pandemic Peaks," Sept. 19, 2023). Based on the assumptions in our sensitivity analysis, we project that these banks could move into the second and third quartile respectively if APRA's proposal is implemented with other things remaining unchanged.

At the same time, Australian banks' total capital—including the T2 capital--would remain unchanged. T2 instruments, which will predominantly replace AT1 under the proposal, have similar gone-concern recapitalization capacity as AT1.

Replacing AT1 Predominantly With T2 Could Weaken Risk-Adjusted Capital Ratio For Some, Including The Major Australian Banks

The phasing out of AT1 could reduce RAC ratios of Australian banks that rely on AT1 capital. Under APRA's proposal in the discussion paper, most of the going-concern loss absorbing capital offered by AT1 capital would be replaced by what we consider to be a lower quality of capital: gone-concern loss absorbing T2 securities:

• 1.5% point of AT1 layer for each of the four major Australian banks, Macquarie Bank Ltd., and ING Bank Australia Ltd. will be replaced by 0.25% of CET1 and the remainder by T2 securities.
• For the other Australian banks, the 1.5% point of AT1 layer will be replaced entirely by T2 securities. (We note that most of the smaller banks do not rely on AT1 at all).

AT1 forms 10%-15% of the Australian major banks' total adjusted capital (TAC; see table 1). TAC is our main measure of a bank's going-concern loss-absorbing capital--meaning it can be used to recapitalize a bank to help it stay afloat. TAC forms our RAC ratio numerator. Conversely, T2 securities do not qualify for inclusion in TAC for any of the Australian banks.

Our sensitivity analysis shows the changes in our pro forma RAC ratios for Australian banks after making the following assumptions:

• Five-sixths of the existing stack of AT1 is eventually replaced by T2 securities for the four major banks and Macquarie Bank.
• One-sixth of the existing stack of AT1 is eventually replaced by CET1 for these five banks.
• All the existing stack of AT1 is eventually replaced by T2 securities for all other Australian banks.

Table 1

Reduced RAC Ratios Could Weaken Some Banks' Stand-alone Creditworthiness

Our RAC ratio is our principal metric for our "initial score" of a bank's capital and earnings strength. Consequently, a fall in the RAC ratio could dent the stand-alone creditworthiness of some Australian banks, based on the assumptions in our sensitivity analysis including other things remaining unchanged. We emphasize that this sensitivity analysis is based on "other things remaining unchanged."

In our assessment of each bank's capital and earnings, we consider the bank's plans. For example, a bank may plan to avert the fall in its RAC ratio by adding more CET1 than that assumed in our sensitivity analysis. Conversely, even absent APRA's proposed changes, we currently forecast a modest fall in RAC ratios of the major Australian banks, because they are carrying a small buffer over what we understand to be their target capital levels.

Our assessment of a bank's creditworthiness, including its capital and earnings, considers quantitative and qualitative factors. For example, we may adjust the initial capital and earnings score for a bank based on: (1) the strength and quality of its capital, which includes the degree to which TAC is made up of common equity; and (2) its earnings capacity and quality. We may also apply an adjustment of up to one notch in either direction to arrive at a bank's stand-alone credit profile (SACP), capturing a more holistic view of its creditworthiness.

Ratings On Australian Major Banks' Senior Debt Can Stand Some Weakening In Their SACPs

The SACP of each of the major Australian banks could weaken by a notch if we considered that its forecast RAC ratio is likely to fall and remain below 10%. Our issuer credit ratings on the major Australian banks, and our ratings on their senior debt issues, should remain unchanged even in that scenario. This is because, based on our current sovereign ratings on Australia, the uplift for our expectation of extraordinary support from the Australian government would expand to two notches if these banks' SACPs weakened by one notch.

Our ratings on a few other Australian banks could also fall by a notch due to a weakening in their RAC ratios. However, we would need to holistically consider any changes in their credit profiles should APRA proceed with implementing the proposal.

Ratings On T2 Instruments Sensitive To Bank SACPs But Not To The Degree Of Subordination

We are likely to lower our ratings on Australian banks' T2 instruments if the issuing bank's SACP weakens. But such downgrades would not be due to the removal of a more deeply subordinated layer of capital. AT1 instruments are more subordinated than T2 instruments but removing this subordinated layer, by itself, would not affect our ratings on T2 instruments. We do not deduct additional notches for different degrees of subordination. This is because our ratings are not based on expected loss or recovery.

Ratings On Instruments Currently Classified As AT1 Will Face Offsetting Pressures

Our ratings on Australian bank instruments currently classified as AT1 capital may face offsetting positive and negative pressures:

• A weakening in an issuing bank's SACP would put downside pressure on our ratings on these instruments. We expect that these instruments will retain their hybrid characteristics despite being reclassified as T2.
• At the same time, we may apply a narrower notching if we considered that the risk of partial or nonpayment of coupon on a going-concern basis has reduced following APRA's reclassification of these instruments as T2. For example, the reclassified instruments may no longer be subject to restrictions on distributions that apply to AT1 instruments.

The net rating impact of these factors could be positive, negative, or neutral. For example, there may be some rating upside for these instruments in a hypothetical scenario, if:

• The SACP of the issuing bank remained unchanged, and
• we considered that these instruments now carry a lower risk of partial or nonpayment of coupon on a going-concern basis.

In our ratings on these instruments, we currently deduct two notches to reflect the risk of partial or nonpayment of coupon. This may reduce to one notch, or zero notches if the coupons were no longer deferrable. In the latter case, our ratings on the reclassified instruments would be the same as those on the "other" T2 instruments issued by Australian banks.

Any Rating Actions Would Be Subject To Certainty

We emphasize that any potential rating actions discussed above would be subject to certainty in relation to APRA's proposed changes as well as banks' responses. This certainty may emerge well before APRA's proposed implementation date of Jan. 1, 2027.

This means that we may also take above-discussed potential rating actions well ahead of the implementation date considering our capital analysis is typically based on forecast RAC ratios for the next one to two years. Nevertheless, the phaseout of bank AT1 is only a proposal within a discussion paper at this stage. APRA will undertake a formal consultation before finalizing any changes to the capital framework. Similarly, we currently lack clarity on how the banks intend to alter their capital structure to respond to this change.

Existing AT1 Instruments Would Lose Intermediate Equity Content From Jan. 1, 2027

Under APRA's proposal, all outstanding Australian bank AT1 instruments will be reclassified as T2 capital on Jan. 1, 2027 although these instruments may retain their contractual terms, including the ability to absorb losses on a going-concern basis. In addition, APRA would expect these instruments to be called and replaced with T2 instruments on their first call dates--first call dates for all the outstanding bank AT1 instruments are scheduled by 2032. Consequently, we expect to exclude Australian banks' outstanding AT1 from TAC from Jan. 1, 2027, if APRA proceeds with implementation of its proposal.

T2 Or Other Alternative Instruments Would Be Unlikely To Qualify For Inclusion Within Our TAC Calculations

One of the questions we have received from several market participants is whether T2 instruments or other alternative capital instruments could qualify for inclusion within S&P Global Ratings' calculation of a bank's TAC.

We consider it unlikely that Australian banks will be able to issue such instruments if APRA implements its proposal, because:

• A T2 instrument may qualify as intermediate equity content if it meets certain criteria. These criteria include going-concern mandatory contingent capital features that transform it into common equity or allow a permanent write down of at least 25% of the principal. We consider it unlikely that APRA would allow a bank to issue a T2 instrument with such features because its proposal is based on going-concern loss absorption features being impractical and potentially counterproductive for a retail investor base.
• For prudentially regulated banks and insurers, we assign no equity content to the instrument (or the portion of the issuance) where it is not included in regulatory capital.

Role Of Government Support Reinforced

APRA's proposal reinforces the Australian government role as a source of extraordinary support for systemically important banks, in our opinion. Government support to boost going-concern capital of a systemically important bank would assume greater importance in the absence of AT1. We also note that APRA's proposal does not in any way hinder the government's ability to support a bank facing distress.

Only A Modest Impact On Bank Earnings

APRA's proposed phaseout would predominantly replace the AT1 with typically lower cost T2 capital instruments. However, the coupons paid on the new T2 issued by Australian banks could rise because of the substantial increase in supply of T2. Furthermore, the larger Australian banks would need to replace about a sixth of their AT1 with costlier CET1. Nevertheless, we--like APRA--believe that these changes should have only a modest effect on Australian bank earnings overall. Also, we consider that the increase in CET1 levels for the larger banks should not be large enough to induce them to take greater risks to maintain their return on equity.

Capital Markets Can Absorb Increased Australian T2 Issuance

We consider that domestic and international capital markets can absorb additional Australian bank T2 issuance needed to meet APRA's proposed changes. APRA estimates that Australian banks would need to issue about A$36 billion in T2 instruments over the next seven years under its proposal. This compares with Australian banks' existing stock of about A$120 billion of T2 and A$44 billion of AT1 instruments as at June 30, 2024.

Current domestic investors in Australian banks' AT1 instruments could choose to invest in their T2 instruments if the Australian banks stopped issuing AT1. The appetite to switch to Australian bank T2 would likely depend on the investors' view of the risk-adjusted return on such instruments; the headline coupons on Australian banks' T2 would likely remain lower than their current AT1. We consider that lack of supply of AT1 would likely create some capacity for T2 in the domestic market. Furthermore, Australian banks have had a positive experience of issuing longer maturity T2 instruments in the much larger U.S. capital market.

As the Australian regulator takes the next steps in following up on its discussion paper, the market participants will adjust and rebalance their plans. For example, if APRA proceeds with implementing its proposal, the Australian banks would need to decide to what extent they replace existing AT1 capital with CET1 to preserve their capital strength. Similarly, the domestic investors in Australian bank AT1 capital instruments would need to consider alternative investment options, including increased supply of the Australian bank T2 paper. S&P Global Ratings will continue to monitor this space to assess the credit implications.

Related Research And Criteria

Related Criteria

• Risk-Adjusted Capital Framework Methodology, May 1, 2024
• Hybrid Capital: Methodology And Assumptions, March 2, 2022
• Financial Institutions Rating Methodology, Dec. 9, 2021

Related Research

• The Role Of Bank AT1 Hybrid Capital One Year On From The 2023 Banking Turmoil, June 26, 2024
• Credit FAQ: Will Australia Increase The Likelihood Of Bank AT1 Loss Absorption?, Oct. 19, 2023
• Top 200 Banks: Capital Ratios Continue To Normalize After Pandemic Peaks, Sept. 19, 2023
• Credit FAQ: Asia-Pacific AT1 Hybrids Investors: Understanding The Credit Suisse Fallout, March 24, 2023
• Swiss Regulator's Statement On Credit Suisse AT1 Confirms Impact Of Documentation And Legislative Powers, March 23, 2023
• European Bank AT1 Hybrids In A Post-Credit Suisse World, March 21, 2023
• Bank Regulatory Buffers Face Their First Usability Test, June 11, 2020
• Europe's AT1 Market Faces The COVID-19 Test: Bend, Not Break , April 22, 2020

External Research

• A More Effective Capital Framework For A Crisis, Sept. 10, 2024
• Enhancing Bank Resilience: Additional Tier 1 Capital In Australia, Sept. 21, 2023