So what is going on with regulation and particularly how will regulatory capital demands play out for investors?
" It's important to recognise the continued implications of current proposals for capital markets in the future."
Andrew Palmer and Kevin Wong, Head of FIG Australia and Director client insights & solutions | ANZ
Financial services regulation has been constantly evolving since the global financial crisis as regulators worldwide seek to address key weaknesses in the financial system. The list is long – Basel III for the banking industry; its sequel, colloquially known as 'Basel IV'; the Australian Prudential Regulation Authority's life and general insurance capital (LAGIC) reforms; and the Australian Financial System Inquiry (FSI).
In Australia, these regulatory reforms have had and will continue to have significant implications for affected financial institutions' capital markets issuance activities, spread across their capital structure from senior unsecured bonds to loss-absorbing subordinated securities.
For investors, the challenge is that capital structures and the issuance pipeline may change or adapt as further regulatory initiatives are implemented in the coming years.
Since January 2013, under the Basel III reforms, investors have seen banks issue regulatory capital instruments that have capital ratio and/or non-viability triggers leading to conversion to ordinary equity for loss absorption purposes.
These triggers are designed to provide an extra level of ordinary equity if an institution gets into trouble.Investors have to consider the risk and price implications of these triggers – in the $A wholesale capital market, the first deal occurred over a year after the introduction of the new capital rules.
In-mid 2015, write-off deal precedents emerged, whereby the value of the capital securities were immediately written down instead of first being converted into ordinary equity.
The 'terming out' of banks' funding profiles – that is, the lengthening of the average period before which banks have to raise new funding - will continue to be reinforced by the proposed Basel III long term liquidity reforms (Net Stable Funding Ratio) intended to be introduced in January 2018.
APRA regulated insurers saw the implementation of their new LAGIC rules in 2013. A key aspect was a new set of capital rules, including the requirement for acceptable capital securities to have a non-viability trigger akin to that for banks under Basel III.
These securities tend to have much longer maturities compared with banks in order to achieve both APRA capital and rating agency equity benefits.
The high-profile FSI concluded in December 2014 with a series of recommendations handed to the Federal Government. A fundamental focus of the inquiry was on the resilience of the financial system.
Given the importance and size of the banking sector for the Australian economy, the FSI recommended larger Australian banks have “unquestionably strong" capital ratios in a global context; that a framework for minimum loss absorbing and recapitalisation capacity be considered (including a 'bail in' regime) in line with offshore developments; and that banks using internal models for capital calculations be required to hold greater levels of capital for residential mortgages.
While the federal government is expected to issue its formal response on the FSI recommendations soon, APRA has already reacted.
In relation to banks having “unquestionably strong" capital ratios, APRA released in mid-July the results of a study comparing the capital position of the major banks against selected international peers, which “will inform, but not ultimately determine" APRA's approach.
APRA highlighted the framework on this issue will take into account developments in Basel IV and international peers' capital positions, and that any required capital strengthening occurs in an orderly manner over a multi-year implementation. The details are still to come.
APRA has also increased the capital adequacy requirements for residential mortgage exposures under the internal ratings-based approach. Announced in late July, APRA's new requirement effectively increases the average risk weightings for the affected banks (major banks and Macquarie) from around 16 per cent to 25 per cent.
While formally taking effect from 1 July 2016, ordinary equity raisings have already been announced (for example by ANZ and Commonwealth Bank) to ensure compliance by the time the implementation deadline comes around.
Finally, Basel IV is knocking on the door of the global banking industry. In December 2014, the Basel Committee on Banking Supervision (BCBS) outlined proposals to:
Details of implementation and transition are yet to be confirmed; however, in a nutshell, advanced banks using internal models may find themselves needing more capital, especially those originating large volumes of mortgages (although risk capital/selection is likely affected across all counter-parties).
A logical follow-on is that banks may come to rely more on retail mortgage backed securities (RMBS) and covered bonds for not just funding but also risk transfer going forward.
The combined affect then is the capital structures of affected regulated financial institutions may change as new regulatory reforms are implemented. The FSI and Basel IV emphasise common-equity Tier 1 (i.e. ordinary equity), while a 'bail in' framework has implications for all types of regulatory capital including potential new security structures.
Broadly (and as already demonstrated by the actions of affected banks), the medium-to-long term implications are for rising capital requirements and therefore greater capital issuance (including common equity), as well as the possible introduction of 'bail in' senior unsecured bonds or a Tier 3 security.
When we look at the major Australian banks and insurance groups*, there is almost $A24 billion in total Additional Tier 1 Capital calls or maturities over 2015 to 2020, while Tier 2 Capital totals over $A30 billion for the same period.
These estimates are for existing securities on issue – depending on both new regulatory initiatives to come as well as market/growth conditions, actual regulatory capital requirements may well be greater.
A strong and profitable banking system means strong organic capital generation, which may reduce the magnitude of incremental capital issuance going forward, across Common Equity Tier 1, Additional Tier 1 and Tier 2 securities.
Higher levels of capital more generally should, in theory, enhance the loss absorption support to senior securities making them less risky – it will be worth watching how this actually plays out in terms of investor pricing for senior unsecured debt.
Finally, depending on the volume of additional capital required, new sources of capital and greater diversity in markets may become more important for affected financial institutions.
For investors, this is definitely a space to watch.
* ANZ, CBA, NAB, WBC, Macquarie, AMP, IAG, Suncorp, QBE
Andrew Palmer is head of FIG Australia and Kevin Wong is director, client insights & solutions.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
21 Jul 2015
02 Sep 2015