The Australian Prudential Regulation Authority (APRA) confirmed that it will phase out Additional Tier 1 (AT1) capital requirements for banks, and smaller Australian banks will be able to fully replace AT1 with Tier 2 capital, with the new framework coming into effect January 1, 2027. This bulletin reviews the proposed changes and discusses why Canada could benefit from adopting a similar approach to replace AT1 with Tier 2 capital.
What you need to know
- APRA's view is that AT1 capital does not effectively do what it is intended to do: absorb losses while a bank is a going concern and support resolution.
- We believe that the Office of the Superintendent of Financial Institutions (OSFI) should consider adopting APRA's approach to AT1 capital for small and mid-sized Canadian banks—in particular, federal credit unions (FCUs).
- In our view, AT1 capital would likely never be used in practice to absorb losses on a going concern basis and replacing AT1 with Tier 2 capital requirements would enable FCUs to raise qualifying regulatory capital more efficiently and cost effectively than they currently are able to.
What led to the proposed changes to AT1 in Australia
On December 9, 2024, APRA confirmed in a letter to all authorized deposit-taking institutions in Australia that it will phase out the use of AT1 capital requirements to simplify and improve the effectiveness of bank capital in a crisis. The announcement came after APRA launched a consultation in September 20241 on a proposal to require banks to replace AT1 with cheaper and more reliable forms of capital that would absorb losses more effectively in times of stress.
Most respondents to APRA's September 2024 consultation (which included various stakeholders, such as banks, industry associations, rating agencies, brokers, investors and peer regulators) agreed that AT1 does not meet the regulatory objectives of stabilizing a bank so that it can continue to operate as a going concern during a period of stress or supporting resolution with the capital strength that it needed to prevent a disorderly failure.
In the consultation, APRA specifically noted that international experience has shown that AT1 absorbs losses only at a very late stage of a bank failure, as evidenced in the case of Credit Suisse in 2023. In that instance, AT1 only absorbed losses when the point of non-viability was imminent and failed to stabilize the entity earlier in stress. While AT1 has been designed to absorb losses prior to resolution, APRA suggested that this has been challenging in practice. As one example, distributions on AT1 are discretionary, meaning that banks under financial stress can cancel distributions to conserve capital—this would theoretically allow a bank to continue lending during tighter economic conditions, but APRA noted that, in practice, the market signaling effects from cancelling distributions are more detrimental than the minor benefit of additional financial support.
While some submissions raised concerns with phasing out AT1, such as investors losing access to AT1 as an investable product, APRA remained of the view that AT1 does not effectively do what it is intended to do: absorb losses while the bank is a going concern and support resolution.
The new APRA approach
Under APRA's proposed approach:
- large, internationally active banks will be able to replace 1.5% AT1 with 1.25% Tier 2 capital and 0.25% Common Equity Tier 1 (CET1) capital (these measures are as a percentage of risk-weighted assets);
- smaller banks will be able to fully replace AT1 with Tier 2 capital, with a removal of Tier 1 requirements and no proposed changes to Total Capital requirements; and
- APRA's requirements applicable to internationally active banks will remain in line with international minimum standards.
APRA intends to finalize changes to prudential and reporting standards before the end of 2025, with the updated framework to come into effect as of January 1, 2027. APRA's intention is that from January 1, 2027, existing AT1 would be eligible to be included as Tier 2 until their first scheduled call date.
Advantages to adopting the proposed APRA approach in Canada
Canadian banks have three types of capital: fully loss absorbing capital (CET1), going concern capital, meant to cushion losses while a bank keeps operating (AT1) and gone concern capital, which might not be able to absorb loss while a bank remains a going concern (Tier 2).
We believe that OSFI should consider adopting APRA's approach to AT1 for small and mid-sized Canadian banks—in particular, FCUs. In our view, AT1 capital would likely never be used in practice to absorb losses in the case of a Canadian bank/FCU other than potentially in the case of a domestic systemically important bank that is also required to hold bail-in-able debt, which dramatically increases the quantity of capital. In order for the Superintendent to form an opinion that it is reasonably likely that the viability of the bank will be restored or maintained after the conversion of non-viability contingent capital (NVCC) instruments (i.e., AT1 and Tier 2 capital), it is imperative that significant new capital be injected into the non-viable bank—the mere triggering of the conversion of the non-common capital instruments into common shares does not increase the quantity of capital (only the quality). The banking business is a "confidence" business and, if the primary regulator of the bank announces that the institution with its current level of capital is not viable, we anticipate that it may be very difficult to attract investors to make an investment if that were meant to be the basis for restoring viability—and we would be concerned that depositors may run and practically that no amount of capital could likely stop that from occurring. Accordingly, we cannot envision any potential scenario where an NVCC conversion could be triggered in respect of a federal credit union; rather, the institution would either merge with another federal credit union, or simply be wound up under the Winding-up and Restructuring Act (Canada).
In addition, by adopting APRA's approach to replace AT1 with Tier 2 capital, FCUs would be able to raise qualifying regulatory capital more efficiently and cost-effectively than they currently are able to.
OSFI's Capital Adequacy Requirements (CAR) Guideline provides that AT1 capital instruments must be perpetual, and that the issuing institution must have full discretion, at all times, to cancel distributions. In order for common shares to be included in a Canadian bank's Common Equity Tier 1 (CET1) capital, distributions may only be paid after all payments on more senior capital instruments (including AT1 instruments) have been made.
Since each of the large Canadian banks are publicly held, there is a built-in incentive to ensure that distributions on AT1 instruments are not cancelled since that would also likely result in a cancellation of the common share dividends (which, in turn, would make it more difficult for that bank to raise additional CET1 capital). Accordingly, we expect that the pricing of AT1 instruments issued by the large Canadian banks reflects a market expectation that distributions on those AT1 instruments will not be cancelled. FCUs do not have common shares and, therefore, are at a competitive disadvantage when considering the issuance of AT1 instruments since there would be no built-in negative market reaction if distributions on the AT1 instruments were cancelled. In other words, it is likely more expensive and competitively challenging for FCUs to sell AT1 instruments because the market will demand higher distribution rates when there is no inherent disincentive to ensure that AT1 distributions will not be cancelled. As a result, by replacing AT1 with Tier 2 capital, FCUs would be in a better position to compete.
This also would be consistent with the Department of Finance's August 2024 Consultation Paper: Proposals to Strengthen Canada's Financial Sector, which sought feedback on how it could work with financial sector stakeholders to encourage growth and expansion of FCUs, and with OSFI's desire for a size-based regulatory regime to ease the burden on smaller banks (highlighted in its recently revised Supervisory Framework, which considers the size, complexity, and potential impacts to the financial system when assigning tier risk ratings to financial institutions).
Footnote
1 This consultation followed a 2023 Discussion Paper issued by APRA to gain feedback on the effectiveness of AT1 capital, which noted that there are currently certain design features and market characteristics that create significant challenges for the effective use of AT1 in Australia: international experience has shown that it does not absorb losses to stabilize a bank early in stress, and it would be challenging to use to support resolution without complexity, contagion, and litigation risk.
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