Agility likely key in tier-two squeeze but big four’s task remains manageable
The Australian Prudential Regulation Authority’s interim target for Australian major banks’ total loss-absorbing capacity is less than 18 months away, and while recent tier-two deal flow suggests liquidity is available pricing has registered a stark widening. Dealers and intermediaries say spreading the issuance net will likely be key to managing higher cost of additional capital.
Intermediaries say liquidity is not in and of itself the issue. They are confident the big-four banks will be able to issue enough to meet their increased additional loss-absorbing capacity (ALAC) requirement, even in a more difficult funding environment.
In fact, recent tier-two deals demonstrate that investors are willing to support additional capital transactions. In late July and early August, National Australia Bank (NAB) and ANZ Banking Group issued domestic deals – both at 10-year non-call five (10NC5) tenor – while Westpac Banking Corporation tapped the US dollar market for an 11NC10 deal, for a total of around A$4.5 billion (US$3.1 billion) equivalent. ANZ also printed a domestic 12NC7 deal on 13 September.
The challenge for Australian banks lies in the cost of this additional capital. Most global regulators introduced a further layer of additional capital their banks can issue to meet loss-absorbency requirements. Falling between tier-two and senior debt in the capital stack, such approaches include holdco-opco issuance from North American banks or the senior nonpreferred format French and Spanish banks use.
By contrast, the Australian Prudential Regulation Authority (APRA) prioritised simplicity in its approach – determining that all ALAC needs must be met using tier-two or instruments with even deeper subordination. This put Australian banks at a marginal but significant cost of funds disadvantage (see box).
However, market users universally agree that the Australian regulator is unlikely to change tack unless there was clear indication that local banks cannot obtain the required level of additional capital.
“Markets are arguably facing the toughest conditions in a generation, but funding has not only still been possible but successful across a wide variety of sources. Liquidity is certainly available, subject to the realities of current pricing and the increased challenges of navigating the volatility that has become embedded into the funding system."
Global alignment of tier-two cost
It is hard to quantify the price global markets charge Australian banks for tier-two relative to what it would be if the same issuers had access to a more senior instrument for loss-absorbing capacity purposes. But intermediaries agree the Australian majors are paying more than banks in other jurisdictions for capital that performs the same purpose.
Ollie Williams, managing director, head of debt capital markets Australia and New Zealand at Citi, says US money centre bank TLAC [total loss-absorbing capacity]-eligible holdco senior debt generally trades at a materially smaller premium to the same issuers’ senior opco-level issuance when compared with the difference between Australian major bank tier-two versus senior bonds. “Tier-two is an expensive form of TLAC financing from a relative global perspective,” Williams confirms.
In theory, Australian major bank tier-two should price somewhere in the middle of where equivalent banks in other jurisdictions price ‘tier-three’ and tier-two, given it performs both roles. Dealers say it is hard to quantify the mispricing, but they are convinced Australian banks’ tier-two is not given sufficient credit for not being subordinated to an additional layer of capital.
“Tier-two is more expensive than what is being used to solve for TLAC in other jurisdictions and the five-year non-call minimum duration aspect is an extra imposition on tier-two borrowers.”
REPRICING IMPACT
The challenge for local banks is that APRA made its decision in June 2019, during an extended period of benign market conditions. The degree of repricing exhibited by recent tier-two deals suggests some of the regulator’s assumptions may have been understated.
Prior to the July-August deals, the last tier-two issuance from a major bank was a A$1.1 billion Commonwealth Bank of Australia (CBA) deal that priced in April at 190 basis points over swap. According to KangaNews data, domestic tier-two pricing since the ALAC determination has got as tight as 132 basis points over swap, also in a CBA deal, last August.
By contrast, NAB paid 280 basis points over swap in its July deal and ANZ tightened that margin by just 10 basis points a week later. The longer-dated ANZ trade in September had a margin of 260 basis points over swap.
Despite the tightening trend, tier-two margins are still more than 50 basis points wider in a period in which pricing data suggest senior margins have increased by not much more than 10 basis points.
APRA’s November 2018 discussion paper, Increasing the loss-absorbing capacity of ADIs to support orderly resolution, estimated the total funding cost impact from increasing the majors’ total capital requirements would be no more than 5 basis points in aggregate, given the relatively small sliver of the total stack the new ALAC buffer will account for. But this was based on spreads at the time, which were roughly 100 basis points tighter than the recent new issuance margins.
APRA also estimated the spread difference between senior and tier-two issuance was 90-140 basis points. Westpac’s US$1 billion tier-two priced at 268 basis points over US Treasuries, equivalent to 308 basis points over BBSW according to a Westpac Institutional Bank research note. The next day its senior printed at 80 basis points over swap benchmarks – a 228 basis point difference albeit also with seven years of additional tenor.
“When markets are tight the best option is not to issue at all – but to do so we need to be ahead of the game. Euros, Australian dollars and US dollars are our core markets but that doesn’t mean we need to tap them constantly. What we don’t want is to end up in a scenario with too much to refinance in a year.”
Liquidity has been hard to find in certain markets during parts of 2022, even at wide margins. “It has certainly become more expensive to meet the TLAC task,” comments Ollie Williams, managing director, head of debt capital markets Australia and New Zealand at Citi. “As of early September, there have been roughly 32 ‘no-go’ zero supply days in the US dollar investment grade primary markets in the year to date. The previous calendar year record was 25 such days, set in 2015 – and 2022 is obviously not over yet.”
Dealers are quick to point out that careful balance-sheet management let the Australian banks ride out the most volatile period with no urgency to come to market. On the other hand, ALAC implementation is not until January 2024 so new issuance was never going to be strictly compulsory unless the market dislocation had continued for many more months.
Duncan Beattie, Sydney-based managing director at Barclays, says it is not surprising that there was such a long period between transactions. “The banks had time between APRA’s announcement and the 2024 and 2026 deadlines, so it is no surprise that they waited to see where markets would stabilise after the period of volatility. They know what their task is, but they don’t have to do anything crazy when markets are panicked.”
Beattie also notes that the banks had generally got well ahead of their issuance run rates by early 2022, which provided additional flexibility to pause. “Issuance doesn’t have to be a straight line toward the two targets,” he says.
When issuance returned, there was no shortage of demand. Nick Chaplin, director and lead portfolio manager at BondAdviser in Sydney, tells KangaNews the ANZ and NAB tier-twos were extremely good value from an investor perspective. Healthy secondary activity and notable tightening following the prints supports this view: both deals were marked at around 250 basis points over swap on dealer rate sheets on 31 August.
The main consideration for bank treasurers is, therefore, likely not the cost of meeting ALAC but finding enough markets and windows to issue the volume they need – and maintain the stack of additional capital on issue.
“Markets are arguably facing the toughest conditions in a generation, but funding has not only still been possible but successful across a wide variety of sources,” says Gerard Perrignon, managing director, debt capital markets at RBC Capital Markets in Sydney. “Liquidity is certainly available, subject to the realities of current pricing and the increased challenges of navigating the volatility that has become embedded into the funding system.”
FUNDING PICTURE
The total requirement for new tier-two issuance remains significant. Dealers estimate the majors have funded A$60 billion between them since APRA’s increased requirement was announced and could have another A$60 billion to do before 2026. Including refinancing, this might mean A$15-20 billion of tier-two issuance a year in total.
With an average A$5 billion a year to issue apiece, dealers speculate that the majors may be unwilling to rely on the US dollar market and will aim for one benchmark trade per year. This leaves a domestic benchmark perhaps every 18 months and A$1-2 billion left to issue.
With the euro market going through one of its periodic periods of uncompetitiveness for Australian dollar funders there is every incentive for the banks to spread the net wider. This could mean issuance in yen or Canadian, Singapore or Hong Kong dollars among others.
In fact, this sort of activity has already started. In late August and early September, KangaNews understands ANZ priced 10NC5 tier-two transactions denominated in yen and Singapore dollars for A$1.25 billion equivalent while Westpac also printed SG$450 (US$320.9 million) in a 10NC5 tier-two trade.
However, Guy Volpicella, managing director and head of structured funding and capital at Westpac in Sydney, says noncore currency issuance should not be considered a like-for-like replacement for the currently uncompetitive euro market.
The key for Westpac is to never be in a situation where it feels forced to issue, Volpicella notes. “Price is a consideration, but there are so many factors at play,” he says. “When markets are tight the best option is not to issue at all – but to do so we need to be ahead of the game. Euros, Australian dollars and US dollars are our core markets but that doesn’t mean we need to tap them constantly. What we don’t want is to end up in a scenario with too much to refinance in a year.”
If markets are conducive, Volpicella tells KangaNews Westpac is comfortable paying a premium for longer tenor if it fits the issuer’s overall tier-two profile – as it did in its recent US dollar deal. It expects to issue roughly A$4-6 billion a year and its strategy is to avoid having refinancing towers of significantly more than that volume in any future year.
“At the same time, if we see a good opportunity in another market – as was in the case of the Singapore dollar trade – we will keep chipping away at our task,” Volpicella adds.
Williams says the US dollar market will remain liquid and actionable for Australian banks, but market volatility is likely to persist as central bank QT continues. Borrowers will unsurprisingly have to be deliberate and nimble with their execution plans even though the recent flurry of issuance is a positive sign, he adds.
Another potential option for supplementing tier-two funding is domestic retail. The major banks typically tap retail investors for their additional tier-one (AT1) issuance but the market could have capacity for tier-two deals as well. Beattie points out that such issuance would not be unprecedented. “Back in 2012, ANZ, Westpac and NAB did retail-targeted tier-two transactions. These priced in line with the domestic institutional market and gave them more capacity in Australia dollars,” he says.
Volpicella suggests retail tier-two is unlikely, however. The three-month gestation period for new issuance means the retail market is not a good fit in volatile environments. “It’s a lot of work and we almost need a crystal ball to know what the market will be like in three months’ time,” he comments. “Even once we have committed, we can be exposed to more execution risk that we feel comfortable with.”