Efforts to change prudential rules so that mutuals can raise equity have failed largely because the corporate watchdog and the prudential regulator have conflicting goals. Further, the impact of this regulatory standoff has been intensified by a series of changes that have served only to confuse an already complicated issue.
The issue revolves around an Australian Securities and Investment Commission interpretation of the Corporations Act, which stops cooperatives from raising capital. According to Paul Williams, Heritage Bank’s chief financial officer, the real challenge facing the sector is that few truly understand the issues.
In a nutshell, he explained, the corporate watchdog will assess a proposed capital-raising transaction through a methodology defined almost two decades ago. This says if ASIC believes the transaction will materially dilute current member interests, it could be deemed a demutualisation.
"This interpretation protects member interests, but severely limits capital management options across the sector,” he said.
Where it gets hard for mutual banks is that the Australia Prudential Regulatory Authority changed its rules so that all prudential capital instruments are required to absorb losses on a 'going concern' basis – that's when a business has been deemed to be ‘non-viable’.
And, to satisfy this requirement, prudential capital instruments must convert to equity at a point before an entity is being wound up.
Testing APRA's terms
The problem for the mutual sector is that the term ‘non-viable’ is an APRA term and doesn’t mean the business is insolvent. So, while the rules say any prudential capital must convert to equity at a point before an entity is being wound up, no one knows at what point this occurs.
As Williams pointed out, the point of non-viability is a concept that is determined solely by APRA - the only definitions of this concept are the ones included in regulatory capital transactions completed in recent years - all of which needed to be approved by the prudential regulator.
“None of these definitions have been tested yet,” he said. “A member interest is generally defined in a mutual's constitution. But that constitution may be silent on how that mutual manages loss absorbency on a going concern basis, particularly as it relates to non-viability.
“This becomes problematic when a mutual bank wants to issue subordinated debt, which traditionally absorbs losses in a 'gone concern' basis."
For listed entities, APRA's concept of 'non-viability' can be met simply by having any instrument convert to common equity. But for mutuals, Williams went on to say, there is no mechanism or instrument to convert to anything, so APRA invented a new prudential instrument: 'mutual equity interest'.
"The mutual equity interest cannot be issued directly, it only exists at the point of non-viability - so mutuals are back to square one. It is not currently a solution to allow them to issue common equity tier one capital.”
With Federal Treasurer Scott Morrison's appointment of lawyer Greg Hammond to recommend a solution by July 14, the mutual sector is expecting there will be a cross section of mutuals that will raise equity if the rules change.
“The only way to solve the whole problem is to address the concept of mutuality in the Corps Act," Williams said, adding "this not just about mutual banks but also mutual insurers, motoring mutuals, and the like".
The Business Council of Co-operatives and Mutuals - the national peak body for cooperatives across all industries - has been pushing hard for its member to be allowed to raise capital by issuing securities without risking the loss of their mutual status.
To the BCCM, corporate diversity matters and legislative frameworks should not restrict particular types of firm from accessing capital to facilitate growth and development.
KPMG has estimated if the reforms were made, mutuals in the banking sector alone could raise an extra $25 billion in capital, boosting profits by $375 million.
Certainly, Williams looks forward to having more capital management options as part of Heritage's strategy to effect a digital transformation. For the mutual bank, an equity raising would be about investing in infrastructure, processes as well as diversifying the network.
“We’ve focused on some of the things that are easy to fix but there is still plenty more to do and we recognise we must invest wisely to ensure initiatives pay their way," he said.