During the Global Financial Crisis (GFC), bank consolidation was a major action undertaken to ensure global financial stability. In Australia, key transactions included Commonwealth Banks takeover of BankWest and the merger of Bendigo Bank and Adelaide Bank. Since then, market concentration in the Australian banking system has lessened competition among participants (Figure 1). Figure 1. Relative size of Australian banking groups (by total residential assets) Source: 2017/18 Budget Papers This shift has been prominent for the major banks which have grown industry market share in terms of assets, loans and deposits by between 8-11% since 2004. Figure 2. Major Bank shift in Concentration Source: APRA As a result, at the end of 2013 the 4 major banks were classifed as domestic systemically important banks (D-SIBs). Under this designation, the major banks are required to hold greater capital balances against risk-weighted assets than smaller Australian banks. This difference is known as the D-SIB buffer which equates to 1.0% of risk-weighted assets and is incorporated as part of the major banks’ Common Equity Tier 1 (CET1) ratio. On other side of the equation, APRA raised the minimum for residential mortgage risk weights from 16% to 25% last year for internal ratings-based (IRB) banks. IRB banks include the majors and Macquarie and are essentially required to hold more capital against residential mortgage assets. Overall, this highlights the clear divergence in the credit risk profiles of banks (and hence, divergence in the point of non-viability) as the regulatory landscape has evolved. Figure 3. Australian Bank Capital Ratios (as at last reported) Source: Company Reports However, Figure 4 paints a different story where the trading margin between major bank additional tier 1 (AT1) hybrids and non-major bank additional tier 1 (AT1) hybrids has actually converged. A reasonable assumption for this has been the persistently low interest rate environment which has driven up AT1 hybrid valuations (against limited supply) in the search for yield. This is despite clear differences in security risk profiles as well as the probability of a non-viability clause being triggered. Figure 4. Major Bank v Non-Major Average Trading Margin Source: BondAdviser Due to regulatory mechanisms and varying treatments, it is obvious the credit risk of the majors is less than other Tier 2 banks but there are also structural implications at a security level that should also be considered. Many AT1 hybrids from non-major bank issuers (i.e. Suncorp, AMP, Macquarie etc.) are issued at a group level rather than within the operating subsidiaries. This is known as the ‘parent entity’ or the ‘non-operating holding company’ (NOHC) of the operational entities. Under this arrangement, the hybrid investor is generally subordinated to the operating subsidiary’s creditors. These creditors are typically senior unsecured debt holders (wholesale OTC bonds) and effectively establishes further structural subordination beyond the traditional capital structure priority of payments. Additionally, these securities are less liquid than their major bank counterparts which overlays liquidity risk when investing in non-major bank securities (Figure 5). Figure 5. AT1 Hybrid Market Size: Major Banks v Non-Major Banks Source: BondAdviser The listed market is currently pricing these risks at a 0.25% premium for a 5 year AT1 hybrid priced to the first optional call date (Figure 6). In the current interest rate environment, these valuations may appear attractive but it is important to acknowledge broader fixed income market. If we construct a curve comprising senior unsecured debt from the same issuers, a 5 year credit risk premium of 0.18% applies (Figure 6). This equates to difference of only 0.07% despite the exponential nature of risk as investors move down the capital structure, structural risk inherent in non-major bank AT1 hybrid securites (NOHC) and liquidity considerations. Figure 6. Major Bank v Non-Major Bank Credit Curves Source: BondAdviser While the Australian banking system is underpinned by a strong regulatory framework and resilient economy, non-major bank debt securities should trade at a risk premium to their major bank counterparts. While this holds true throughout the capital structure, this premium should also expand as investors move down the capital spectrum due to increased volatility and associated recovery rates. In the listed market, this premium is now at a historical low and technicals (demand outpacing supply) is dictating market direction rather than fundamentals. Although investors may be comfortable with current market valuations, unforeseen events can lead to a long road to recovery (Figure 6). For this reason, investors need to weigh up if the 0.25% pick up in yield is worth it for the clear distinctions in risk profiles described. Figure 6. GFC: Worst Case Scenario Example Source: BondAdviser