Markets get APRA wrong

Christopher Joye

Coolabah Capital

This week I kick-along the debate about ScoMo's unprecedented proposal to fund $2 billion of SME loans, which I helped design, and examine how investors have whacked Aussie bank and insurer subordinated bonds as if there has been a mini-GFC as a result of a widely misinterpreted APRA discussion paper, which should, ironically, be positive for the sector (click on that link or AFR subs can click here). Excerpt enclosed:

While smaller banks and non-banks have praised ScoMo’s globally unique initiative to invest at least $2 billion into highly rated portfolios of SME loans, there has been chatter that this might interfere with the market by crowding out private activity. Absolute codswallop!

First, how are non-banks and fin-techs competing with big banks that have government-guaranteed deposits, government-guaranteed emergency liquidity (via the RBA), and an artificially low cost of capital because they are too-big-to-fail, remotely operating in a free or fair market?

Second, there is circa $300 billion of SME loans sitting on bank balance-sheets and roughly $80 billion of new finance originated each year. In absolute dollar terms, the government’s investment is, therefore, trivial. But symbolically for the global investment community it is massive.

Finally, the government is not replacing the private sector, but rather providing funding to both smaller banks and non-banks to allow them to offer more SME loans in competition with the majors.

It is doing so by co-investing in two critical parts of the liquidity chain that smaller banks and non-banks rely on when providing SMEs with finance. The first are the loan aggregation vehicles, or “warehouse facilities”, that SME lenders draw on until they have a sufficiently diversified portfolio of loans that can be sold to investors.

The second is this sale, or so-called "securitisation", process that involves taking SME loans out of a warehouse and turning them into a bond, or an asset-backed security (ABS), that is sold to investors. This replenishes the warehouse, enabling a new round of SME lending...

Let's move on to APRA's excellent discussion paper proposing the banks build an extra "total loss absorbing capacity" (TLAC) capital buffer amounting to 4 to 5 per cent of risk-weighted assets.

Credit rating agencies cheered the approach, with Standard & Poor's stating it will upgrade the major banks' senior bonds to AA- "stable" if it is implemented. APRA has, as a result, finally shored up the nation's most important capital importing conduit.

Global investors have, however, got ahead of themselves, smashing subordinated bonds issued by Aussie banks and insurers, pushing spreads up to 30 basis points wider (a two-standard deviation plus shock) on the presumption the banks will have to raise all this TLAC capital via Tier 2 bonds.

There is precisely a 0 per cent probability of this happening.

APRA is extremely keen to consult with the banks on the best TLAC solution, and has explicitly asked for responses to questions regarding the optimal instruments to fund the shortfall, the market capacity to absorb said funding and the probable price impacts.

For the purposes of its discussion paper, APRA assumed credit spreads were unchanged, undertook no capacity analysis and suggested the 4 to 5 per cent TLAC shortfall could be met via existing capital instruments (equity, tier 1 or tier 2).

If the majors tried to fund the shortfall using the cheapest tier 2 bonds, they would have to raise a staggering $126 billion accounting for existing maturities and balance-sheet growth over the next five years. If you include the non-major banks also captured by this policy, the number is closer to $140 billion and over $150 billion if balance-sheet growth is slightly stronger than recent averages.

Total global issuance of tier 2 was less than $50 billion over the last year, which makes this an impossible task, especially during anything remotely resembling volatile conditions that are likely to be the norm in the years ahead as quantitative easing unwinds.

APRA states that the government mandated it to implement the Financial System Inquiry's (FSI) TLAC recommendations, which dictate that APRA cannot put Aussie banks at a significant competitive disadvantage in offshore funding markets nor depart materially from global best practice apropos TLAC.

The FSI repeatedly recommended the consideration of a tier 3, or non-preferred senior bond, solution, which is a regulatory capital security that sits between traditional senior and current tier 2. Importantly, this has unambiguously become global best practice for meeting TLAC shortfalls.

Total global tier 3 issuance in the last has year has been around $350 billion, or seven times higher than Tier 3, which is dying as an asset class. Investors have much larger portfolio limits for tier 3 because it ranks higher than tier 2 and has a superior credit rating. The major banks' tier 3 would carry an A- rating assuming S&P upgrades Australia's economic risk score, which it is on track to do.

Whether the TLAC shortfall is funded via tier 2 or tier 3 does not practically matter to APRA, since both can be bailed into equity at the same time. But it makes an enormous difference to the financial system, which can do the job using tier 3 but has zero hope using tier 2. The behaviour of the latter since the APRA report only underscores how absurd that hypothetical is.

While APRA flew the kite on a four-year implementation timeframe, it may calibrate this given any fixed period would open Aussie banks up to adverse gaming by global investors. A more flexible through-the-cycle TLAC target would allow banks to raise tier 3 during good times, and then tap bullet-proof, old-style senior bonds when markets get flighty.

It's hard to imagine the 4 to 5 per cent shortfall shrinking given this only just puts the majors into the 50th percentile of global peers, which APRA is right to insist on. One thing is, however, certain: we will, through the cycle, see about $130 billion less traditional senior bond issuance from the majors, which will be replaced by non-preferred senior.  

Read more here.


Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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