5 April 2019
Australia’s largest banks will soon be required to issue further regulatory capital. Discussions are currently ongoing with APRA in relation to the precise form of this capital. If Australia adopts the approach seen in a number of European countries then it is possible that a further class of securities (commonly referred to as “Tier 3” capital) will be introduced in Australia. Although such Tier 3 securities should be classified as debt for Australian tax purposes, it is likely that further Regulations will be required in order to ensure this treatment.
From 1 January this year, Australia’s largest banks will be required to issue additional loss absorbing capital to supplement their existing Basel III regulatory capital requirements. This additional buffer of “total loss absorbing capital” (TLAC) is designed to support banks by providing access to additional capital in the event of bank failure. The TLAC standard was released by the Financial Stability Board (FSB) in 2015 and provides for implementation of the additional TLAC buffer by Australia and other FSB members (broadly, G20 countries) over a 4 year transition period commencing in 2019.
European response to TLAC – bail-in-able Tier 3
Many European regulators have introduced TLAC regimes to supplement their existing Basel III requirements for common equity, Additional Tier 1 capital and Tier 2 capital. Under such regimes, the TLAC buffer can be satisfied by additional issuances of existing forms of regulatory capital and also by a new type of TLAC eligible instrument - known variously as “Tier 3”, “junior senior” and “non-preferred senior” instruments. These new instruments rank above Tier 2 in insolvency and below senior unsecured funding. A key feature of TLAC-eligible instruments is that they are “bail-in-able” under local insolvency laws. Broadly, “bail-in” is a process that takes place before a bankruptcy and empowers the regulator to impose losses on holders of TLAC instruments by way of write-down and/or conversion of principal to equity, while leaving untouched other creditors of a similar rank.
Australian response to TLAC – no new Tier 3 (yet)
Australia’s Prudential Regulatory Authority (APRA) released its proposal for implementing TLAC late last year, subject to a consultation process. Under APRA’s current proposal, the 4 major Australian banks will be required to increase their loss absorbing capital by 4-5% of risk weighted assets – which equates to over $75 billion of increased capital. TLAC requirements for other banks will be individually assessed. APRA proposed that the new TLAC requirements should be satisfied by the issuance of existing forms of regulatory capital – essentially Tier 2 capital. Following submissions received from the banks, it appears that APRA’s position may have softened – in a meeting on 19 March 2019, APRA indicated that it was still open to considering other forms of meeting the requirements. As such, although still uncertain there remains the possibility that Australia may allow banks to satisfy these requirements by issuing capital in the form of a new “Tier 3” note or similar instrument.
What would Australian Tier 3 look like?
If APRA ultimately determines that market and other considerations dictate that a Tier 3 instrument be made available to meet Australian TLAC requirements, it will be necessary to determine what changes would be required to Australia’s insolvency laws and APRA’s standards to implement such an instrument. It seems clear that the instrument would need to provide for loss absorption in a manner that is sufficiently analogous to bail-in under TLAC instruments issued in Europe and elsewhere, and this would likely require changes to Australian law. It may therefore be preferable to create a new class of instruments under which senior creditors contractually agree to be bailed-in after the holders of lower ranking regulatory capital instruments.
Characterisation of Tier 3 as debt
If APRA permits Australian banks to issue bail-in-able Tier 3 instruments, then it will be important that the instruments are characterised as debt for Australian tax purposes (under Division 974). In this regard, it will be necessary to consider the implications of bail-in-ability in determining whether the payment obligations under the instruments are treated as “non-contingent obligations” for the purposes of Division 974. In the case of Tier 2 subordinated notes, which include non-viability conditions providing for conversion into equity or write off if APRA determines that a non-viability trigger event has occurred, specific regulations were introduced in order to ensure that such non-viability conditions did not prevent the payment obligations from being “non-contingent obligations”. It is likely that similar specific regulations will be required in order to provide similar comfort with respect to bail-in features of any new TLAC-eligible Tier 3 instruments.
Partner, Head of Financial Services