Category: Regulation

APRA proposes to simplify the capital adequacy framework by phasing out Additional Tier 1 (AT1)

APRA recently announced that it had concluded that AT1 instruments had not been shown to act effectively in a going concern scenario and were worse than Tier 2 capital in a resolution scenario leaving it with three choices:

  • Maintain the status quo while monitoring to see whether a solution emerged from international developments (either Basel redesigning the instruments or some kind of market solution)
  • Unilaterally redesign AT1 to make it more effective in Australia via some combination of a higher trigger for conversion, a new discretionary trigger and/or restrictions on the investor base
  • Simplify the capital adequacy framework by replacing AT1 with Common Equity Tier 1 (CET1) and/or Tier 2

APRA summarised their conclusion in favour of the “Simplify” option as follows:

“Replacing AT1 with more reliable forms of capital will enable banks to more quickly and confidently use their capital buffers in a crisis scenario and is expected to reduce compliance costs for banks. It will also strengthen the proportionality of the prudential framework by embedding a simpler approach to capital requirements for small and mid-size banks compared to the new requirements for large banks,” Mr Lonsdale said.

Under APRA’s proposed approach:

  • Large, internationally active banks would be able to replace 1.5 per cent AT1 with 1.25 per cent Tier 2 and 0.25 per cent Common Equity Tier 1 (CET1) capital.1
     
  • Smaller banks would be able to fully replace AT1 with Tier 2, with a corresponding reduction in Tier 1 requirements.

One thing we can all agree on is that phasing out AT1 does make the framework simpler, I have questions though:

  1. How does removing AT1 makes it easier to use capital buffers in a crisis?
  2. Does the option to convert to CET1 have no value in a going concern scenario?
  3. Just how risky are these AT1 instruments from an investor perspective?
  4. Will the debt market happily accept the smaller banks switching from AT1 to Tier 2 (i.e. if the debt market and rating agencies do see some value in having AT1 then will the smaller banks be required to hold CET1 instead)?
Does removing AT1 make it easier to use capital buffers in a crisis?

APRA questions whether AT1 discretionary distributions will in fact be cancelled when a bank is under stress and losses are eating into the capital buffers because “… the market signal effects from canceling distributions are considered more detrimental than the minor benefit of additional financial support“,

I don’t disagree that adverse signalling is a concern with any capital management action but I am not sure that this particular example is as big an issue as it is presented to be. This is partly because the dollar value of the AT1 distributions is so small that they don’t really help very much. By all means suspend them at the time that ordinary dividends have been suspended completely but otherwise respect the seniority of these instruments in the capital stack and loss hierarchy.

This brings us to adverse signalling concern that seems to be a significant factor in APRA’s analysis. Clearly you can cut ordinary dividends without the adverse signalling constraint so why is this a problem for AT1 distributions?

  • I suspect the problem is that the seniority of AT1 to CET1 creates the reasonable expectation on the part of AT1 investors that ordinary dividends should be required to do the initial heavy lifting on loss absorption and capital conservation and that AT1 distributions should come into play only when the ordinary dividend is cut to zero
  • APRA itself also acknowledges that the actual financial support created by cancelling the AT1 distributions is “minor” which begs the question why should the A1 distributions be cancelled when the loss absorption and capital conservation requirements can be easily achieved by increasing the reduction in ordinary dividends.
  • Once you get to the point where ordinary dividends are completely cancelled, there is room for AT1 distributions to be cancelled as well without the adverse signalling concern, especially if the bank is reporting losses.

Sometimes this is not the way it has played out. Part of the reason that this logical, predictable hierarchy of loss absorption can be disrupted lies I think with the overly complex way that the Capital Conservation Ratio (CCR) is applied. An explanation of why the CCR is overly complex is a whole topic in itself that I will leave for another day. The people who best understand this point are those working in stress testing who have had to calculate the CCR in a stress scenario (you really have to get into the detail to understand it).

The CCR issue could be addressed by simplifying the way it is calculated and I imagine there would be broad agreement that simplicity is always a desirable feature of any calculation that has to be employed under conditions of stress and uncertainty. The main point I want to make is that “simplifying” the application of the way the CCR is used to conserve capital might be a useful place to start before you decide to get rid of AT1 completely.

The bigger question I think is whether the option to convert AT1 into common equity has no value, either in a going concern scenario or in resolution.

APRA argues that

“Rather than acting to stabilise a bank as a going concern in stress, international experience has shown that AT1 absorbs losses only at a very late stage of a bank failure. … If AT1 was used in Australia APRA considers it would not fulfil its role in stabilising the bank before non-viability was reached.” 

In one sense, late conversion is a feature as opposed to a bug in the design of AT1 instruments. They are designed to convert as a last resort when the 5.125% CET1 Point of Non-Viability is crossed so it should not be a surprise that they convert relatively late in a stressed scenario. Perhaps more importantly the conversion option is calibrated to a point where a bank has run through the standard set of options for conserving and rebuilding capital buffers.

APRA acknowledges that the trigger could be set higher so that conversion happens earlier but asserts that “... this could undermine recovery plan actions and the usability of capital buffers“. So far as I could determine, the only reason cited to support this conclusion is that “A higher trigger, if exercised, may operate as a negative signal to the market at the very time when regulators are aiming to restore confidence“.

The statement regarding market signals is interesting. The conversion trigger, wherever it is set, is something that the “market” is well aware of, so the potential for adverse signalling seems to imply that the situation in the bank is much worse than was commonly understood by the market. If that was not the case then conversion is simply an outcome that the market should have been anticipating. A related concern for APRA is that international experience has shown that banks have failed with CET1 ratios much higher than 5.125 per cent, further reducing the potential value of the PONV trigger in their eyes.

It is obviously true that banking has an unfortunate history of seemingly solvent banks very quickly being found out not to be solvent (or maybe just perceived to be insolvent – much the same thing in practice), let’s call this Scenario 1. This still leaves a lot of other scenarios in which a bank has taken a large hit and just needs an infusion of new common equity to rebuild and survive.

Remember that APRA is proposing to replace 1.5% of AT1 with .25% of CET1 (and 1.25% of T2) for the big banks, while the smaller banks simply swap AT1 for Tier 2. For the bigger banks, the extra 0.25% CET1 arguably makes no real difference to the outcome for a Type 1 scenario, but a bigger block of convertible capital could be useful in the other adverse scenarios. For the smaller banks, they just have less options. So the capital framework proposed by APRA is simpler for sure but it is not obvious that it is better.

A related question is just how risky are these instruments from the investor perspective

The theory is that AT1 should be less risky than common equity because they pay investors a predetermined income distribution and have a more senior position in the loss hierarchy. Clearly we are all comfortable with retail investors holding common equity so in theory it should be ok for them to invest in something less risky.

This nice theoretical framework can get a bit messy in the real world for a couple of reasons:

  • Firstly, the CCR as currently implemented can result in AT1 distributions having to be cut in conjunction with the ordinary dividend thereby disrupting the simple hierarchy in which AT1 only comes into the frame once cutting the ordinary dividend has totally exhausted its capacity to satisfy the CCR
  • Secondly, there have been instances in which loss absorption has been achieved by the write down of the AT1 instrument rather than by conversion to common equity (thereby absorbing loss in a way that benefits common equity at the expense of AT1 investors and violating the loss hierarchy benefits that the AT1 investor though they were paying a premium for.
  • Even if conversion does play out as expected, there remains a risk that the value of the ordinary shares received on conversion continues to fall before the AT1 investors can convert them into cash. Indeed, the simple fact that a block of shares is being issued to investors who are not long term holders can itself contribute to a decline in the share price.

Most of these problems (not all) seem to be fixable:

  • Simplifying the way in which the CCR must be met would help reduce the potential for AT1 distributions to be required to absorb loss sooner than would be expected under the principle that AT1 ranks senior to ordinary equity
  • Similarly, loss absorption at the PONV can also be implemented in ways that respects the hierarchy of loss that AT1 investors believed they had contracted to. I am open to someone making the case that the option to write off AT1 has some value but mostly it just seems to introduce complexity and raise doubts about the seniority of the AT1 instruments.

The potential for AT investors to receive less than par value via the conversion is I think a risk that can’t be eliminated but I am not sure that it need to be eliminated. In the event that the shares received on conversion are sold for less than the conversion price, AT1 investors are still likely to have realised lower losses than those experienced by ordinary shares under the same scenario. Investing at this end of the capital stack is about relative risk and reward, the real question is whether the risk is correctly valued.

It is possible that APRA still concludes that retail investors are unable to accurately assess and price the risks. In that case, you retain the option of restricting the sale of the instruments to sophisticated investors and institutional money. That seems to me like a perfectly reasonable compromise that retains the useful features of these AT1 instruments. I just don’t see that the case has been made to completely eliminate the options that AT1 offers.

Last, but not least, we come to the question of what the debt market thinks about the proposal for smaller banks to completely replace AT1 with T2.and perhaps more importantly what do the rating agencies think?

I have to confess that I don’t know. It does seem to me however that something is being lost. The consultation on the proposal is currently open and more informed minds than my own will I hope be addressing that question in the feedback they offer.

I am speculating here but the only way that I can rationalise the policy option proposed by APRA is that they have concluded that the CET1 levels they have established in response to Unquestionably Strong target set by the 2014 Financial System Inquiry have rendered other forms of “going concern” capital redundant. The rating agencies will clearly have an opinion on this question.

I have been a long way from the front line on these issue for some time but that is my 2 cents worth – as always please let me know what I am missing.

Tony – From the Outside

Japanese housing

At face value the value of Japanese housing might appear a bit off topic for an Australian based banking and finance blog. I believe however that anyone interested in banking probably needs to understand the economics of the housing market in which the banking system operates. Housing affordability is also a recurring topic of debate in Australia without much evidence the problem is being resolved.

With that bit of context, I offer up a post that Noah Smith wrote in response to an essay written by the BBC’s outgoing Tokyo correspondent reflecting on his time in Japan. Noah’s over-riding argument is that Japan is not as stagnant as the BBC correspondent contends. He makes a number of counter arguments but the one that caught my attention is his assessment of the Japanese housing market.

Noah notes that the BBC correspondent opens his article by complaining that Japanese houses tend to depreciate instead of appreciate:

In Japan, houses are like cars.

As soon as you move in, your new home is worth less than what you paid for it and after you’ve finished paying off your mortgage in 40 years, it is worth almost nothing.

It bewildered me when I first moved here as a correspondent for the BBC – 10 years on, as I prepared to leave, it was still the same.

Japan was the future, but it’s stuck in the past

Noah argues that what appears like a problem to someone who is accustomed to expect that house prices should always go up is in fact a strength of the Japanese system …

Weirdly, this is presented as a chronic problem — something Japan should have fixed long ago, but hasn’t. But in reality, depreciating real estate is one of Japan’s biggest strengths. Because Japanese people don’t use their houses as their nest eggs, as they do in much of the West, there is not nearly as much NIMBYism in Japan — people don’t fight tooth and nail to prevent any local development that they worry might reduce their property values, because their property values are going to zero anyway.

As a result, Japanese cities like Tokyo have managed to build enough housing to make housing costs fall, even as people continued to stream from the countryside into the city.

Increased supply is often talked about as a big part of the solution to the housing affordability problem in Australia. Depreciating real estate is clearly not something that the Australian public is going to embrace any time soon (at least not until the political power of renters outweighs home owners) but the Japanese model is interesting none the less if only to see how a society functions under this model.

Tony – From the Outside

Residential mortgage risk weights

I have posted a few times challenging the often repeated assertion that advanced banks are subject to materially lower risk weights than their competitors operating under the standardised approach (see here for example).

I have not seen the argument asserted for some time but APRA has chosen to publish a short note repeating their conclusion that the difference is nowhere near as big as claimed.

Here is a link to the APRA note but the short version is

“APRA estimates that the average pricing differential for housing lending due to differences in IRB and standardised capital requirements is 5 basis points.4 Taking into account the IRRBB capital charge and higher operational costs for IRB banks would further reduce this pricing differential.”

Tony – From the Outside

Moneyness – it’s complicated

… arguably too complicated.

Interesting post here by JP Koning exploring the differences between the way PayPal’s two forms of payment mechanisms are regulated. His conclusion might surprise you.

Here is a link to his post

jpkoning.blogspot.com/2023/09/there-are-now-two-types-of-paypal.html

This is the short version if you are time poor

Which type of PayPal dollar is safer for the public to use? If you listen to Congresswoman Maxine Waters, who in response to PayPal’s announcement fretted that PayPal’s crypto-based dollars would not able to “guarantee consumer protections,” you’d assume the traditional non-crypto version is the safer one. And I think that fits with most peoples’ preconceptions of crypto. Not so, oddly enough. It’s the PayPal dollars hosted on crypto databases that are the safer of the two, if not along every dimension, at least in terms of the degree to which customers are protected by: 1) the quality of underlying assets; 2) their seniority (or ranking relative to other creditors); and 3) transparency.

Let me know what I (and JP) might be missing

Tony – From the Outside

Small banks …

This post by Cetier on the RBNZ Financial Stability Report poses an interesting question about the future of small banks. He notes that the big banks seem to be doing fine but that small NZ banks are struggling to cover their cost of capital. This disparity between big and small banks also seems to be feature of the Australian banking system. It also looks like big banks in the USA are getting bigger at the expense of the small banks.

There is a perennial question of whether small banks need some support (possibly in the form of less onerous regulation) so that they can offer a source of competition to the larger banks. This is a policy choice that the USA has very deliberately made but it has been argued that this is one of the factors that contributed to the recent spate of bank failures.

This is part of a larger conversation about the tension between competition and financial stability. Marc Rubinstein did a good post on this question which I covered here.

I don’t have any answers but the question is one that I think will get more focus as the US considers its response to the most recent case studies in why banks fail. I don’t have enough expertise on the US Banking system to offer an informed opinion but the Bankers Policy Institute does offer an alternative perspective that argues that the failures were more a question of bad management and lax supervision than of regulation per se. I can say that the risks these US banks were running did seem to clearly violate the principles of Banking 101.

Let me know what I am missing …

Tony – From the Outside

The Secret Diary of a Bank Analyst …

… is the title of a post that Marc Rubinstein dropped this week summarising his perspective on why banks don’t behave like other companies. This is a question I have long been pursuing and I found Marc’s post well worth reading. Marc lists the following factors:

  1. Customer or Creditor
  2. Public or Private
  3. Growth is … not good
  4. Confidence is king
  5. Nobody knows anything

Let’s start with a quick outline of Marc’s observations about why banks don’t behave like other companies.

1) Customer or Creditor?

Marc writes …

“The first thing to understand about banks is that they operate a unique financial structure. Other companies borrow from one group of stakeholders and provide services to another. For banks, these stakeholders are one and the same: their creditors are their customers.”

This is oversimplifying a bit. Banks do also borrow from the bond markets but the key point is that deposits do typically from a large part of a bank’s liability stack and depositors clearly have a customer relationship. Understanding this is fundamental to understanding the business of banking.

2) Public or Private

Marc writes …

“Banks have a licence to create money which confers on them a special status somewhere between private enterprise and public entity. Economists argue that commercial banks create money by making new loans. When a bank makes a loan, it credits the borrower’s bank account with a deposit the size of the loan. At that moment, new money is created.”

He notes that the privilege of creating money comes at the price of being heavily regulated. Getting a banking licence is not easy and once granted banks must comply with a range of capital and liquidity requirements tied to the riskiness of their assets and liabilities. They are also subject to intense oversight of what they do and how they do it.

All of that is pretty well known but Marc makes another observation that may not be so widely understood but is possibly more important because of the uncertainty it injects into the business of banking

“All of this lies in the normal course of business for a bank. What is sometimes overlooked, because it is utilised so infrequently, is the executive power that authorities retain over banks. In some countries, where state owned banks dominate the market, intervention is explicit … But even when a bank is notionally private, the state can exercise direct influence over its operations.”

3) Growth is … not good

Marc writes …

“Most companies thrive on growth. “If you’re not growing, you’re dying,” they say. For investors, growth is a key input in the valuation process. 

But if your job is to create money, growth is not all that hard. And if the cost of generating growth is deferred, because the blowback from mispricing credit isn’t apparent until further down the line, it makes growth even easier to manufacture.”

This certainly resonates with my experience of banking. If you are growing faster than the system as a whole (or aspire to) then you should be asking yourself some hard questions about how you are going to achieve this. Are you really providing superior service or product or are you growing by giving up one or both of margin and credit quality. At the very least, it is important to recognise that growth is often achieved at the expense of Net Interest Margin (NIM) and everyone agrees that a declining NIM is a very big negative for bank valuations.

Marc goes on to observe that …

“The corollary to this is that., unlike in other industries, competition is not necessarily that good either – or at least it comes with a trade-off against financial stability”

Some economists might struggle with this but bank supervisors as a rule can be relied on to chose stability over competition. Marc notes however that US are a possible exception to the general rule …

US authorities are unusually squeamish about the trade-off. Partly, it reflects a respect for private markets but mostly it’s because their smaller banks harness significant lobbying power. …

The US is not necessarily making the wrong choice – its economy is more complex than others and its companies have more diverse financing needs. But it is a choice. As Thomas Sowell said, “There are no solutions. There are only trade-offs.”

4) Confidence is king

The fact that banking is a confidence game is of course no great secret. Marc notes that the problem in part is that confidence in the bank is largely based on proxies for soundness (e.g. capital and liquidity ratios, supervisory oversight, credit ratings) that have a history of being found wanting. So the foundations of confidence in your bank or the banking system as a whole are not themselves entirely reliable. A bank can tick all the boxes but still lose the confidence of the markets and find its viability subject to the (inherently risk averse) judgments of its supervisor and/or central bank.

The problem is exacerbated by the fact that it is difficult if not impossible to restore confidence once it is questioned. Marc restates Bagehot’s classic take on this question …

“If you have to prove you are worthy of credit, your credit is already gone”

Lombard Street: A Description of the Money Market; Walter Bagehot 1873

as follows …

It’s very difficult to restore confidence once it’s gone. One thing not to do is put out a press release saying your liquidity is strong. You’d think people would have learned after Bear Stearns, but no. When the proxies cease to work, saying it ain’t so won’t help either. 

5) Nobody knows anything

Marc writes …

“The dirty secret among bank analysis is that it’s quite hard for an outsider to discern what’s going on inside a bank… It’s only after the the fact it becomes apparent what questions to ask.”

This is probably my personal favourite because I was a bank insider for close to four decades and now I am looking at banks from the outside (hence the name of my blog). I like to think that I learned a bit about banking over that time but mostly what I learned was that banks are really complex beasts and I am still learning new things now. Hats off to anyone who really understands banking without having had the benefit of working on the inside or having the access to talk to people working on the front line of banking.

So what

Marc’s observations accord with my experience so I recommend his post for anyone interested in banking. Banks are one of the core institutions of our economy and our society so understanding them is I think important. Even if you don’t agree with him (and me), his post offers a useful reference point for checking your perspective.

If you want to dig further then there are couple of posts on my blog (see links below) that dig into these questions based in part on my experience but also summarising useful papers and other insights I have come across in the as yet incomplete quest to understand how banks do and should operate.

Tony – From the Outside

Links:

Loss absorption under bail in – watch this space

So much going on in banking; so many lessons and precedents. The way in which Credit Suisse’s Additional Tier 1 securities were applied (and equally as importantly) the way the market reacts is one I think is definitely worth watching.

It was easy to miss this detail given how much has been going on but John Authers (Bloomberg Opinion) neatly sums it up …

Holders of “Additional-Tier 1 (AT-1)” bonds have been wiped out. Credit Suisse’s roughly 16 billion Swiss francs ($17.3 billion) worth of risky notes are now worthless. The deal will trigger a complete writedown of these bonds to increase the new bank’s core capital — meaning that these creditors have had a worse deal than shareholders, who at least now have some stock in UBS.

Bloomberg Opinion “And then there was one”, Points of Return, John Authers 29 March 2023

The relative treatment of shareholders and AT Creditors was, for me at least, a surprise. In the conventional capital stack, shareholders absorb losses before all stakeholders. I did a post here setting out my understanding of loss absorption under bail-in. Christopher Joye helpfully explained that the Swiss seem to do bail in differently …

In contrast to many other bank hybrids, including those issued by Aussie banks, CS bank hybrids cannot, and do not, convert into equity in this scenario (ie, Aussie bank hybrids are converted into equity before a write-off). Instead, the CS hybrids must legally go directly to write-off. They further do not permit any partial write-off: the only option is for the regulator to fully write-off these securities.

“UBS buys Credit Suisse in CHF3 billion deal, bonds fully protected as AT1s are zeroed” Christopher Joye, Livewire 20 March 2023

John Authers offers some more context …

“Additional Tier 1” capital was a category introduced under the Basel III banking accords that followed the GFC, with the intention of providing banks with more security. Holders of the bonds were to be behind other creditors in the event of problems. In the first big test of just how far behind they are, we now know that AT1 bondholders come behind even shareholders.

…. he goes on to note that, while limiting moral hazard requires that someone be at the pointy end of loss absorption, the Swiss precedent poses the big question – who wants to buy Swiss style Additional Tier 1 knowing what they know now …

This follows the logic of the post-crisis approach, and it limits moral hazard. The question is whether anyone will want to hold AT1 bonds after this. The market response will be fascinating, and it remains possible that the regulators have avoided repeating one mistake only to make a new one.

The Swiss logic of favouring shareholders is not obvious to me so maybe I am missing something. It might offer some short term advantage but I am with John Authers on this one. Who signs up for this deal next time. We are definitely living in interesting times.

Tony – From the Outside

Moneyness: Let’s stop regulating crypto exchanges like Western Union

J.P. Koning offers an interesting contribution to the crypto regulation debate focussing on the problem with using money transmitter licences to manage businesses which are very different to the ones the framework was designed for …

The collapse of cryptocurrency exchange FTX has been gut-wrenching for its customers, not only those who used its flagship offshore exchange in the Bahamas but also U.S. customers of Chicago-based FTX US.

But there is a silver lining to the FTX debacle. It may put an end to the way that cryptocurrency exchanges are regulated – or, more accurately, misregulated – in the U.S.

U.S.-based cryptocurrency exchanges including Coinbase, FTX US, and Bianca.US are overseen on a state-by-state basis as money transmitters.

— Read on jpkoning.blogspot.com/2022/11/lets-stop-regulating-crypto-exchanges.html

Tony – From the Outside

Fed Finalizes Master Account Guidelines

The weekly BPI Insights roundup has a useful summary of what is happening with respect to opening up access to Fed “master accounts”. This is a pretty technical area of banking but has been getting broader attention in recent years due to some crypto entities arguing that they are being unfairly denied access to this privileged place in the financial system. BPI cites the example of Wyoming crypto bank Custodia, formerly known as Avanti, which sued the Kansas City Fed and the Board of Governors over delays in adjudicating its master account application.

The Kansas Fed is litigating the claim but the Federal Reserve has now released its final guidelines for master account access.

The BPI perspective on why it matters:

Over the past two years, a number of “novel charters” – entities without deposit insurance or a federal supervisor – have sought Fed master accounts. A Fed master account would give these entities – which include fintechs and crypto banks — access to the central bank’s payment system, enabling them to send and receive money cheaply and seamlessly. BPI opposes granting master account access to firms without consolidated federal supervision and in its comment letter urged the Fed to clarify which institutions are eligible for master accounts.

The BPI highlights two main takeaways from the final guidelines:

The Fed does not define what institutions are eligible to seek accounts and declined to exclude all novel charter from access to accounts and services.

The guidelines maintain a tiered review framework that was proposed in an earlier version, sorting financial firms that apply for master accounts into three buckets for review. Firms without deposit insurance that are not subject to federal prudential supervision would receive the highest level of scrutiny. The tiers are designed to provide transparency into the expected review process, the Fed said in the guidelines — although the final guidelines clarify that even within tiers, reviews will be done on a “case-by-case, risk-focused basis.”

The key issue here, as I understand it, is whether the crypto firms are really being discriminated against (I.e has the Fed been captured by the banks it regulates and supervises) or whether Crypto “banks” are seeking the privilege of master account access without all the costs and obligations that regulated banks face.

Let me know what I am missing

Tony – From the Outside