(Bloomberg) -- Australia’s banking regulator has proposed lenders scrap the use of AT1 bonds in capital requirements, potentially becoming the first jurisdiction to phase out the securities that were wiped out after Credit Suisse’s collapse last year.

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Replacing additional tier 1 bonds with existing, more reliable securities would simplify and improve the effectiveness of bank capital in a crisis, the Australian Prudential Regulation Authority said in a statement Tuesday.

AT1 bonds were introduced after the global financial crisis to prevent taxpayers from shouldering the burden for a bank’s failure. They are the lowest rung of bank debt, producing healthy returns in good times. But they became controversial after $17 billion of the securities were completely written off when UBS Group AG rescued Credit Suisse in March 2023.

APRA Chair John Lonsdale said AT1 bonds don’t fulfill the function of stabilizing a bank during periods of stress due to their complexity, the potential for legal challenges and the risk of contagion. In Australia, those risks are heightened because an “unusually high proportion” of the notes are held by retail investors, he said.

“The proposed changes seek to support financial system stability at times of crisis with simpler and more certain resolution of banks in the unlikely event of failure,” APRA said. “They are also aimed at reinforcing confidence in the safety of deposits at times of stress.”

Australia’s big four banks have about A$39 billion ($26 billion) in combined AT1 issuance, according to Bloomberg Intelligence.

Under APRA’s proposal, the transition will start from Jan. 1, 2027, with all current AT1 bonds on issue expected to be replaced by 2032. It’s not seeking changes to AT1 settings for insurers. The regulator began examining use of the securities in September last year.

The global market for AT1 securities is worth hundreds of billions of dollars, with banks selling more than $10 billion of such debt this month alone, according to data compiled by Bloomberg.

UBS’s bailout of Credit Suisse, brokered by the Swiss government, helped to shore up confidence in the global financial system at a time when US regional lenders were collapsing. But it also triggered legal action by AT1 bond investors left out of pocket in countries from Switzerland to Japan.

The proposed changes “draw on the lessons of last year’s global banking turmoil where several US and European banks either failed or needed to be resolved in short succession, with a number of governments having to intervene to minimise the risk of contagion and financial system instability,” APRA said.

Australia’s big four banks each hold AT1 bonds equal to at least 1.5% of their risk-weighted assets. Under the proposal, they will be able to replace those bonds with 1.25% tier 2 capital and 0.25% common equity tier 1 capital. Smaller lenders would be able to fully replace AT1 with tier 2 instruments.

Implementation of the framework would likely lead to a “relatively low” increase in funding costs for so-called advanced banks, APRA said in a discussion paper. It estimated an A$70 million impact as a base case.

The proposal comes as contingent convertible bonds stage a recovery from the Credit Suisse-induced slump. Hybrid bonds globally, the vast majority of which are from banks, returned 8.9% so far this year, beating gains on US high-yield corporate notes that made 6.7% in the same period, Bloomberg indexes show.

What Bloomberg Intelligence says:

CBA, NAB, Westpac and ANZ could save nearly A$1 billion in interest on combined AT1 bond issuance of about A$39 billion after the regulator’s decision to allow the current AT1 capital requirement to be shifted into 1.25% Tier 2 and 0.25% equity from January 2027.

— Matt Ingram, BI senior industry analyst

US-currency AT1 bonds of Westpac Banking Corp. and Macquarie Bank Ltd. both climbed by more than 1 cent on the dollar Tuesday in their biggest advances since March of last year, according to data compiled by Bloomberg, as investors snapped up the higher-paying debt securities.

Bank shares rose, with Westpac climbing more than 1% at 2:35 p.m. in Sydney. Commonwealth Bank of Australia and National Australia Bank Ltd. gained in line with the benchmark S&P/ASX 200 index’s 0.4% advance. ANZ Group Holdings Ltd. rose 0.1%.

Australia has previously stood out in its management of bank capital risks. In late 2022, APRA urged financial institutions not to redeem capital securities early if they need to pay higher interest to issue new ones. That came after an obscure South Korean insurer’s decision to skip a call option for a buyback sparked a region-wide selloff in such bonds, and fueled concerns that a wave of financial companies could follow suit.

--With assistance from Peter Vercoe.

(Updates with bond performance from 13th paragraph)

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