Forget Australia, European AT1s are here to stay

Earlier this week the Australian Prudential Regulation Authority (APRA) proposed scrapping Additional Tier 1 (AT1) instruments and not replacing them with any other form of junior debt, with the consultation paper suggesting that instead Australian banks could fill their 1.50% AT1 allowance with a combination of Tier 2 (1.25%) and Common Equity Tier 1 (CET1) capital (0.25%).

The price of outstanding Australian AT1s jumped 1-2 points in response to the headline, and the focus has inevitably turned to other AT1 markets (chiefly in Europe) as investors look to understand whether similar measures could be taken in other jurisdictions. We have explained before why we think AT1s will remain a key feature of European bank balance sheets for some time to come, but this latest development is a good opportunity to highlight why the Australian case is different.

For one, Australia’s banking system is far more concentrated than Europe’s with four big banks holding the vast majority of market share in commercial banking operations. It is also far more homogenous, with the big four having relatively similar fundamental profiles with CET1 ratios above 12% and leverage ratios at or above 5%. Another crucial difference is the composition of the AT1 investor base, with our calculations suggesting only around 10% of Australian AT1 bonds are placed with institutional investors – indeed, the APRA paper acknowledges the “additional complexities” created by its banks’ reliance on issuing AT1s to retail investors in smaller denominations. In our view, the proposed changes would have the biggest impact on Australian banks’ leverage ratios, reducing them by around 60-80bp to a range of 4.4%-5.2%.

By contrast, Europe’s banking sector is anything but homogenous. The UK for example has a number of banks (mostly building societies) that are constrained by leverage ratios rather than CET1 metrics, which remain well above requirements. Changes like those proposed by the APRA would create a need to raise fresh equity, yet some of these institutions do not have a clear mechanism for increasing this form of capital at short notice. In addition, some of the biggest banks rely on AT1s to facilitate some of their investment banking activities that consume more balance sheet. The need to replace AT1s with more expensive equity would significantly curtail these operations. In continental Europe, banks from jurisdictions where risk-weighted asset density (RWAs as a proportion of total assets) is lower, such as Sweden and France, would also likely end up with significantly lower leverage ratios if AT1s were to be eliminated. These issuers would require significant net profit retention to restore their leverage ratios to levels demanded by the market.

Just as importantly, the competitiveness of European banks against their US counterparts or other global peers would most likely be eroded if AT1s were to be eliminated. We do not anticipate any changes from the US authorities to preference shares, which supplement the leverage ratios of US banks. As a result, if banks in Europe were to meet leverage ratio metrics only with equity, it would limit the scope of operations in which they can engage and stay competitive, especially when it comes to investment banking operations.

Finally, unlike Australian banks, European issuers can place their AT1 debt only with institutional investors (the minimum denomination is €100,000). This creates fewer problems with regards to any mis-selling of bonds to end investors, and from a resolution perspective creates a more robust risk-absorption instrument which is desired by regulators.

Taken together, we do not see an imminent read-across to European AT1s from the APRA’s proposals. As we wrote earlier this year, we cannot rule out some reform of AT1s, but even that is not our base case scenario – the burden imposed on the sector to replace the existing stock would be too high versus the marginal benefit from making minimal adjustments to the format of junior bank debt. However, even in a scenario where the unexpected does happen and European AT1s or any form of junior debt is indeed phased out, the existing instruments would most likely trade higher, much like the Aussie issues this week, on the clear expectation of being taken out at their first call date.