Why AT1s must be phased out | USAEMALL.com

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The writer is a former banker and author of ‘Traders, Guns & Money’, ‘Extreme Money’ and ‘Banquet of Consequences’

In the wake of the financial crisis, new capital instruments were introduced to buffer the shock when banks ran into trouble. The inelegantly named Additional Tier 1 notes have since mushroomed into a major global market of around $270bn in size.

But now they should be phased out, just as Australian regulators have announced they plan to do. Despite their appeal to investors seeking higher yields than traditional bonds, the collapse of Credit Suisse bank has shown they do not work well in countering distress or rescuing a non-viable bank.

AT1s are intended as regulatory capital — ie the amount of capital that banks must set aside to cover future losses. Ongoing payments on the instruments to investors are contingent on capital ratios remaining above a certain level. If the ratios fall below that level, the structure mandatorily converts into the bank’s shares or is written off to absorb losses (also known as the bail-in).

Such hybrid instruments have lower costs than equity sometimes due to tax treatment, helping mollify banks unhappy about raised capital levels. They also avoid equity dilution as issues do not typically carry voting rights until conversion.

But there are several problems with them. One is that the conversion to equity or writedown depends on the issue terms, which often grant regulators significant discretion. That creates legal uncertainty as ongoing litigation over the treatment of Credit Suisse’s AT1s has demonstrated.

More important, bail-ins risk setting off a death spiral. They can reinforce any market fears over the issuer’s financial problems, resulting in higher funding costs, a rush by depositors to withdraw funds, and cancellation of interbank credit lines. The share price of the issuer might also fall due to additional dilution from conversion of AT1s and worries over the rising possibility of default. In addition, some investors might sell shares to hedge against declines in the value of existing positions. Other investors might sell equity to depress the market price and thereby capture more shares on conversion of AT1s, possibly starting an adverse feedback loop.

As evident in previous crises, contagion effects can rapidly affect the entire banking industry irrespective of individual institutions’ actual condition.

For investors, hybrids constitute an investment that is deeply subordinated to other forms of capital, and brings uncertain income and significant liquidity risk. Outcomes during times of stress are variable. Credit Suisse AT1 holders may have recovered some value if the issue converted into shares instead of being written down.

Pricing may not compensate for the risks. Valuation requires subjective inputs and models combining three interrelated elements: the debt, the risk of default or conversion and the effects on share price of a trigger event. Most investors cannot assess and price these securities accurately, relying instead on their faith in the issuer, and a belief that current capital levels make the likelihood of write-offs or distressed conversion remote. They place unjustified reliance on the market price, which is simply a margin over bank subordinated debt or based on existing comparable issues.

AT1 securities pose important public policy issues. Cheap hybrids may magnify the bank’s incentive to increase the riskiness of its activities. Given significant retail investment in these securities, any bail-in is also political. As the Swiss authorities have discovered, ensuring equity between different types of investors is tricky and there is a risk of protracted legal challenges.

Regulators are rethinking the use of AT1s. In October, the Bank of England said it planned to raise the threshold above which banks need to raise such debt — although it is also planning to require a contractual trigger in loss-absorbing debt for operationally viable UK banks when the foreign parent of a British bank is put into resolution.

In contrast, in December 2024, the Australian Prudential Regulation Authority came to the conclusion it was best to phase out the use of AT1 capital instruments to simplify and improve the effectiveness of bank capital in a crisis. Feedback during consultation mostly accepted that AT1s did not stabilise a distressed bank or prevent a disorderly failure. The only concern was the loss of a popular investment product. It would be wise of other bank regulators to follow Australia’s lead.