Are regulators wrong to think of AT1s as debt?

The regulatory tide appears to be turning against Additional Tier 1 bonds, a form of regulatory bank capital that was thrust into the spotlight following Credit Suisse’s emergency takeover by UBS last year.

Earlier this month, the Australian Prudential Regulation Authority proposed scrapping AT1s altogether, marking the latest in a series of regulatory statements expressing a dislike for the asset class. 

Banks would doubtless welcome a bigger role for AT1s

Sceptics say AT1s are too complex and have failed to help save banks from collapse. The instruments are intended to ‘bail-in’ banks by converting into equity or being written down when capital ratios fall below a certain level. In practice, that’s never happened ahead of a bank failure.

Is the growing sense of distrust fair? Some argue that regulators are muddled in their thinking about the part AT1s can play in bank solvency.

“The role of AT1s has been widely misunderstood,” BNP Paribas head of bank advisory Adrian Docherty wrote in a recent note to clients. He argues that regulators ought to think about AT1s not as debt, but as an alternative form of equity.

As good as stocks

In this view, the perpetual nature and discretionary coupons of AT1s mean the instruments can be thought of as contributing to bank solvency from day one, regardless of whether a bail-in ever occurs.

Docherty says regulators’ unwillingness to think of AT1s this way – and so to treat them as core capital – arose because of the accounting treatment for bonds. Fixed income instruments were not written down during the financial crisis, leading regulators to conclude they do not absorb losses.

Accounting treatment, though, is a false guide when it comes to bank solvency, Docherty contends. “The accounting carrying value of AT1s should be irrelevant to a solvency assessment of a bank. All non-debt liabilities provide solvency,” he states.

This is “definitely not a consensus view”, Docherty tells Risk.net. Only a few people veer from the official line that equity should be the sole qualifying form of core regulatory capital.

But a change of mindset could make a big difference. Banks would doubtless welcome a bigger role for AT1s. Issuing the instruments is far cheaper than raising new equity, a point echoed by others in the market. “If you’re going to expect banks to have higher levels of capital, you have to make it viable for them to issue the stuff,” says Tim Skeet, who has been involved in the issuance of AT1s and heads the International Capital Markets Association’s working group on bail-in.

At the same time, improvements to the AT1 structure are possible, Docherty reckons, which could help further. Discretionary coupons – designed to be cancelled to boost a troubled bank’s capital – have never been pre-emptively halted. Critics of the structures say doing so could panic investors and hasten a bank’s demise, in part by destroying economic value for the bondholders.

Docherty – along with others in the industry – proposes making AT1 coupons cumulative. The payments could be deferred, the suggestion goes, protecting the value of the notes, and arguably shielding a bank from the worst extremes of investor panic during a time of stress.

Which is to say, AT1s would look and behave more like equity. As some see it, so they should.

Editing by Rob Mannix