The big four banks estimated they would have to raise between $67 billion and $83 billion over four years. That may represent more than triple the $25 billion of Australian major bank Tier II debt sold over the past four years. Of that $15 billion to $20 billion is due to be refinanced over the next four years, adding to the funding task.
Tier II bank debt forms part of regulatory capital banks are required to hold to protect depositors and senior bondholders against losses. The claims of Tier II bondholders ranks ahead of Tier I hybrid and common equity holders, but below senior bonds, and is therefore more expensive to raise.
While banks have selectively raised this capital from individual Australian investors, the majority is raised from offshore institutions and the increased funding burden of this relatively expensive debt would almost certainly increase overall funding costs with potential knock on effects for lending rates.
Westpac treasurer Curt Zuber said he supported the APRA proposal to build a large buffer in the form of Tier II capital in principle but said the global fixed income market had moved away from buying Tier II bonds.
“As we go through cycles, it is potentially problematic for the banks to get the volumes they need in an economic way for the system which allows for the balance we want to achieve,” he said.
Another bank funding official said the “simplicity” of the APRA proposal was a positive.
“But to increase the total outstanding of Tier II product from one jurisdiction by threefold even over a four-year period is certainly a challenge,” the banker said.
Tier II ‘bail-in bonds’
Tier II bonds rank below deposits and senior unsecured bank bonds in the capital structure, but above common equity and hybrids. These securities can be “bailed in” by a regulator in the event of a crisis, to protect depositor funds.
The APRA proposal is for Australian banks to meet global “total loss absorbing capital” requirements by increasing the capital they hold as Tier II bonds by between 4 to 5 percentage points, which the big four banks have estimated to be between $67 billion and $83 billion.
To comply with an overall increase in capital for the major banks from 14.5 per cent to up to 19.5 per cent, banks must still hold 6 per cent as Tier I capital (4.5 per cent equity and 1.5 per cent hybrids). Tier I is the most expensive form of capital. Where previously the banks could hold ‘the next’ 2 per cent as Tier II capital, this increases by 4 to 5 per cent, to the next 6 to 7 per cent, and will show up as a thicker layer in their ‘capital stack’
The credit margin on Australian Tier II bonds, relative to benchmark interest rates, widened almost immediately in the aftermath of the announcement by about 20 basis points, and after a spate of volatility in global markets are now about 60 basis points wider.
At present, analysts estimate that banks would have to pay well in excess of 2.5 percentage points over US Treasuries to issue Tier II bonds with a 10-year maturity in the US, compared to 1.9 percentage points in early November.
APRA had estimated that the proposed increase in Tier II issuance would increase bank funding costs by 5 basis points, an estimate that on early evidence appears to understate the impact, given the increased supply would drive up costs.
Others meet TLAC with Tier III
The banks are pointing out that in other jurisdictions banks have met their TLAC requirements by issuing “non preferred senior bonds”, a subset of Tier III bonds. While the market for this format of bonds has grown because regulators have accepted this form of “loss absorbing capital”, the Tier II market has shrunk.
While bankers point out the difference in risk between Tier II and Tier III bonds is marginal, Tier III bonds have a larger market of buyers because they have a “senior” ranking in the capital structure.
“For Australian banks to meet the proposed amount they would become one of the largest issuers of Tier II debt globally,” said National Australia Bank head of group funding Eva Zileli.
Chinese and US banks are the largest issuers of Tier II debt but most of the funding is sourced from domestic investors, whereas Australian banks source the majority of this capital from international investors.
While a large increase in Tier II debt issuance would force up wholesale funding costs, the banks insist that their primary concern is not the likely increase in funding costs.
Rather, the concern is that in periods of market stress, they may not be able to achieve the quantum of Tier II funding required to meet the prescribed threshold, which could itself undermine the perceived strength of the banks.
Looking back to 2011
Mr Zuber likened the consultation process to the bank’s efforts to allow them to issue covered bonds in 2011.
APRA had previously been opposed to efforts by the banks to allow them to issue triple-A rated covered bonds, which are secured against a pool of mortgages, because it effectively reduced the assets available to depositors in a wind-down.
But an agreement was eventually reached in which the Australian banks could issue up to 8 per cent of their total assets in covered bonds, giving the ability to raise inexpensive funding in tough market conditions.
The banks have used this format sparingly in good times so that when conditions in credit markets become more challenging, they have capacity to issue higher rated covered bonds.
For instance, in 2018 when credit markets were favourable, all of ANZ’s funding needs were met by issuing senior unsecured bonds.
Debt in 2019
But this year has proved more challenging, prompting the banks to opt for covered bonds already. Earlier this week Westpac raised funds in the US dollar market via a covered bond deal while ANZ was marketing a British pound denominated covered bond on Friday.
The bank funding teams are often at the front-line of the economy facing at times volatile funding markets to source the capital required to lend to households and businesses.
However the task of the bank treasurers has been made easier of late. The “heavy lifting” required to meet new liquidity rules has largely been done while slowing credit growth, driven by reduced home lending, has further eased funding requirements.
Commonwealth Bank’s annual wholesale funding target for instance has fallen to $25 billion in 2019 from $33 billion the 2018 and $40 billion in 2017.
Mr Zuber said the banks did not “feel the same amount of funding pressure as we did in the past” while competition for the most important source of funding – deposits – has also eased.
“The big picture is that credit growth has slowed and most experts expect it to continue slow in 2019,” he said.
“That means you are less likely to see banks aggressively chasing deposit volume growth on a relative basis.”