Charles Littrell, Executive General Manager - KangaNews Debt Capital Markets Summit, Sydney
Good afternoon. Today I intend to provide a broad overview on how APRA considers its impacts upon Australia’s capital markets, particularly fixed income markets.
Let’s first consider APRA’s statutory mission, as defined in the APRA Act: APRA is to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality and, in balancing these objectives, is to promote financial system stability in Australia.
This statutory mission is supplemented by the Statement of Expectations the Government has given APRA, which was last updated in 2014. Relative to statutory missions given prudential regulators in other countries, APRA’s mission is narrowly and effectively focussed on balancing safety with a number of desirable attributes, and promoting financial stability. We are not tasked with, for example, promoting Australia as a global financial centre, or promoting the general growth of financial services or capital markets in this country. APRA welcomes the benefits such developments can bring, but I note that other agencies, and more generally the private sector, have these missions.
APRA considers that its main contribution to Australian capital markets, including traded debt markets, is to provide considerable confidence to participants that the prudentially regulated entities within these markets can be relied upon to meet their financial promises. There is an important secondary consideration, in that prudentially regulated entities should remain sufficiently confident in their own soundness, to be able to engage proactively in their chosen markets not only as borrowers, but as investors and counterparties. Although APRA devotes some effort to capital market and payment systems soundness and operations, ASIC and the RBA are the preeminent agencies in these areas. APRA’s focus is very much upon the individual and collective soundness of market participants, rather than the soundness of the markets themselves.
As APRA pursues its safety and stability missions, we often find that our work has direct product implications for some financial markets. I will discuss some of these issues today. As a general starting proposition, APRA does not seek to promote or discourage particular financial markets products, but some impacts are inevitable from, most notably, our capital and liquidity regulations.
Banks and insurance companies are subject to near-identical regimes to determine their eligible capital, but industry-specific regimes to determine the regulatory capital requirement. APRA’s regulatory capital definitions, which among other things are consistent with international standards, create three capital types:
- Common equity Tier I, so-called CET1 in the Basel framework;
- Additional Tier I, or AT1; and
- Tier II capital.
For our major institutions, CET1 is essentially listed ordinary equity, net of regulatory deductions. The two fixed income capital classes are probably of more interest today.
First, AT1, which in the Australian context largely comprises converting preference shares, largely sold to individual investors or their self-managed super funds. This instrument has been around for many years, with the first issue perhaps coming from Westpac in 1993. Modern iterations of this instrument generally feature franked dividends calculated to generate a yield over bank bills, and an eventual conversion to ordinary equity. The major banks are large issuers of this instrument, and dominate the market.
Tier II instruments are typically subordinated debt, but this time the institutional specifics of the Australian market dictate that much of the volume is placed with offshore, wholesale fixed income investors.
For both instruments, the major recent reform has been the move to automatic or forced conversion to ordinary equity, in circumstances where the issuer is operating close to minimum regulatory capital requirements, or is in financial difficulty. In the global context, instruments that write down are relatively more popular than the local preference for instruments which convert to ordinary equity. In either case, investors in these instruments have accepted contracts in which they automatically contribute to recapitalising the issuer, under certain circumstances.
We have yet to see how these conversions and write-downs will work in the Australian context, and ideally we will need to wait many years to find out. It is clearly the case, however, that the capital quality of these instruments, relative to the instruments issued before Basel III came into force, has improved. An important consequence of that improvement is that holders of AT1 and TII need to be prepared for large - and possibly total - losses, should their bank or insurance company issuer encounter severe financial difficulty.
There are a great many technically interesting issues associated with AT1 and Tier II issues, but in general, APRA is comfortable that these securities are fit for purpose. They are likely to fulfil their function as shock absorbers should an issuer get into trouble, and accordingly deserve regulatory credit as valid capital instruments.
This regulatory validity may create issues for investors, particularly AT1 retail investors, who may be unduly comforted by the issuer name on the instrument. It is important to remember there is a reason these instruments offer a higher yield: they are clearly riskier than deposits.
Unsecured senior bank debt
Australia’s banks issue a great deal of unsecured wholesale debt, both locally and offshore. As a first approximation, APRA’s capital rules have little impact upon these issues. We note two emerging considerations, however, that may materially affect the balance between return and risk for unsecured bank debt.
The first issue is TLAC, for Total Loss Absorbing Capacity. The TLAC concept is emerging for a group of global systemically important banks. There are no Australian banks in this group. It would be unsurprising, however, if over several years the TLAC concept extended to a wider set of banks, as was suggested by the recent report of the Financial System Inquiry.
The second issue is bail-in. “Bail-in” is a somewhat loose concept concerning the ability of banks and their regulators to convert fixed income claims into more junior claims, or perhaps to cancel these claims. AT1 and TII are forms of bail-in instruments, with the bail-in an explicit contractual condition.
Should the world evolve in a way that requires banks to hold more instruments with contractual bail-in features, essentially a new form of Tier II, then unsecured senior creditors will pretty clearly be better off. Should the world instead evolve such that TLAC is achieved by statutorily imposing bail-in outside contractual terms, then senior creditors will pretty clearly be worse off. APRA is currently minded to favour the contractual rather than the statutory approach.
In 2007, APRA commenced a substantial project to strengthen its bank liquidity requirements. The world had other ideas, however, so we did not finish this project until January 2015. At that point, the liquidity coverage ratio or LCR became effective, with many banks also entering a committed liquidity facility or CLF with the RBA.
It turns out that the capital markets impacts from APRA’s liquidity requirements are broader and probably more interesting that the impacts from our capital requirements. The LCR’s fundamental benefit is that it lengthens the time to illiquidity in the Australian banking system. From a regulator’s perspective, in practice the previous five business day rule meant that the public sector had perhaps two to three days to respond to a rapidly worsening liquidity crisis. The LCR will probably not allow a full 30 days of contemplation, but should at least give a materially longer period of decision time. Emergency decisions taken over a couple of weeks will hopefully prove more effective and less expensive than decisions that need to be made over two days. The LCR approach also means there is a reasonable prospect that a bank can ride out a short term liquidity shock, without requiring extraordinary public sector support.
APRA sees at least four substantial capital markets effects flowing from the LCR:
- First, most important and least often commented upon, we now have more stable bank liquidity in Australia. Given that bank liquidity is an exceedingly important part of the Australian capital markets, compared to many of our offshore peers, this increased stability must help in reducing the frequency and depth of market shocks.
- Second, APRA’s definition of High Quality Liquid Assets means that securities not issued by the Commonwealth and states enjoy no relative advantage against each other.
- Third, the RBA’s collateral terms for the Committed Liquidity Facility (CLF) mean that many fixed income security classes are eligible for inclusion, and this may encourage bank holdings of those instruments; and finally
- We are seeing a number of specific product feature changes in the markets.
On the product front, for example, APRA and ASIC have worked to reduce the presumption that retail term deposit holders have a free break right in less than thirty days. This historical anomaly could have added to liquidity strains in times of stress, and is hopefully now a historical rather than a prospective risk.
In the wholesale markets, we are seeing the 30 day LCR time frame, and perhaps a more general appetite for improved liquidity, move average bank bill tenors out a few months. We are also seeing 31 day notice accounts, both for wholesale and retail depositors.
Our expectation is that bank balance sheets and the Australian capital markets will continue to be influenced by the LCR. The CLF is a distinctive feature of the Australian liquidity regime, under which the banking sector has secured and pays for about $275 billion in collateralised lines of credit from the RBA. The RBA administers the CLF, but APRA determines which banks have access to the CLF, and the amount of access. It is important to understand that neither APRA nor the RBA is looking to increase the CLF. In fact, we expect CLF recipients to deploy all reasonable efforts to minimise reliance upon this facility. APRA continues to refine what we mean by “all reasonable efforts”, and this will remain a work in progress for many years to come. We expect the banking sector to continue its progress towards more stand-alone liquidity, and less reliance upon the public sector, to the greatest extent reasonably achievable. This means, among other things, that CLF as a proportion of balance sheets should drop over time.
I note that the global conversation on bank liquidity often makes a large distinction between domestic and foreign liabilities, and also retail vs. wholesale liabilities. APRA, on the other hand, is much more focussed on the difference between short term and long term liabilities.
Many of you will be aware that APRA is working towards a reformed prudential framework for securitisation. I don’t propose to say much about this today, other than to observe our increasing confidence that we will be able to develop a prudential regime which supports a larger, simpler, and safer securitisation market. Such a development would likely increase competition in home lending, and improve banking system liquidity. There is considerable devil in the details, so we are hastening slowly.
I will be disappointed if in five years securitisation isn’t a larger part of Australia’s capital markets, and if local super funds and insurance companies aren’t larger investors in this high quality paper.
Derivatives, central clearing, risk management
In 2009 and 2010, the major international and national standard-setting bodies made a number of important decisions about how the world’s derivatives markets should operate. Among other things, these decisions mean that a great deal of the world’s derivatives trading will now be concentrated through central counterparties or CCPs. In practical terms, this means a degree of forced conformance in regulation and industry practices in relation to derivatives trading and associated risk management.
As a result, APRA will introduce globally compliant regulation in the area of derivatives, lest Australian financial institutions be subjected to dual regulatory requirements that will be burdensome, and potentially irreconcilable, or that foreign entities are unable to continue to participate in Australian markets, thereby lessening market depth and liquidity.
In conclusion: APRA’s mission does not provide an explicit role to develop Australia’s capital markets, but our mission does quite a lot to protect these markets, and perhaps this protection helps them grow. Furthermore, our capital and liquidity approaches generate a number of specific influences on the products available in the Australian markets. In going about our tasks, APRA strives to avoid specific product influence, but from time to time this can’t be helped. Our expectation is that the wholesale Australian fixed income markets will grow over time, and at the moment we are particularly focussed upon securitisation and finalising liquidity reforms. We are also considering how to optimise Australia’s regulatory arrangements with international standards.
And most importantly, we are doing all this while remaining focussed upon ensuring that Australia’s prudentially regulated financial institutions meet their financial promises, and that we all remain reasonably confident that they will continue to do so.
Thank you for your attention.
- Section 8, APRA Act.
- See for example APRA’s November 2014 speech APRA update: Reforming the prudential framework for securitisation.