What happened when the IMF ran big stress-test on Aussie banks

Christopher Joye

Coolabah Capital

The IMF has just run a massive stress-test on all the Aussie banks, involving a 10% fall in GDP, a 30% drop in house prices, a blow-out in credit spreads and a recession similar to what the US experienced during the GFC. In my column today I discuss their findings, the implications for the bail-in of bank hybrid securities, and APRA's evolving policy approach to the banks issuing bail-in-able bonds (click on that link to read for free or AFR subs can click here). Excerpt only:

The IMF found that Australia’s five largest banks’ CET1 ratios fell from 10.6 per cent to only 7.2 per cent, comfortably above the 5.125 per cent CET1 threshold at which Additional Tier 1 (AT1) capital hybrids are switched into shares. “These results are broadly similar to those obtained by APRA in its bottom-up stress test conducted one year earlier,” the IMF noted.

The IMF also interrogated Aussie banks’ exposures to global systematically important banks (GSIBs) overseas, and documented a much lower level of interconnectedness compared to Asian, European, Japanese and US banks’ correlations with one another. (Interbank exposures domestically were likewise found to be “relatively small” at just 5 per cent of assets.)

An interesting feature of the IMF’s paper was its explicit call for APRA to introduce a “creditor no worse off” regime to protect the investors that fund our banks “as an additional legal safeguard to the bank resolution framework”. This is a significant development in the context of APRA’s current consultation process regarding its evolving “total loss absorbing capacity” (TLAC) framework, which the government (and the IMF) has stated should conform with global best practice.

In addition to requiring hybrids to convert into equity if a bank’s CET1 ratio falls to 5.125 per cent, which injects extra “going concern” capital while a bank is alive, APRA also has the right to unilaterally switch AT1 hybrids and Tier 2 subordinated bonds into a bank’s ordinary shares if it declares a “non-viability” event. This gives APRA access to “gone concern” capital to recapitalise a failing bank with equity once it has become non-viable.

APRA defines these rights in the prudential standard that dictates the terms on which banks can issue AT1 and Tier 2 securities, which are then embedded into their contracts. In March 2018 APRA upgraded the Banking Act to legislatively acknowledge that hybrids and Tier 2 bonds can be bailed-into equity under their contracts.

It is not widely appreciated that this means that Aussie hybrids and Tier 2 bonds now possess both “contractual” and “statutory” (or legislative) bail-in. More technically, APRA created a circular reference in the legislation that endorses bail-in only where the security’s contract explicitly references APRA’s bail-in rights, which carves out depositors and senior bondholders where no such contractual terms exist.

The problem identified by the IMF (and global investors) is that APRA’s non-viability clauses have not been properly defined and do not protect against regulatory decision-making errors. Here global best practice recommends two core principles. First, that the “gone-concern” bail-in right should only be invoked when a bank is truly “gone” (ie, about to be placed into administration). And, second, that if a regulator erroneously imposes losses on creditors, they should have legal recourse to sue for appropriate compensation.

Under Title II of the Dodd Frank Act in the US and the European Bank Resolution and Recovery Directive, creditors are entitled to receive the same economic outcome in any gone concern bail-in that they would experience if the bank was resolved via standard bankruptcy processes. This is why the IMF implores APRA to adopt a “creditor no worse off” protection, which ensures regulators exercise their bail-in rights carefully and mitigates the risk of errors caused by carelessness and/or political pressures to inflict punitive damages on certain stakeholders.

As a consequence of APRA’s nebulous non-viability clauses, global investors have historically required Aussie banks to pay an extra risk premium when raising money via securities that are subject to them, which is inevitably passed on to bank customers.

In the context of APRA’s TLAC consultation process one interesting development was the French bank, BNP, issuing a 5 year, “non-preferred senior”, or “Tier 3”, TLAC bond last month to Aussie investors, sourcing $475 million at a cost of just 1.75 per cent above the bank bill swap rate (BBSW).

The government’s financial system inquiry expressly recommended APRA consider this type of Tier 3 product, which has become global best practice, to ensure our banks can source TLAC capital in the lowest cost and most liquid manner possible. Trying to raise an extra $80 to $90 billion of TLAC funding via Tier 2 subordinated bonds (or $125 billion including existing Tier 2 maturities) would make our banks some of the most financially unstable in the world. This is because their capital structures would have a globally unprecedented 6 to 7 per cent sleeve of illiquid and volatile Tier 2 securities (compared to just 2 per cent for banks overseas) that would be impossible to refinance during stressed market conditions.

Tier 3 bonds rank higher than Tier 2 in the capital structure, have superior credit ratings, and are classified by global investors as “senior” rather than “subordinated”, which means the capital available to invest in them is orders of magnitude larger than Tier 2 (actual global Tier 3 issuance is about 10 times larger than Tier 2).

At just 1.75 per cent above BBSW, the spread on the BNP Tier 3 issue last month was also notably 75 basis points cheaper than the 2.5 plus per cent spread the major banks would have to pay if they attempted to originate $125 billion of Tier 2, and this assumes benign market conditions.

Tier 3 issued by the major banks would likely carry the same A band rating as BNP’s bond, and in Australian dollars would price well inside BNP at about 1.5 per cent above BBSW or roughly 1.5 times the cost of current senior bonds (where the latter are subordinated to deposits but rank above Tier 3 in the same way that Tier 3 ranks ahead of Tier 2 but below current senior).

Following APRA’s recent upgrades to the Banking Act, it has room to accommodate a Tier 3 security via an “other securities” carve-out. Yet if APRA wants our banks to be able to access global Tier 3 markets at the same cost and with the same liquidity as rivals overseas, it will have to embrace a creditor-no-worse-off protection and ensure its bail-in clauses can only be exercised in true gone concern events.

Read the full column 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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