04 April 2024
IAM Event at CYCA Sydney
Exploring Bank Capital and Regulatory Implications
Last Thursday, Income Asset Management (IAM) hosted an event at the Cruising Yacht Club in Rushcutters Bay, delving into the evolving landscape of bank capital and its implications for income investors. The focus was on the $43 billion hybrid market, considering pending regulatory changes aimed at reducing retail investor participation in these instruments. The event featured Craig Swanger, IAM’s Chief Investment Officer, Danielle Press, former ASIC Commissioner, and Simon Maidment, former Deputy Treasurer of CBA and Head of Global Funding.
Craig Swanger initiated the discussion by highlighting the scale and significance of the hybrid market. Swanger pointed out that retail investors contribute significantly to this market, which has prompted regulatory scrutiny. The hybrid market is valued at approx. $43 billion, with nearly half of this investment stemming from retail investors.
Regulatory Challenges and Considerations
Danielle Press elaborated on the regulatory concerns, explaining that hybrids, designed as a stress buffer for banks, pose risks when held by retail investors. The challenge arises from hybrids’ potential to convert into equity during a bank’s financial stress, misleading retail investors about their safety. The crux of the issue lies in their sale to retail investors, who may not fully grasp the associated risks. Press outlined the regulatory tension where on the one hand, ASIC criticizes the retail sale of hybrids for their complexity and risk, warns that they are risky and in danger of being mis-sold as safe and deposit-like. APRA on the other hand deems them insufficiently risky from a bank capital perspective. Press outlined APRA’s considerations for reform, including increasing the conversion trigger point and limiting retail access through higher minimum investment thresholds.
Simon Maidment underscored the longstanding nature of the product and the regulatory unease over its risk profile. He explained that while hybrids do have the risks disclosed in prospectuses and offering documents, he asked whether retail investors are reading these documents cover to cover. This means the understanding and acceptance of the risks that come with hybrids remains problematic, especially among retail investors.
Press emphasised the need for investor education, given the intricate nature of these instruments and their potential consequences during market stress. The discussion touched on the regulatory efforts to enhance transparency and ensure that hybrids are sold to investors who understand the risks. As the Credit Suisse example showed, which we’ll touch on more shortly, when investing in individual securities, reading and understanding the documentation can be crucial.
Market Dynamics and Investor Behavior
Maidment speculated on the consequences of removing hybrids from the ASX, suggesting alternative capital raising strategies for banks, such as issuing subordinated debt or seeking funds from institutional and offshore markets. He also discussed the evolving landscape of bank capital requirements, noting an increase in Tier 2 capital as regulators seek to diversify banks’ capital bases.
The event addressed the recent upheaval caused by the Credit Suisse scenario, which turned the spotlight on hybrid securities. As a result of the Swiss government’s bail-out of Credit Suisse, its hybrids were written off. Press discussed the global banking pressures and explained the decision to bail in the hybrid capital and write the value off to zero. The market was already jittery due to the regional banking crisis in the US, and it was unclear how far-reaching the consequences would be. This incident heightened regulatory alertness in Australia concerning the potential risks in the hybrid market.
Maidment touched upon the systemic issues revealed by the Credit Suisse situation, emphasizing the swift financial movements in today’s digital age, which means that cash travels extremely fast when you get a run-on banks and the subsequent elevated risks for banks and their hybrid securities.
An audience member asked what happened to hybrid trading levels in Australia following the Credit Suisse incident, and this sparked a lively discussion, as although there was a great deal of uncertainty in offshore markets in the aftermath of the CS default, in Australia there continued to be a disconnect in comparing the spreads of Tier I hybrids issued by the major banks, and more senior ranking Tier II securities. The Tier II securities rank one notch higher and yet for most of last year, the credit margin difference was very small, and the pick-up generated from the hybrid did not seem sufficient compensation for slipping down the capital structure.
A question from the audience asked about the potential unintended consequences of regulatory changes and pointed out the irony of possibly pushing retail investors towards riskier assets. Will a crackdown on hybrids mean that investors seeking yield will look elsewhere to riskier asset classes such as stocks? In response, Press pointed out that when investors are buying equities, they know they are purchasing equities. However, when investors are buying hybrids, they may feel as though they are buying fixed income – when in reality, it may be converted to equity (or in the case of Credit Suisse, written off).
For Australian investors, hybrids have long been a favoured option for investors seeking higher income. The panel provided an overview of this market, highlighted some of the risks that investors may not be aware of, and discussed other parts of the bank’s capital stack such as Tier 2 debt that investors can get exposure to. Thanks to all who attended this event and to the CYCA for hosting us!
