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Law firms back use of hybrids in bank capital

Monday 29th July 2019

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Law firm Buddle Findlay says the Reserve Bank “must revisit” its decision not to allow hybrid securities to count as tier 1 capital when calculating the balance sheet strength of the country’s banks.

The securities – which are usually treated as debt but can be converted to equity – are recognised by international banking authorities and feature in the plans of Australia’s banking regulator to increase the capital required of that country’s banks.

Buddle Findlay says there is no reason for the Reserve Bank to take a different approach to other international regulators. It believes hybrids should also be available to meet tier 2 capital requirements. Deputy governor Geoff Bascand has repeatedly said RBNZ is open to getting rid of tier 2 requirements.

“Implicit in the decision to disqualify certain internationally accepted alternative tier 1 instruments is a lack of confidence in New Zealand’s conduct and prudential regulators and the regimes they administer. This is unwarranted,” the firm says in a submission on the central bank's proposals.

The RBNZ wants to almost double the minimum tier 1 capital that banks must hold from 8.5 percent to 16 percent over five years as part of a plan to ensure they can withstand the worst of financial shocks likely over a 200-year period. 

It estimates the big four banks would have to raise $20 billion of fresh equity and suggested they do that by retaining 70 percent of their net earnings over that five-year phase-in, reducing the dividends they would pay their Australian parents.

And it wants that tier 1 capital only to comprise more costly common equity – estimated by some to be about five times the cost of hybrids.

In contrast, the Australian Prudential Regulation Authority is allowing that country’s biggest banks, which own New Zealand’s major banks, to increase their capital exclusively through the use of hybrids.

The Reserve Bank is concerned that, in the event of a failure, the government would come under pressure to bail out investors who lose money on such instruments.

Law firm Russell McVeagh has advised on all of the convertible instruments issued by New Zealand banks since the introduction of the Basel lll global banking standards in 2009.

It believes the RBNZ’s concerns are “not well founded.”

“The government has repeatedly said that it would not bail out a bank that was failing,” the firm noted.

The disclosure requirements of the Financial Markets Conduct Act ensure that offer documents for hybrid securities include prominent warning statements, and the law firm says there is no reason to think the contractual terms or write-off provisions of such instruments would not be enforced.

“There is no compelling reason why they would not operate as intended.”

More than $3 billion of NZX-listed hybrid securities have matured and investors repaid since the RBNZ surprised the market in March 2017 when it questioned whether Kiwibank’s hybrids, which RBNZ had approved several years earlier, qualified as capital. 

Kiwibank’s owners, New Zealand Post, the New Zealand Superannuation Fund and ACC, then tipped in another $247 million of equity to replace the questioned hybrids, only to have the Reserve Bank reverse its stance and say the Kiwibank hybrids did qualify as capital.

No bank has since issued new hybrids in New Zealand, which are attractive to retail investors because they pay higher interest than is available on senior bonds or bank term deposits.

In 2017, former acting RBNZ governor Grant Spencer said the pricing of hybrids suggested retail investors did not really understand their additional risk.

He suspected retail investors thought of them as a high-return debt product when they could be considered low-return equity. Investor protection usually falls under the Financial Markets Authority’s remit, not RBNZ’s.

NZX would like the RBNZ to allow hybrids for banks’ tier 1 and tier 2 capital requirements. 

“Last year, there were 27 retail debt issues – including issuances by three new debt issuers – raising $6.3 billion across a range of industry sectors,” its submission says.

“This highlights the suitability of the NZX debt market to support all forms of funding.”

Stockbroker Forsyth Barr, which has a large retail client base, says it has been an active participant in the tier 1 and tier 2 hybrids market.

It appears to have given up on  tier 1 hybrids as a lost cause; its submission concentrates on tier 2 hybrids.

Forsyth Barr stresses the “negligible cost” to the wider economy of tier 2 instruments and  contests the RBNZ’s view that tier 2 capital can’t support the ongoing operation of a bank that gets into trouble and is only useful after a bank collapses.

“The assertion above ignores the comfort that senior lenders – depositors – receive from lower ranking capital on an ongoing basis,” Forsyth Barr says.

It says tier 2 hybrids are typically priced at about 100 basis points above senior funding and that the appetite for them “has been unequivocally demonstrated” by demand for past issues.

Forsyth Barr also points to APRA’s views on bank capital.

Earlier this month, APRA modified its bank capital proposal, now requiring total capital to increase by three percentage points of risk-weighted assets by January 2024, via tier 2 instruments.

Previously, APRA had been targeting a four or five percentage point increase in bank capital, significantly less than the more expensive 7.5 percentage-point increase the RBNZ is proposing.

APRA said the modified amount of new capital required “will be easier for the market to absorb and reduce the risk of unintended market consequences.” It estimates Australia’s major banks will need to sell about $50 billion of tier 2 securities to meet its requirements.

Law firm Chapman Tripp suggests the RBNZ’s opposition to hybrids is driven by a desire for simplicity, when it should be focused on optimal capital composition.

Alternative capital instruments “can also contribute to soundness by creating another group of stakeholders with a vested interest in a bank’s stability,” it says.

“We are concerned that the Reserve Bank’s approach may be driven, at least in part, by constraints on its supervisory resources.”


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