With interest margins softening and bad debts likely to rise, at least investors could take comfort in the banks sitting on surplus capital. With an average common equity Tier 1 ratio of 12.1%, all Australian major banks comfortably exceed the regulatory requirement of 10.25%.

The Australian Prudential Regulation Authority does expect banks to maintain a buffer though, hence major banks have set their own targets of 11%-11.5%. This surplus capital position could be under threat if APRA sees fit to shake up the hybrid market.

APRA is seeking feedback on improving the effectiveness of hybrid capital bonds. These bonds are considered additional Tier 1, or AT1, capital and makeup around 10% of total major bank capital. Changes could range from:

  1. Tightening when banks must stop or limit paying distributions, for example, if making losses or breaching certain capital levels;
  2. Lifting the capital level at which point banks must convert AT1 to equity, currently at 5.125%;
  3. No longer allowing hybrids to be offered to domestic retail investors;
  4. Limiting AT1 as a source of capital.

Morningstar equity analyst Nathan Zaia thinks it is likely APRA will change product terms in an attempt to make it clear to investors and banks alike, that in times of financial stress, there is a chance distributions will be missed, and AT1 will be converted to equity, or even written off. In other words, trying to shift the perception that distributions will be paid at all costs.

This likely leads to a modest increase in the cost of new issuance, but it is not material enough to warrant any adjustment to our unchanged earnings forecasts or fair value estimates. Zaia thinks Westpac (ASX: WBC) and ANZ Group (ASX: ANZ) reflect the best value among the wide-moat-rated majors trading at material discounts to his respective $8 and $31 fair value estimates. National Australia Bank (ASX: NAB) is fairly valued against his $30 fair value estimate, while Commonwealth Bank (ASX: CBA) remains an expensive outlier to his $90 fair value estimate.