Is the ghost of Bill Shorten's failed attack on franking credits looming again?

After the 2019 Federal Election which resulted in a surprise victory for the Coalition, Bill Shorten, the then losing Labor leader admitted “I misread franking credits”.

The policy on franking credits, which was set to end annual tax refunds of up to $6 billion for retired shareholders not liable for personal income tax, led to polling swings as severe as 15 percent away from Labor in areas where over 60-year-olds constituted more than 15 percent of the population.

The rest is political history.

Once again, not far out from a federal election, we have what seems to have been a seemingly routine announcement from the Prudential Regulator, APRA, around the potential phasing out of Additional Tier 1 (AT1) instruments (aka bank hybrids) from the capital markets.

Bank hybrids generally provide reasonable proportions of franking credits as part of their regular distributions. Consequently, they are particularly attractive to Self-Managed Super Funds (SMSF’s) as the SMSF will receive a tax rebate for the difference between their 15% tax rate and the 30% corporate tax rate paid by the hybrid issuer.

APRA has proposed that it intends (subject to a two-month consultation period) commencing the transition to a ‘simpler capital framework’ from 1 January 2027, with all current AT1 on issue expected to be replaced by 2032 with both subordinated bonds (unfranked) and a small proportion of equity. While on the surface, APRA’s concerns represent its role as prudential regulator, a deeper analysis suggests potential political undertones influenced by past controversies involving franking credits.

APRA previously consulted with the market a year ago after announcing interest in adjusting the structure and/or the amount of AT1 being issued by Australian banks. It was clear that APRA’s main concerns were that following the Credit Suisse failure in Switzerland in March 2023, it seemed AT1 wasn’t being triggered to support failing banks early enough and that Australia’s unique situation of a large proportion of hybrids being owned by retail investors meant the government may act to bail retail out just at the wrong moment when AT1 should be bailing them in.

APRA’s job is to be vigilant in regulating the banks and protecting Australia’s depositors, however, it would seem to be jumping at shadows here. Australia’s banking industry is one of the safest globally. Australia is home to four of the top seven banks in the world with AA-band credit ratings. The ‘big 4’ banks have historically maintained strong credit ratings due to the stability of Australia's banking system, conservative lending practices, and robust regulatory environment. APRA has historically regulated very well.

Further, Australia’s four major banks are mortgage banks, not investment banks unlike most global banks that have seen trouble in the last 15 years, including Credit Suisse. The simpler business model of Australian banks makes them vastly less likely to see a liquidity event.

Having said this, APRA still wants to remove retail investors from holding hybrids, even though they, and ASIC, are happy with anyone holding the lowest ranking equity of the banks. “It’s ok. Everyone understands equity” is the common call.

Removing retail investors from the hybrid market is remarkably simple to achieve. As the regulator, simply require that banks issue their hybrids for trading only ‘over the counter’. I.e. no ASX listing. This would immediately prevent any retail investor due to the minimum investment and trading amount of $500,000 being required in the wholesale market. Problem solved. With retail out of the product, AT1 can continue to provide an important plank of capital support for bank depositors.

If resolving one of the central issues APRA has is so simple, and if removing AT1 results in a materially weakened banking industry – the opposite of APRA’s mandate – then why is APRA wanting to do this?

Could it be that franking credits are the real topic here? If Labor couldn’t progress their aims to restrict franking credit rebates in 2019 because it was front page news, then doing it, at least partially, but surreptitiously via a prudential regulatory proposal may be a quieter, yet more successful solution.

True, it would only achieve removing franking credit use on the bank hybrids, rather than all equities, but hybrids represent a $40 billion+ market with significant franking credit usage. It is estimated that the government would be clawing back at least $800 million annually from this move.

While APRA's mandate is to safeguard the interests of depositors and ensure the stability of the financial system, the proposed changes to AT1 instruments raise questions about the underlying motives - potentially driven by a desire to indirectly manipulate franking credit distributions without direct legislative changes. It is crucial for policymakers, industry stakeholders, and the public to engage in a thorough scrutiny of these proposals to ensure that regulatory actions do not inadvertently harm financial stability or retiree incomes under the guise of simplification.

It would seem these matters require a more transparent discussion around the motives and implications of financial regulatory changes.