Australia: Basel introduces tough capital rules affecting hybrid securities

On Thursday, 13 January 2011, the Basel Committee announced guidelines that impose tough new requirements on hybrid securities if banks wish to count these towards their regulatory capital. The aim of the new guidelines is to ensure that a bank's regulatory capital fully absorbs loss at the point the bank becomes "non-viable" and exposes taxpayers to losses.

The guidelines follow the announcement in December last year of detailed Basel III rules on regulatory capital and global liquidity standards which introduced stricter capital and liquidity requirements for banks.

Thursday's announcement appears to evidence the Basel Committee's determination to tighten capital requirements even further in order to protect taxpayers (who are often required to rescue distressed banks to protect depositors) in contrast with previous regulatory capital rules, which are largely focused on protecting depositors.

In addition, the new capital requirements potentially have the effect of converging the criteria for Additional Tier I and Tier II capital instruments which may diminish the incentive for Tier II hybrid capital issuance.

What is hybrid capital and what are the problems?

Hybrid capital is capital which has certain properties of debt (eg. payments to investors are classified as interest and are thus tax deductible) but is treated as equity as far as depositors are concerned (eg. they are subordinated to depositors). Prior to the financial crisis many banks issued hybrid capital as a cost-effective means of meeting their Tier I and Tier II capital requirements. However, the financial crisis showed that many hybrid capital instruments did not absorb losses as expected, which resulted in a number of distressed banks being rescued by the public sector injecting funds in the form of common equity.

In response to this, the guidelines introduced by the Basel Committee last week require banks to ensure that their Additional Tier I and Tier II capital includes a mechanism for absorbing losses before taxpayers are required to bail out banks. The mechanism is colloquially known as a "bail-in" and requires that capital instruments either be written off or converted to common equity prior to the bank being rescued by taxpayers. In fact, Germany introduced bail-in laws in November which means that holders of unsecured bonds issued by German banks (ie. securities that rank ahead of hybrid debt) could be forced to swap some of their investments for equity to help rescue a bank before taxpayers are called upon.

Trigger event for a "bail-in"

Under the new guidelines, the terms and conditions of all capital instruments issued by internationally active banks on or after 1 January 2013 which are to be counted towards Additional Tier I or Tier II capital must specify that they are to be either written off or converted to common equity upon the occurrence of certain trigger events (or subject to applicable laws which achieve the same result).

It is possible that in interpreting "internationally active banks" APRA will adopt the same approach that it did for the global liquidity standards. In December last year, APRA indicated that internationally active banks for the purposes of the global liquidity standards would include the larger ADIs (around 40 in number).

Whether a trigger event has occurred will be determined by the prudential authority in the jurisdiction in which the capital is recognised for regulatory purposes (eg. APRA in the case of an Australian ADI). The trigger event would occur on the earlier of: (i) a decision that a write-off is necessary to avoid a bank becoming non-viable; and (ii) a decision that a public sector injection of capital, or equivalent support, is necessary to avoid a bank becoming non-viable. In each case, the relevant authority will be required to determine the point at which the bank becomes "non-viable". This role is likely to pose significant challenges for prudential authorities.

Any compensation paid to investors as a result of a write-off must be paid immediately in the form of common stock (ie. it must be a debt for equity swap).

Uncertainty –when is a bank non-viable?

The recent announcement gives no guidance on when a bank is considered to be "non-viable". Whether this would occur at the point that a bank becomes technically insolvent or at some earlier point is unclear. This is unfortunate, as it means that Australian ADIs may defer developing new regulatory capital products until further clarification is given as to what constitutes a "non-viable" bank. Alternatively, ADIs could simply issue instruments which refer to "non-viable" as designated by APRA from time to time and pass the risk of what constitutes a "non-viable" bank to the investors. However, this approach may not be attractive to ADIs because of the negative impact it could have on pricing.

Any capital instrument issued on or after 1 January 2013 must meet the above criteria if it is to be counted towards Additional Tier I or Tier II capital. Recognition of capital instruments as Additional Tier I or Tier II capital that are issued prior to 1 January 2013 and do not meet the new criteria will be progressively phased out from 1 January 2013 (even though they meet the other Additional Tier I or Tier II criteria). The phase-out procedures will require recognition of such instruments for capital purposes to be capped at 90% from 1 January 2013 (based on the nominal amount of such instruments outstanding on 1 January 2013), with the cap reducing 10% each subsequent year.

Convergence between Tier I and Tier II capital?

Interestingly, the new capital criteria announced last week seem to converge the criteria for Additional Tier I and Tier II instruments. We say this because the criteria detailed in the Basel III capital rules categorised Additional Tier I instruments as "going-concern" capital (ie. capital that can be depleted without placing the bank into insolvency, administration or liquidation) and Tier II instruments as "gone-concern" capital (ie. capital that is subordinated to depositors in the winding-up or insolvency of the bank).

Consistent with this, the December Basel III capital rules stated that Additional Tier I capital must have a principal loss absorption mechanism through either conversion to common shares or a write-down at a pre-specified trigger point. However, the Tier II capital rules did not include this criterion (presumably because Tier II capital is only intended to absorb losses on a gone-concern basis).

The new capital requirements provide that both Additional Tier I and Tier II instruments must be written down or converted to shares at a pre-determined point. Therefore, if the "non-viability" of a bank is determined to be some point prior to its winding-up or insolvency, then it appears that notwithstanding the Basel Committee's earlier categorisation, Tier II capital will also be required to provide loss absorption on a going-concern basis. If this is in fact the Basel Committee's intention, it could render the distinction between Additional Tier I and Tier II capital instruments less relevant for internationally active banks.

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