FSI member Kevin Davis warns of bank hybrid risks

Australian Financial ReviewSep 21 2016 11:45 PM

James Eyers

Retail investors may be underestimating the risks of bank hybrid instruments being converted into equity by the regulator in a crisis, a move that could lead to a run on bank deposits, says one of the members of the financial system inquiry committee, Professor Kevin Davis.

Well over half the buyers of the $30 billion of bank hybrids listed on the ASX since 2011 are retail investors but Professor Davis, the research director at the Australian Centre for Financial Studies, says the securities – which can be converted to equity by the Australian Prudential Regulation Authority – are complex and their fair value is "well-nigh impossible".

"There is something paradoxical in regulatory requirements inducing banks to issue extremely complex and difficult to value securities – particularly when a large part of the target market is retail investors. Their ability to assess the likely future outcomes – uncertainty/risk – and determine a fair return is undoubtedly questionable," Professor Davis writes in a paper to be published by the ACFS on Thursday titled Bail-In Securities: is the game worth the candle?

APRA can put restrictions on hybrid distributions if a bank's common equity tier 1 (CET1) capital falls below 8 per cent and can convert hybrids to equity, or write off their value, if a bank's CET1 falls below 5.125 per cent.

APRA can also convert the instruments to equity if it considers a bank might not be viable without such action. But Professor Davis says "exactly what this means is far from clear, and APRA has given no guidance on what situation would be likely to lead it to make such a declaration".

"The uncertainty involved is that it is not feasible to realistically estimate either the probability of bail-in occurring at some future date nor the consequences of a bail-in on the value of the investor's position."

Converting hybrids to equity is supposed to bolster the equity buffer of a failing bank to protect bondholders and depositors and allow APRA to resolve a bank failure in a more orderly fashion. But Professor Davis said the decision to trigger a hybrid conversion itself would have a de-stablising effect. "The chances that a bail-in will, on its own, facilitate orderly resolution appear very slim," he writes. "Government guarantees will most likely be needed to avert a run."

Professor's Davis' concerns about the instruments, which have become popular as investors search for yield in a low interest rate environment, follow recent comments from APRA chairman Wayne Byres, who reminded investors hybrids serve as a "first line of defence" when the regulator manages a banking crisis.

Hybrids are attractive to banks because they are a cheaper form of regulatory capital than issuing equity, even though the margin above the bank bill swap rate of hybrids has climbed from less than 2 per cent in mid-2014 to about 5 per cent today. Professor Davis expects more hybrids to be issued when the banks have to meet new "total loss absorbency capacity" (TLAC) rules being created by global regulators as part of the package of post-GFC banking regulation.

In the paper, Professor Davis highlights a range of other practical complexities with the instruments including uncertainty about the amount of "bail-in" securities that would be converted and how the shares that are received are valued.

Using similar "product intervention" powers to those proposed by the FSI for the Australian Securities and Investments Commission, the UK's Financial Conduct Authority temporarily banned the issuance of hybrids to retail investors in 2014, before imposing in mid-2015 strict limitations on the marketing and sales of the securities.