APRA sets expectations on capital calls for insurers and banks

With global credit spreads widening dramatically over the past 12 months, the prospect of new capital requirements issued at higher credit spreads than equivalent outstanding instruments has become more pronounced. As a result, the Australian Prudential Regulation Authority (APRA) has released a letter to reinforce existing prudential requirements for Additional Tier 1 Capital or Tier 2 Capital instruments.

APRA’s letter outlines its expectations for authorised deposit-taking institutions (ADIs), general insurers, and life insurers seeking the regulator’s approval regarding existing prudential requirements for both tiers of capital instruments.

In its letter, the regulator emphasised that its regulated entities’ capital base must be high quality and have a high degree of permanence.

“To that end, an instrument issued by an ADI or insurer must meet all applicable criteria specified in the relevant prudential standard relating to the measurement of capital,” APRA wrote.

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The criteria mentioned above require Additional Tier 1 Capital to provide a permanent and unrestricted commitment of funds. Meanwhile, for Tier 2 Capital, the capital attributed to each instrument must be amortised in the five years to maturity.

“These criteria are reinforced by the requirement that the issuer must not create an expectation that a call will be exercised,” APRA said.

Additionally, ADIs, general insurers, and life insurers should not call an Additional Tier 1 Capital or Tier 2 Capital instrument and replace it with an instrument with a higher credit spread or that is more expensive to avoid creating expectations that the issuer will exercise a call option on other outstanding Additional Tier 1 Capital and Tier 2 Capital instruments with call options.

On satisfying themselves and APRA as to the economic and prudential rationale of the call, insurers and ADIs should, at minimum, provide analysis that demonstrates:

The cost of issuing the replacement instrument is equal to or less than the cost of keeping the existing instrument outstanding. This analysis should consider various scenarios including, but not necessarily limited to, comparative spread levels and issuance volume. Where relevant, it should also factor in any loss of Tier 2 capital benefit due to amortisation offset by the benefit that the instrument provides as debt funding; and
The credit spread at which the ADI or insurer will consider the cost of the replacement instrument uneconomic.