APRA’s proposed changes to hybrids and the impact on banks

Well, last September APRA released a discussion paper outlining proposed changes to the capital framework for banks. And the changes are designed to simplify the capital structure, enhancing their financial stability. In short, APRA proposes to phase out the use of additional tier one capital instruments or hybrids as they’re commonly referred to. Now, hybrids sit towards the bottom of a bank’s capital structure, one tier above common equity, and they’re designed to have characteristics of both debt and equity, which carry additional risks. And ASIC has long viewed bank hybrids as an inappropriate investment for retail investors. Their primary concern being that most retail investors do not understand the risks. It also follows experiences offshore. The primary example being the collapse of Credit Suisse last year, but also the UK which banned hybrids for retail investors a decade ago in 2014. Now, specifically the major banks’ 81 requirement. Currently one and a half percent would need to be replaced with an extra 0.25% of common equity, tier one capital and 1.25% of tier two capital. Smaller banks are able to fully replace hybrids with tier two capital. Whilst insurance companies are actually not impacted by this proposal, the proposal is expected to commence in January, 2027 with all hybrids expected to be replaced by 2032, and currently it’s in consultation and APRA is expected to provide an update later this year.

Overall, we believe the proposed changes are slightly negative for the banks, but manageable banks currently issue around 40 billion of hybrid securities, which equates to around 2% of risk weighted assets. As a result of utilising franking credits, banks have been able to obtain favourable pricing on hybrids with the implied net distributions, excluding the cost of franking having a positive impact on earnings. Now, the transition from hybrids to tier two instruments is likely to see tier two spreads widen due to additional expected loss absorption and an increased supply of tier two notes. So in terms of earnings, the likely impact will be a minor negative for the big four banks. Now, as for capital an extra 0.25% of CET one equates to around 5 billion of ordinary equity, which reduces on our estimates excess capital from around 10 billion to 5 billion. So the impact to EPS will be around 1% due to for on buybacks.

A substantial portion of hybrid instruments have been absorbed by retail investors who are attracted by the fully frank grossed up yields. Now, assuming the proposed changes proceed, retail investors will need to consider alternatives to hybrids, and these alternatives may include corporate hybrids, subordinated debt, other fixed income products, cash or indeed equities. And obviously each of these have their own risk return considerations for investors. Now, whilst the impact to earnings and capital will be minimal, banks are likely to retain more franking credits as a result of the proposal. Now, in 2023, the rules around using off-market buybacks as a vehicle distribute franking credits were changed and more or less limited this to traditional dividends going forward. Now they’re already emerging signs that companies with excess franking credits are beginning to release them via high payer ratios and special dividends for CBA. CBAs payout ratio has been around 70 to 80% for the past 20 years, and it’s typically landed around the midpoint at 75%.

Now in its FY 23 result presentation CBA flagged a move towards the top end of its payout ratio and it it’s delivered at this level over the course of FY 24. Now, they recently stated that they believe its franking neutral payout ratio is around that level at 80%. So we expect CBA to maintain that level of payout going forward. For Westpac, they have a payout ratio target range of around 65 to 75% and they’ve been paying towards the top of that range recently. Now, at its first half result, Westpac used special dividends to distribute excess capital and franking credits, although they elected not to pay a special dividend at their recent FY 24 result. Citing conservatism given global uncertainty. Now, in our view, unless Westpac can improve its ROE materially, it will be difficult for them to justify an increase in payout ratio from current levels.

For NAB has a payout ratio target range also of 65 to 75%, and they’ve been currently paying within that range. Now it has less franking credits than CBA or Westpac, so less inclined to change its payout ratio. And then finally for ANZ, their payout target range is around 60 to 65%, slightly lower. And one of the reasons it’s lower is that it has less franking capacity than peers. Although the Suncorp acquisition may help justify a high payout ratio into the future capital’s, Australian equities, large cap strategies currently have a mid-teen underweight position in the big four banks despite falling earnings, which has been driven by a number of factors including lower net interest margins, slowing credit growth, robust competition in both mortgages and deposits, cost pressures, and the potential for rising mortgage delinquencies. The sectors trading at all time, high PEs. In fact, Commonwealth Bank, its 12 month forward. PE has just expanded to over 25 times. Its price to book ratio is over three times and its dividend yield is just 3% less than the cash rate. So with no growth and no credit cycle, we remain comfortable with that underweight position and it really represents our non holding in CBA, which is due to valuation and our preferred bank remains NAB.