UK risk premium looks too steep with stability restored
The Australian Prudential Regulation Authority (APRA) issued a surprising statement on Tuesday entitled ‘Expectations on capital calls’, in which it stated that institutions were requesting permission to make “uneconomic calls”, and outlined its guidance.
The regulator specified that, at a minimum, “the cost of issuing the replacement instrument is equal to or less than the cost of keeping the existing instrument outstanding” and “the credit spread at which the ADI or Insurer would consider the cost of the replacement instrument to be uneconomic”. The timing of the statement is probably linked to the fact that there are a lot of upcoming low-reset (uneconomic) calls from banks, mainly in Tier 2 debt but also in AT1s, and the regulator is keen to set out its stall in advance.
While it is not unusual for regulators to give guidance, and indeed the European Union’s Capital Requirements Regulation (CRR) contains similar instructions, what is surprising is that it appears the APRA is being very direct and clear in telling financial institutions that they should only consider economic calls. The statement added: “A rationale solely based on exercising calls to maintain access to capital markets (or limit reputational damage) would undermine the permanence and quality of capital that the Prudential Standards seek to maintain”.
This looks like a very aggressive step to us. If a bank or insurance company is well-run, adequately capitalised and not under regulatory scrutiny, why should the regulator seek to influence how that institution funds itself? Of course, if an institution is in danger of putting itself into a precarious position by continuing with uneconomic calls, then you would expect the regulators to have a word, but since the regulator sets capital and buffer requirements, this is how you would expect it to influence decision-making.
What constitutes an “economic” call is also not as clear as it might appear. The capital value of Tier 2 bonds amortises over the last five years of their life, and if institutions are forced to issue additional Tier 2 debt to make up the shortfall, that’s probably not very economic. In addition, banks who are very frequent issuers, and thus carry a lot of Tier 2 and AT1 debt, are rightly mindful of having investors reprice their entire funding curve upwards due to their not calling one bond. The APRA doesn’t want them to be too focused on reputation, but in the funding markets reputation matters.
Nevertheless, we do need to consider whether there could be a read-across here to other jurisdictions, and we think the answer is no. Similar to the ARPA, the Eurozone and UK regulators also give guidance to banks, but if capital levels are adequate, then call decisions have always been left up to the issuer. In addition, many banks have more Tier 2 and AT1 debt outstanding than they need, as this increases flexibility for their Treasury; it is unlikely that regulators would force these institutions to leave bonds outstanding in these circumstances. So far, non-calls have been on a bank-by-bank basis, depending on capital requirements and capital planning, and we would not expect this to change.
Lastly, we should highlight again that it is the spread being paid that is important, not the yield, and the gap to “economic” might not be as large as it appears. As we wrote
it may well be economic for a bank to call a low-coupon AT1 and issue a new one if the spread is similar to the reset rate of the old bond. This decision hangs not on the all-in yield but on the spread level. As regards market reaction, Australian Tier 2 and AT1 bonds did cheapen on the news, but other jurisdictions were unchanged, which wasn’t a surprise to us.