There is a country that has proposed to banks to stop using debt instruments known as CoCos (convertible notes) as mattress capital, after the earthquake they caused last year in the Swiss entity Credit Suisse. Australia has set to work to ensure that banks bury little by little in the coming years. This complex and high-risk debt arose in the wake of the 2008 crisis and has aroused great distrust in 2023. Why is Australia taking this step now? And more importantly, is it possible that other countries or regions will consider a similar approach?
The Australian regulator (APRA) has proposed that banks phase out the use of these bonds, also known as AT1 (because they are additional Tier 1 capital, the riskiest for the investor), which were introduced after the global financial crisis of 2008 to prevent taxpayers from taking losses in the event of a bank failure). Instead, it suggests that “cheaper and more reliable forms of capital“. The organization has opened a consultation in which it raises a transition period starting on 1 January 2027so that all currently issued AT1 bonds will be replaced by 2032. This proposal follows a consultation paper last year which sought comments on how to improve the AT1 structure in light of what happened with Credit Suisse.
Broadly speaking, the idea is to swap these AT1s for Tier 2 (T2) bonds, which are one step higher in the order of priority for recovery in the event of bankruptcy. Why swap one for the other? “The AT1 serves as a business continuity. If the bank starts losing capital, then AT1 becomes equity, In capital (or a to write off of the bond), so that the bank can remain viable. While T2 is used as gone concern, in other words, once the bank has already been deemed unviable, then T2 serves as mattress “so that older creditors suffer fewer losses,” explains a bank expert who prefers not to be named. In recent crises (notably those of Popular or Credit Suisse), we have seen that AT1 ends up “also functioning as concern gone and which is therefore similar to a T2 (once the bank is deemed non-viable then it serves as mattress), SO The Australian regulator thought that banks might be able to replace the expensive AT1 with the cheaper T2.“, he emphasizes.
“APRA’s proposal is to replace the 1.5% AT1 requirement with 1.25% Tier 2 and 0.25% CET1 for active international Australian banks and allow smaller banks to replace their AT1 with T2, removing its AT1 requirement and without proposing any changes in terms of total capital,” explains Carlos Cortezo, head of capital markets for financial institutions at Société Générale.
APRA chairman John Lonsdale said on Tuesday that CoCos do not fulfil their “role of stabilising a bank during times of stress due to their complexity, potential for legal challenges and risk of contagion”, according to BloombergIn Australia, he stressed, these risks are increasing because a “an unusually high proportion” is in the hands of retail investors.
In Spain, in general, subordinated debts (AT1 and T2) are not a financial instrument suitable for every investor. In fact, the issues of these securities are reserved for large investors, but they can be included in a diversified portfolio with investment funds. . for those who are willing to assume their risks in exchange for returns that are generally higher than those of other fixed income assets.
Experts consulted by this media believe that, for the moment, there will be no other markets that would consider withdrawing CoCos as Australia is proposing.We do not believe that other countries will follow in the footsteps of the Australian regulator, as this situation is very specific to this market.“, they estimate from Société Générale. “The other countries have not yet commented on anything. “Anything we wanted to do in Europe would take many years to be approved,” warns the expert from another investment bank.
Market recovery
As highlighted in Bloomberg, Australia is ‘first jurisdiction to phase out’ these instruments which were no longer used for a few months last year after the bankruptcy of Credit Suisse. At that time, Switzerland broke the rules of the game and it was decided that the holders of the bank’s CoCos would be the ones to absorb the losses before the shareholders of the entity, who are lower in the natural order of collection, valuing these bonds at zero.
This triggered great concern in the rest of Europe and a clear flight of investors, and the European Central Bank (ECB) itself had to take up the defence of this debt, ensuring that this did not happen in the eurozone. But it took a few months for the waters to calm down and the prices of many bonds collapsed, also paralysing issuance. According to AFME data, 2023 was the year with the lowest CoCo emissions in Europe in the last decade. It was a Spanish entity, BBVA, the first in Europe, that dared to resume the placement of CoCos three months later. This market is gradually normalizing. Prices have recovered and, in fact, one of the CoCos banking indices that includes Bloomberg It is trading at highs not seen since 2021 (see chart).
