No bank dividends for investors in next recession

We don’t think Australian bank shareholders are cognisant of the risk that if equity capital ratios fall modestly, there are new automatic restrictions imposed by the regulator on the distribution of earnings that mean dividends may not be paid.  In fact, it is likely that some banks will stop paying dividends altogether in the next recession as they rebuild capital eroded by loan losses. 

We first publicly canvassed these hazards in August in the context of additional tier one capital (AT1) securities (or “hybrids”).  The chairman of the Australian Prudential Regulation Authority, Wayne Byres, has since dedicated much of an important speech to the matter.

APRA concurrently released a letter it had sent in response to a submission from the banking lobby that sought to convince APRA that the “automatic restriction on AT1 capital distributions is undesirable as it could result in a loss of confidence in [a bank] and adversely impact the demand for its capital instruments, particularly at a time when additional capital may be needed”. Thankfully APRA was staunch: the rules remain.

At his best, the nation’s chief banking boss has traits of Guy Debelle in him: fearlessly frank and authentic even if it means breaking a few noses. (For those who don’t know, Debelle is the Reserve Bank of Australia’s notoriously blunt, guitar-playing deputy governor.)  Byres also has a handy habit of burying his best content in long footnotes that reward the studious – like the time he stealthily disclosed that all the capital the major banks held against their home loans was wiped out in the 2014 stress tests while smaller banks’ capital was sufficient to cover their losses. (We were the first to publicly revealed that gem.)

Byres’ latest speech confirmed our analysis that APRA will garnish 40% of a major bank’s earnings from being used for dividends, AT1 hybrid coupons and/or staff bonuses if their common equity tier one (CET1) capital ratio falls below 8%.  If equity declines to less than 7.125% (6.25%), APRA will restrict 60% (80%) of total earnings. A formal stop on 100% of all payments to equity and hybrids kicks in when the CET1 ratio hits 5.375% of risk-weighted assets.

So the de facto equity and hybrid default thresholds start at 8% CET1 and are absolute at 5.375%, which are both notably above the 5.125% equity conversion trigger hybrid investors have traditionally focused on.  Capital is only likely to be declining in a recession because banks are losing money as they did in 1991 when both ANZ and Westpac reported losses and slashed dividends.

Yet in the next recession if a bank suffers negative earnings and CET1 falls below 8%, prudent investors should assume they are going to get no dividends or AT1 distributions. (In APRA’s recessionary stress tests, CET1 ratios fell by more than 3 percentage points.)  For the avoidance of doubt, there is nothing stopping the bank continuing to making interest payments on deposits, senior debt and subordinated bonds.

But the “going concern” perpetual equity securities that count as Tier 1 capital – ordinary shares and AT1 hybrids – will be appropriately furnishing the bank with the buffer required to rebuild first-loss reserves.

This is why it’s madness to think a defensive fixed-income portfolio can be solely made up of hybrids. Or in APRA’s words, “viewing [hybrids] as simply higher-yielding substitutes for vanilla fixed-interest investments, let alone deposits, is something to be counselled against”. (For the record, we do invest in hybrids.)

One Byres comment we did find fault with was the statement that hybrids “are providing the important first lines of defence that we can call into action [correct!], in some instances even ahead of shareholders [no!], to aid an orderly resolution”.  This refers to the “inability event” clause whereby if APRA cannot convert the hybrid into equity, it can write it off completely ahead of shareholders. In all other instances the hybrid ranks ahead of equity and dilutes its voting rights in a conversion event.

Preserving the integrity of the capital structure hierarchy is a global best-practice regulatory principle and APRA should avoid like the plague any situation where hybrids suffer greater losses than shareholders, even though that is precisely what equity (and management for that matter) might call for to avoid dilution in a crisis.  In another footnote, Byres quipped that not every bank blow up “will necessarily imply a failure of the regulatory regime”.  That’s a direct response to our argument that declaring a “non-viability” event is a tacit admission of prudential supervisory failure and risks blowing up the banking system.

We think APRA agrees that broadcasting that a systematically important bank is non-viable could trigger catastrophic contagion across the system. Byres classifies these as “disorderly failures”, which he says “are to be avoided”.  “The potential for contagion to other financial firms, not to mention the widespread adversity it can impose on the broader community, means the failure or near-failure of a bank is no run of the mill matter,” he says.

And it is technically possible, albeit unlikely, that a bank could go bust in an entirely unpredictable fashion that the regulator could have never realistically anticipated.  Two real tests of APRA’s policy independence will come in the form of the final definition of what an “unquestionably strong” bank is (most expect a new target CET1 ratio of 10%) and the related “total loss absorbing capacity” (TLAC) regime the government has asked it to introduce.

If APRA gets captured by the bank lobby (there is regrettably no counter-balancing “depositor lobby”), it may take the easy option of not lifting CET1 ratios while allowing banks to introduce a new non-preferred senior “or Tier 3” security between senior and subordinated bonds to boost TLAC ratios.  It is hard to fathom how a bank could be unquestionably strong with more than 15 to 16 times leverage.  And it would be very unwise for APRA to further increase the complexity of bank capital structures while permitting senior bondholders to continue to believe they are implicitly government guaranteed.  If APRA follows the Canadian or US lead, it will clearly state in statute that it can impose losses on all creditors bar protected depositors through its asset transfer powers before drawing on taxpayer equity injections.

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