A more effective capital framework for a crisis

The international banking turmoil that occurred in 2023 reinforced the importance of the regulatory framework operating effectively in a crisis. While unlikely, disorderly bank failure can cause significant disruption to the Australian financial system, with swift and decisive responses required to provide stability. An effective regulatory framework safeguards the interests of depositors and limits risks to financial stability in these circumstances.

This Discussion Paper outlines potential amendments to APRA’s prudential framework to ensure that the capital strength of the Australian banking system operates more effectively in stress, proposing to replace Additional Tier 1 (AT1) capital with more reliable and effective forms of capital. 

Policy background

Over the past decade, APRA and the Australian Government have implemented measures to strengthen the crisis preparedness of the Australian financial system. This includes legislative changes to enhance APRA’s crisis management powers, developing a policy framework for resolution planning, and requiring certain banks to increase their loss-absorbing capacity. 

More recently, APRA has been seeking to enhance the effectiveness of capital in a crisis. In 2023, APRA issued a Discussion Paper to gain feedback on the effectiveness of AT1 capital. The intent of AT1 is to stabilise a bank so that it can continue to operate as a going concern during a period of stress, and support resolution with the capital that is needed to prevent a disorderly failure.

The Discussion Paper noted that there are currently certain design features and market characteristics that create significant challenges for the effective use of AT1 in Australia: international experience has shown that it does not absorb losses to stabilise a bank early in stress, and it would be challenging to use to support resolution without complexity, contagion, and litigation risk. Australia is an outlier internationally with a material proportion of AT1 held by domestic retail investors.

Following the release of the Discussion Paper, APRA undertook around 40 engagements with a range of external parties and received 26 formal submissions. While responses varied, there was constructive discussion on the challenges with AT1 and on the potential policy options. APRA also discussed the feedback and policy options with other agencies on the Council of Financial Regulators (CFR).

Policy pathways

Through the course of the first half of 2024, APRA reviewed the feedback and issues raised and assessed the options for policy reform. APRA considered three broad policy paths: 

• Maintain status quo, with no immediate changes, while continuing to monitor international developments. This path, however, does not address the current challenges that could limit the effectiveness of the capital framework during crises.
   
• Redesign AT1 in Australia to make instruments more effective as a going concern tool, with enhancements including higher trigger levels, a new discretionary trigger, and restrictions on the investor base. Feedback from industry was clear, however, that this would be complex and costly to implement effectively, particularly if it required increased offshore issuance.1
   
• Simplify the framework by replacing AT1 with other existing, more reliable forms of capital (Tier 2 and Common Equity Tier 1 (CET1)). This would, however, be a significant structural change and would require careful consideration and transition.

In APRA’s view, AT1 has not been shown to act effectively in a going concern scenario and does not offer advantages to Tier 2 in resolution; in fact, it has the potential to create additional complexities through the investor base. While APRA has explored options to improve AT1 to address these concerns, these are likely to be more complex and costly to implement than the simpler third path. APRA is therefore seeking feedback on the third path.

For insurers, APRA is not proposing any changes to capital instruments at this time. APRA’s concerns for AT1 are less acute for insurers, and simplifying the capital framework involves different trade-offs, given the different nature of how stress may impact the insurance industry. APRA will monitor developments in the AT1 market for insurers and may review the approach to insurance capital instruments in due course.

A more effective capital framework

The aim of APRA’s proposed changes is to ensure that regulatory capital more effectively does what it is intended to do: absorb losses while the bank is a going concern and support resolution. This Discussion Paper sets out the design of a simpler capital framework in line with this aim, evaluates its benefits and trade-offs, and discusses the steps needed for transition. 

The proposed approach is summarised in the graphic on the following page. At a high level: 

• Large, internationally active banks would be able to replace 1.5 per cent AT1 with 1.25 per cent Tier 2 and 0.25 per cent CET1 capital.2
• Smaller banks would be able to fully replace AT1 with Tier 2, with a removal of Tier 1 requirements and no proposed changes to Total Capital requirements. 

Key benefits from implementing this approach include:

• Improving capital effectiveness in crises, with fewer uncertainties and complexities in its operation that could undermine confidence, and hinder recovery or resolution.
• Reducing compliance costs for banks, by simplifying the framework and replacing an instrument in AT1 that is subject to additional burden relating to design, marketing and issuing.
• Further enhancing proportionality, with a simpler approach and lower capital requirements for smaller, domestic banks relative to larger banks.

For depositors, the proposal reinforces confidence in the safety of their deposits, with a simpler and more certain approach to resolving banks in the unlikely event of failure. For existing investors, APRA does not envision an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates.

Next steps

This Discussion Paper outlines a conceptual policy framework. APRA seeks to confirm whether these proposals appropriately address the challenges in using AT1 in a balanced and proportionate way. APRA will consider and assess any adjustments to the proposed approach that may be required, before drafting specific changes to requirements and finalising future implementation plans. To ensure this decision considers feedback from industry and other key stakeholders, APRA requests submissions on the framework design, expected impacts, and other implementation considerations relevant to the proposed approach.

Written submissions should be provided to APRA by 8 November 2024. APRA intends to hold roundtable discussions with industry associations on this Discussion Paper and is open to meeting with key stakeholders thereon. Following subsequent discussions with the CFR, APRA plans to provide an update on the consultation process in late 2024 and formally consult on specific changes to prudential standards in 2025.

An accessible version of the infographic is available here.

Chapter 1 – Overview 

This chapter recaps APRA’s reforms to enhance crisis preparedness, the challenges with AT1 in Australia, and discusses the path forward to address these challenges. APRA’s response to submissions to the 2023 Discussion Paper is provided in Appendix A.

Strengthening crisis preparedness in Australia

APRA is responsible for protecting the interests of beneficiaries (depositors, policy holders and superannuation fund members) and promoting financial system stability in Australia. In line with this mandate, APRA sets prudential requirements to improve the financial safety of regulated entities, and, in the unlikely event of entity failure, protect beneficiaries and limit risks to the broader financial system. The disorderly failure of banks, as previous crises have shown, can cause significant disruptions to the broader financial system. It is critical that regulators have a comprehensive set of tools to limit the negative consequences that can arise from bank failure. 

APRA and the Australian Government have taken steps over the past decade to be better prepared to respond to a crisis in Australia. These include:

• enhancing crisis management powers available to APRA to manage a bank failure;3
• developing a prudential standard for resolution planning, to ensure large and complex entities are pre-positioned in a way that will protect beneficiaries and the financial system, should they fail;4 and
• increasing loss-absorbing capacity for certain banks, to facilitate orderly resolution and minimise the potential need for taxpayer support.5

These reforms to reduce the impact of failure are in addition to APRA reducing the likelihood of a crisis; by requiring banks to hold additional levels of capital, which strengthens their financial resilience.6

While these reforms have improved the toolkit available to limit the adverse effects of bank failure and help reduce the execution risks in resolution, last year’s international banking turmoil demonstrated the importance of regulatory capital performing as designed and when needed. In 2023, APRA released a Discussion Paper on the operation of AT1 capital instruments in Australia that sought feedback on options to improve their effectiveness in stress and resolution.

Figure 1. Crisis policy reforms

Role of AT1

APRA’s current framework defines three forms of regulatory capital. AT1 is a form of regulatory capital that sits between CET1 capital and Tier 2 capital. AT1 was implemented in Australia in 2013 as part of reforms to the international banking regulatory framework in response to the Global Financial Crisis. The objective of these reforms was to improve the quality and quantity of capital to increase banks’ financial resilience in periods of stress and to support orderly resolution.

Implementation of the reforms differed internationally, leading to a variety of AT1 capital instruments available in the global market today. AT1 issued by Australian banks are generally permanent, hybrid forms of capital with discretionary coupons.

Table 1. Forms of regulatory capital

AT1 has two fundamental roles in APRA’s prudential framework:

1. stabilising a bank so that it can continue to operate as a going concern during a period of stress; and
    
2. supporting resolution with the capital that is needed to prevent a disorderly failure. 

While AT1 has been designed specifically to perform these roles, the strength and resilience of Australia’s banks means AT1 has never been tested domestically. In 2023, APRA raised concerns over whether AT1 would function as intended in Australia when needed, after reviewing how AT1 has performed internationally, its design features, and the unique characteristics of Australia’s AT1 market.

Challenges facing AT1

While AT1 has never been used in Australia to stabilise a bank, international experience has shown that AT1 has not been effective in absorbing losses in stress and can complicate resolution. APRA’s 2023 Discussion Paper highlighted certain design features and market practices that would create significant challenges to, or potentially compromise, the effectiveness of AT1 in Australia. 

Reflecting on the lessons learnt from the international banking turmoil of 2023, the Basel Committee on Banking Supervision noted that ‘there may be merit in further assessing the complexity, transparency and understanding of AT1.7

Challenges in using AT1 to absorb losses in stress

Rather than acting to stabilise a bank as a going concern in stress, international experience has shown that AT1 absorbs losses only at a very late stage of a bank failure. This was evidenced in the case of Credit Suisse in 2023, with the Swiss National Bank noting that ‘the AT1 features designed for early loss absorption in a going concern were not effective’.8 In this instance, AT1 only absorbed losses when the point of non-viability was imminent and failed to stabilise the entity earlier in stress. If AT1 was used in Australia APRA considers it would not fulfil its role in stabilising the bank before non-viability was reached. 

While AT1 has been designed to absorb losses prior to resolution, this has been challenging in practice:

• Discretionary distributions – distributions on AT1 are discretionary, meaning that banks under financial stress can cancel distributions to conserve capital. In theory, this would allow a bank to continue lending during tighter economic conditions. However, in practice, the market signalling effects from cancelling distributions are considered more detrimental than the minor benefit of additional financial support. This was observed internationally where Credit Suisse did not cancel distributions despite reporting losses over several consecutive quarters.
   
• Loss absorption trigger – APRA requires banks to include a loss absorption trigger in their AT1 capital instruments that requires banks to either convert them to shares or write them down when their CET1 ratios fall below 5.125 per cent. However, international experience has shown that banks have failed with CET1 ratios much higher than 5.125 per cent, making it unlikely the loss absorption trigger would be used in practice. With Australian major banks running CET1 ratios of higher than 11 per cent, they would have to deplete more than half of their CET1 capital base before reaching the trigger. While the loss absorption trigger could be increased, this could undermine recovery plan actions and the useability of capital buffers.

Challenges in using AT1 to support resolution

The impact of bank failure can go beyond disrupting creditors and depositors, to having significant implications on broader financial stability. Bank failure can occur quickly and can often be complex. Having frameworks and tools in place that can be rapidly and effectively deployed is essential to limiting adverse outcomes. There are also benefits in taking actions to reduce complexity in resolution before stresses emerge.

Removing AT1 can help reduce complexity of bank resolution and increase certainty of the treatment of bank stakeholders during stress and in resolution. Replacing AT1 with other forms of regulatory capital would mean there is no longer a form of capital that may or may not absorb losses while the bank remains a going concern. This change would provide greater certainty of how investors would be treated when a bank is under stress or in resolution, reducing the potential for unexpected outcomes and resulting contagion effects.

The below table summarises the key prudential challenges AT1 faces with supporting resolution. 

Table 2. Prudential challenges in using AT1 to support resolution

Challenge	Key considerations
Challenges in absorbing losses	The complexity of AT1 instruments can also lead to complications and likely resistance by investors to absorb losses.  This was observed during the banking crisis in Spain in 2008-2014, where litigation proceedings by retail investors led to the Government guaranteeing the instruments and taxpayers instead absorbing losses.9
Contagion risk	AT1 instruments are complex and there is a risk that investors do not understand their loss absorbing nature.10 Converting AT1 would impose losses on investors who may not be prepared to absorb those losses, potentially leading to contagion in the broader financial system, further undermining confidence in a crisis.  This is heightened in Australia where retail investors, who are less equipped to absorb losses compared to wholesale investors, participate in the AT1 market.
Complicating decision-making	The 2023 banking turmoil illustrated the speed required for regulators and governments to make decisions to contain a crisis.11 Any decision-making process to convert AT1 is hampered where there is uncertainty around investor reactions, contagion risks, and broader systemic impacts.  Additionally, instead of moving forward with an orderly resolution of an entity using its Tier 2, authorities must first require a bank to convert its AT1. This could potentially slow the recapitalisation process.

Australia is an outlier internationally with a material proportion of AT1 held by domestic retail investors.12 This could make it more challenging to use AT1 to facilitate the recapitalisation of a bank in resolution, as APRA is concerned that imposing losses on these investors would bring complexity, contagion risk, and undermine confidence in the system in a crisis.

Addressing these challenges

Stakeholders generally agreed with the challenges outlined in APRA’s 2023 Discussion Paper. However, views on the best policy options to address these challenges were mixed. Many stakeholders were supportive of limited changes to AT1 instruments, suggesting APRA should only increase the loss absorption trigger to no more than 7 per cent and amend the eligibility of AT1 to remove advised retail from primary offerings to ensure a prudent investor base at issuance. However, it is unlikely that these changes alone would improve the loss absorbency of AT1 in stress or simplify the resolution process.

There were concerns with APRA proposing more material changes to the design of AT1 instruments. Increasing the trigger level beyond 7 per cent could undermine recovery plan actions and the useability of capital buffers. A higher trigger, if exercised, may operate as a negative signal to the market at the very time when regulators are aiming to restore confidence. Restrictions on retail investment through minimum denominations, as implemented in other jurisdictions, could limit domestic investment, and require banks to issue AT1 offshore at a higher cost, particularly given Australian tax settings.13

Based on this feedback, APRA is concerned that material improvements to AT1 would be complex and costly for industry to implement. Moreover, without raising the trigger significantly or basing it on more subjective forward-looking measures, it would be difficult for AT1 to stabilise a bank in stress and restore confidence. This means that AT1 as currently designed is likely to fulfill a role in Australia more akin to gone concern capital. Changes to the eligibility of AT1 based on restrictions on the investor base are also likely to be complex to implement effectively in practice, and in some scenarios could materially increase the cost of issuance for banks. 

After assessing stakeholder feedback and exploring policy options to improve AT1, APRA is not confident that regulatory requirements can be adjusted to address the challenges facing AT1 – to ensure AT1 absorbs losses in a going concern and operates as intended in resolution. APRA is therefore seeking feedback on another option to address issues with AT1 – simplifying the capital framework by replacing AT1 with other forms of existing regulatory capital. 

Chapter 2 of this Discussion Paper details proposed changes to the capital framework for Australian banks. Given AT1 is not meeting its regulatory purpose by only operating as gone concern capital, APRA considers it reasonable to replace AT1 largely with Tier 2 capital, a simpler and cheaper form of gone concern capital. Chapter 3 of this Discussion Paper explores the benefits and trade-offs of the proposal, including analysis on the ability for banks to issue more Tier 2 and the cost implications. APRA expects the cost of this proposal would be significantly lower than that arising from implementing more material changes to the design of AT1 instruments.

Chapter 2 – A more effective capital framework

The feedback to APRA’s 2023 Discussion Paper highlighted the difficulty in enhancing the design of AT1 while limiting costs and complexity. APRA is therefore exploring a simpler approach to address the challenges with AT1 in Australia.

This chapter outlines proposed amendments to the capital framework in Australia, for consultation with industry. It sets out the proposed capital requirements, and discusses other considerations such as transition arrangements and consequential amendments.

Design of the framework

The framework design balances three key principles, which are outlined in the below table.

Table 3. Key design principles

Design principles	How the principles have informed the proposed framework
Maintain capital neutrality	There is no increase or decrease in the overall level of capital requirements (minimum prudential capital requirements and capital buffers). The mix of CET1 and Tier 2 that is used to replace AT1 is estimated to be broadly capital neutral in maintaining the strength of the capital framework.
International equivalence	The framework continues to maintain international equivalence, and meets the Basel minimum standards for internationally active banks (including with an equivalent Tier 1 Capital minimum of 6.0 per cent).14
Capital instruments operate as intended	APRA’s capital framework should operate as intended in crisis, meaning that capital instruments should fulfil their intended purpose. A simpler framework ensures that only capital instruments that APRA is confident would operate, as designed when needed, are included in the framework.

Advanced banks

There are currently six banks in Australia that have received APRA approval to use the Internal Ratings-based Approach to credit risk capital requirements (Advanced banks).15 Guided by the design principles outlined above, the proposed approach would:

• replace the existing 1.5 per cent AT1 with 0.25 per cent CET1 and 1.25 per cent Tier 2;
   
• increase the minimum CET1 requirement from 4.5 per cent to 6.0 per cent, but offset this increase by removing the Advanced portion of the capital conservation buffer of 1.25 per cent. The reason for this change is to maintain a minimum Tier 1 capital ratio of 6.0 per cent and a minimum 2.5 per cent CCB in line with the Basel minimum standards; and
   
• retain the total capital requirement plus CET1 buffer level of 13.75 per cent by increasing the minimum Total Capital ratio to 9.25 per cent as a result of the additional Tier 2.

Standardised banks

The design for banks using the Standardised Approach to credit risk capital requirements (Standardised banks) would mirror the Advanced changes, with further simplification:

• fully replace AT1 with Tier 2 capital; and
• remove the minimum Tier 1 Capital ratio.

 

Table 4. Minimum prudential capital requirements under the proposed approach

Minimum capital requirements	Advanced		Standardised
	Current	Proposed	Current	Proposed
CET1 Capital requirement	4.5%	6.0%	4.5%	4.5%
Tier 1 Capital requirement	6.0%	-	6.0%	-
Total Capital requirement	8.0%	9.25%	8.0%	8.0%
Total Capital requirement + CET1 buffers16	13.75%	13.75%	11.5%	11.5%

Insurers 

APRA’s AT1 reforms have largely focused on bank capital requirements given the prudential challenges with using AT1 are more acute for banks compared to insurers. This is a result of the differences between how financial crises unfold for banks and insurers, and the different implications for recovery and resolution planning. For example, banks are more susceptible to sudden crises and contagion risk compared to insurers. 

Some features of AT1 may remain useful for insurers in resolution. This is because of the different approaches to resolving banks and insurers; while banks often need to be resolved relatively quickly, insurers are generally subject to lengthy run-off periods where an insurer is no longer operating but still has outstanding policies. During run-off, the permanent nature of AT1 may be beneficial for policyholders. This is because the insurer can cancel distributions and not exercise AT1 call options, and instead redirect capital to paying out insurance claims. 

While APRA has considered retaining the alignment between the bank and insurance capital frameworks, there are inherent differences in the costs and benefits of AT1 and Tier 2 between the two industries. APRA is therefore not proposing any immediate changes to AT1 policy settings for insurers. APRA will monitor the extent of any impact to insurers from the changes to the bank prudential framework and may review the approach to capital for insurers in due course, following the finalisation of AT1 policy settings for banks.

Other considerations

In addition to amending bank capital adequacy requirements, APRA must also consider other impacts on the prudential framework and the broader market. To ensure the smooth implementation of the proposed approach, APRA would employ adequate transition periods and implement consequential amendments.

Transitional arrangements

APRA’s intention is for an orderly transition path with changes implemented over time. This would allow an orderly replacement of AT1 with Tier 2 by banks and ensure there were no immediate changes for existing AT1 investors. More information on next steps is provided in Chapter 4. 

To achieve this orderly outcome, APRA would likely apply the following high-level transitional arrangements:

• Changes to the minimum capital requirements and buffers would come into effect from 1 January 2027. This would include the increase to CET1 levels required of Advanced banks.
• From this date, existing AT1 instruments would be eligible to be included as Tier 2, until their first scheduled call date. All existing instruments would reach their first call date by 2032 at the latest.
• To maintain an orderly transition, APRA would not expect to approve regulatory calls of these instruments at an earlier date than the first call.
• APRA would also not expect to see banks increase AT1 from current levels or extend call dates beyond 2032 in advance of APRA confirming changes to prudential requirements.  

APRA would welcome feedback on these arrangements and whether other options should also be considered. 

Consequential amendments

Alongside the above changes to the capital framework which would be implemented in Prudential Standard APS 110 Capital Adequacy, Tier 1 Capital is referenced in other parts of the prudential framework. Requirements such as the leverage ratio, large exposures limits and related entities limits, for example, are set in relation to a bank’s Tier 1 capital position. APRA would consider amending such requirements in line with the principles of maintaining (rather than strengthening or relaxing) current settings and retaining international equivalence. 

The required consequential amendments to AT1 and Tier 1 capital references in other areas of the prudential standards are summarised in the table below.

Table 5. Summary of consequential amendments

Framework	Consequential amendments
Amending Tier 1 measures in the framework	The following three measures would need to replace a base of Tier 1 with CET1 capital. APRA would also consider amending the calibration of these requirements.  The leverage ratio calculation set out in Prudential Standard APS 110 Capital Adequacy is calculated with a reference to Tier 1 Capital (which includes AT1).  Prudential Standard APS 221 Large Exposures limits a bank’s exposure to an individual counterparty or a group of connected counterparties based on the bank’s Tier 1 Capital. Prudential Standard APS 222 Associations with Related Entities limits the exposures of a bank to related entities based on the bank’s Tier 1 Capital.
Removing other references to AT1	Prudential Standard APS 111 Capital Adequacy: Measurement of Capital sets out the eligibility criteria for AT1. This standard would need updating to remove reference to AT1 and Tier 1 Capital, including adjustments for any transitional arrangements. This would be a machinery change and not directly impact prudential requirements. Other prudential standards and guidance that would require updating to remove references include Prudential Standard CPS 001 Defined Terms, Prudential Standard APS 330 Public Disclosure, and Prudential Guidance CPG 110 Internal Capital Adequacy Assessment Process and Supervisory Review.
Tier 2	At this stage, it is difficult to assess whether there will be any consequential shift in the nature of Tier 2 instruments that creates material new challenges. For example, if there was to be a material change to the structure of Tier 2 instruments or a significant increase in retail participation in Tier 2. APRA will monitor future developments in Tier 2 instruments and markets. Additional amendments to Tier 2 may be considered in future depending on the nature and materiality of any risks that may emerge. APRA welcomes feedback on if there are potential amendments that should be considered at this stage.
Reporting framework	APRA would need to amend relevant reporting standards to ensure they align with the revised prudential requirements; removing references to AT1 and reflect other consequential amendments.

Chapter 3 – Expected impacts

This chapter details the key benefits and trade-offs of the proposed changes to bank capital requirements. The more detailed cost analysis includes consideration of the ability for banks to raise additional Tier 2 Capital and compares costs to other options to enhance AT1.

Benefits of the proposed approach

While the proposed approach would task banks with raising additional CET1 and Tier 2 to replace existing AT1 in the short term, the simplification would provide broad benefits over time. The key benefits are summarised in the below table.

Table 6. Benefits of the proposed approach

Benefits	Key considerations
Improving capital effectiveness in crisis	The proposed framework only uses existing forms of capital that will more reliably support recovery and resolution: CET1 and Tier 2. Replacing AT1 removes complexities and uncertainties that could undermine confidence and hinder recovery or resolution in a crisis. This also enables swifter and more effective decision-making by the regulator.
Reducing compliance costs	Replacing AT1 with other forms of existing capital simplifies the regulatory framework and reduces compliance burden on regulated entities.  Banks would no longer face the cost to design, market, and issue complex capital instruments, and can streamline issuance costs by instead relying on Tier 2.
Further enhancing proportionality	The framework has been simplified for domestic banks in Australia. For Standardised banks, the current AT1 requirements are replaced entirely with Tier 2. There is a clear differential between the minimum CET1 requirement for Standardised banks (4.5 per cent) and Advanced banks (6.0 per cent) which maintains the differential in APRA’s ‘unquestionably strong’ capital benchmarks.

Trade-offs of the proposed approach

APRA recognises there are also several key trade-offs to be considered in implementing the proposed approach, as set out below. There are no reform options that do not involve trade-offs, so APRA recognises the importance of working through issues and considerations.

Table 7. Trade-offs of the proposed approach

Trade-offs	Challenge	Key considerations
Reduced flexibility	Replacing AT1 reduces the flexibility to respond to crises.  There is no longer the option of converting AT1 to equity in a going concern.  Raising the minimum CET1 ratio to 6.0 per cent for Advanced banks would result in a smaller capital buffer.	APRA considers that the benefits of reform outweighs the reduced flexibility. International events have shown that AT1 does not act effectively as going concern capital. Implementing material changes to the trigger level would be complex and costly.  APRA does not consider that the removal of the lower tranche of the CET1 buffer would likely impact the point of resolution.17 Buffers may also become more useable, as banks are reluctant to use buffers that trigger restrictions on AT1 distributions.18
Less internationally comparable	Removal of AT1 reduces international comparability of the capital framework for Australian banks. This may impact the market perception of investors regarding Australian banks.	There would be no change to international comparability on CET1, which is a key focus of investors and is unchanged (or slightly increased for Advanced banks). There would, however, be some impact on Tier 2 international investors from the removal of AT1, which may in turn impact pricing (see below).19
Increased funding costs for Advanced banks	While banks would benefit from predominantly replacing AT1 with a cheaper instrument in Tier 2, this is likely to be partially offset by an increase in Tier 2 costs.  Advanced banks will also need to fund an increase in CET1, which is more expensive than AT1.	APRA expects the long-term funding cost impact is likely to lead to a relatively low cost increase for Advanced banks and a neutral to potential cost saving for Standardised banks. This analysis is detailed further below. APRA considers that these impacts are reasonable in the context of the broader benefits of the reform.
Investors will need to seek alternative products	While there is no impact to current investments, investors will lose access to new AT1 going forward, given it is unlikely that banks would issue AT1-like instruments in the absence of Tier 1 capital recognition in the framework. In this case, investors would need to seek alternative investment products.	While AT1 has been an attractive investment to some investors, the core purpose of the instrument is to support prudential regulatory outcomes. On balance, APRA considers the proposed changes, removing the recognition of AT1 in the capital framework, are needed to improve the effectiveness of bank capital in a crisis.  This may result in a material change in asset allocation for some individual investors. However, at an aggregate level, AT1 is only a small proportion of overall assets held by households, reflecting the size of the AT1 market in the broader securities market.

Funding cost impact

APRA expects that the implementation of the proposed framework over the long term is likely to lead to a relatively low cost increase for Advanced banks and a neutral to potential cost saving for Standardised banks. While replacing AT1 with Tier 2 should deliver funding cost benefits to issuers, given that Tier 2 is cheaper to issue, the broader cost of Tier 2 would likely increase without AT1 in the capital structure. This is because banks will need to issue more Tier 2 with some potentially in longer dated format, Tier 2 will have less subordination in the new capital stack, and there may be rating downgrades.

Advanced banks are likely to experience relatively larger impacts over time compared to Standardised banks, given the small additional increase to CET1 requirements and the larger existing stock of Tier 2 to be repriced (particularly for banks meeting additional loss-absorbing capacity requirements). The expected cost impacts of the proposed framework across three potential scenarios are summarised in the table below. The base case is considered the most likely outcome.

Table 8. Expected funding cost impacts across industry ($ million)

Cohort	Lower case	Base case	Higher case
Advanced banks	20	70	260
Standardised banks	-15	-10	0

The proposed approach is unlikely to materially impact the pricing of loans. The cost impact for Advanced banks is expected to equate to a 0.1 basis point increase to the cost per interest-bearing asset, with a 0.3 basis point decrease for Standardised banks.

While implementing the proposed framework could lead to increased costs for some parts of industry, APRA considers that the benefits of the proposed framework as discussed in this Chapter outweigh these costs. APRA welcomes feedback on the potential cost impact of the proposed approach. More detail on the feedback process is provided in Chapter 4.

Tier 2 market capacity

In considering the funding cost impact, APRA has considered whether there is enough market capacity to support an increased volume of Tier 2 capital. APRA’s initial analysis shows there is likely to be sufficient capacity. The below chart depicts the expected volume of Tier 2 funding needed to replace AT1 over the next several years. These volumes seem manageable in the context of banks currently having around $125 billion of Tier 2 outstanding.

Figure 3. Tier 2 additional funding task ($ billions)

Banks could source the Tier 2 funding domestically, including from previous AT1 investors, or offshore. APRA expects the material demand from offshore investors for Australian Tier 2 capital instruments will remain, albeit at higher pricing given the changes to bank capital structures and the potential for increased issuance in longer dated format. The below chart compares Tier 2 issuance in recent years, in both the offshore and domestic markets, showing that there likely remains offshore capacity.

Figure 4. Recent Tier 2 issuance by Australian banks ($ billions)

Chapter 4 – Providing feedback to APRA

Next steps

Depending on the outcome of this Discussion Paper, APRA intends to formally consult on amendments to APRA’s prudential framework in 2025. If APRA decides to implement the proposed approach, it will ensure appropriate transition arrangements are in place to minimise disruption on market participants. Further detail on the expected timeline is provided in the below table.

Table 9. Timeline for reform

Timeline for reform
Discussion Paper	September-November 2024
APRA provides an update on the consultation process	Late 2024
Consultation on specific changes to prudential standards	H1 2025
Effective date for new requirements and start of transition	Expected January 2027

APRA welcomes feedback on these arrangements and whether other options should also be considered.

Request for submissions and cost-benefit analysis information

APRA invites written submissions on the proposals set out in this Discussion Paper. Written submissions should be sent to policydevelopment@apra.gov.au by 8 November 2024 and addressed to:

General Manager
Policy
Policy and Advice Division
Australian Prudential Regulation Authority

To assist interested stakeholders in providing feedback on the proposals outlined in this Discussion Paper, APRA offers the following questions to guide, but not limit, responses:

Table 10. Discussion questions

Questions
Design: How could APRA improve the design of the proposed approach, in line with the core design principles?
Impact: What is the likely impact (benefits and costs) of the proposed approach?
Implementation: Are there other relevant implementation (and transition) considerations for the proposed approach?

Important disclosure notice – publication of submissions

All information in submissions will be made available to the public on the APRA website, unless a respondent expressly requests that all or part of their submission is to remain in confidence. Automatically generated confidentiality statements in emails do not suffice for this purpose. Respondents who would like part of their submission to remain in confidence should provide this information marked as confidential in a separate attachment.

Submissions may be the subject of a request for access made under the Freedom of Information Act 1982 (FOIA). APRA will determine such requests, if any, in accordance with the provisions of the FOIA. Information in the submissions about any APRA-regulated entity that is not in the public domain and that is identified as confidential will be protected by section 56 of the Australian Prudential Regulation Authority Act 1998 and will therefore be exempt from production under the FOIA.

Request for cost-benefit analysis information

APRA asks that all stakeholders use this consultation opportunity to provide information on the compliance impact of the proposals, and any other substantive costs including business costs. Compliance costs are defined as direct costs to businesses of performing activities associated with complying with government regulation. Specifically, information is sought on any changes to compliance costs incurred by businesses as a result of APRA’s proposals.

Consistent with the Government’s approach, APRA will use the methodology behind the Regulatory Burden Measurement Framework to assess compliance costs. It is available at https://oia.pmc.gov.au/resources/guidance-assessing-impacts/regulatory-burden-measurement-framework.

APRA requests that respondents use this methodology to estimate costs to ensure the data supplied to APRA can be aggregated and used in an industry-wide assessment. When submitting cost assessments to APRA, respondents should include any assumptions made and, where relevant, any limitations inherent in their assessment. Feedback should address the additional costs incurred as a result of complying with APRA’s requirements, not activities that institutions would undertake due to foreign regulatory requirements or in their ordinary course of business.

Appendix A – Response to submissions

APRA’s 2023 Discussion Paper sought feedback on three broad policy options to improve the effectiveness of AT1 capital instruments to stabilise a bank during stress and to support resolution. This appendix summarises stakeholder feedback on these three policy options, which are summarised in the table below.

Table 11. Policy options in APRA’s 2023 Discussion Paper

Policy Options
Design of AT1	Improving key design features to ensure AT1 more effectively absorbs losses and can be used earlier to stabilise a bank in stress.
Role of AT1	Reducing reliance on AT1 by changing the level or mix of regulatory capital requirements.
Participation in AT1	Changes to diversify the AT1 investor base away from domestic retail investors.

Feedback summary

In response to APRA’s 2023 Discussion Paper, APRA received 26 formal submissions and undertook around 40 engagements with a range of external parties, including banks, insurers, industry associations, investment banks, rating agencies, law firms, investors, brokers, academics, and peer regulators internationally and domestically. 

While responses varied between respondents, and there was debate on the options raised by APRA, there was broad acknowledgement of the challenges discussed. The table below summarises stakeholder feedback and APRA’s responses.

Table 12. Summary of stakeholder feedback

Options	Comments received	APRA’s response
Design of AT1	There was consensus that the current loss absorption trigger level for converting AT1 is too low and would be reached too late in stress. However, suggestions for increasing the level of this trigger varied. Submissions suggested that one way to improve the loss absorbency of AT1 on a going concern basis was to implement a ‘discretionary trigger’ that APRA could use. This trigger could operate similarly to the PONV trigger, but on a going concern basis. There was also feedback that the capital benefits of AT1 coupon cancellations are not material, and policy changes to make these more efficient would have a limited impact.	Increasing the trigger above 7 per cent would increase complexities and costs for banks that are disproportionate to the benefits, reduce international comparability of instruments, and restrict buffer useability. The introduction of a ‘discretionary’ trigger would also increase complexity and costs, as there would be ambiguity around how it would operate, and investors would likely demand higher returns to take on the additional risk. APRA agrees that cancelling AT1 distributions would likely not produce a material capital benefit and notes the negative market signals.
Role of AT1	There was a strong preference from industry to not replace AT1 with CET1 capital or impose a cap on the amount of eligible AT1.  Some submissions suggested pivoting the role of AT1 from a loss absorption instruments to a recapitalisation tool. Some submissions noted that changes to AT1 requirements could impact each cohort of banks differently.	While replacing AT1 with CET1 would significantly improve the financial safety of regulated entities, APRA recognises the cost implications. Changing the role of AT1 would be challenging to implement in practice, particularly relating to the implementation of a ‘discretionary’ trigger. It would also create a new type of capital instrument unique to Australia.  APRA also recognises that amendments to the level or mix of AT1 have different implications across cohorts.
Participation in AT1	Many industry stakeholders understood the prudential concerns on the retail investor base.  While stakeholders were supportive of restricting retail eligibility based on target market determinations, many raised challenges with minimum denominations. For example, it would make it difficult to meet ASX listing rules. The Design and Distributions Obligations (DDOs) that were introduced in 2021 were seen as having already shifted AT1 away from retail investors.20 Some submissions raised concerns that restricting the ability to purchase AT1 would remove a source of income for some investors, particularly for those in or close to retirement. However, other submissions suggested that retail investors could obtain similar returns to AT1 more efficiently elsewhere.	APRA recognises the difficulties of implementing minimum denominations to restrict retail participation in both the primary and secondary markets. For instance, a $5000 minimum denomination would require a $500 million issuance to meet ASX listing rules, which would be larger than the typical transaction by a Standardised bank. While DDOs may have already decreased AT1 issuance to retail investors, there are no restrictions on secondary market transactions. APRA’s purpose is to protect the safety and resilience of regulated entities and promote financial system stability in Australia. Consistent with this purpose, APRA only considers regulatory instruments from a prudential perspective, to ensure capital instruments perform their role in stress and support orderly resolution.