Australia is considering phasing out AT1 bonds. Will Europe do the same?

On 10 September, the Australian financial regulator APRA released a consultation paper proposing the phasing out of Additional Tier 1 (AT1) bonds for Australian banks and their replacement with a mix of Common Equity Tier 1 (CET1) capital and Tier 2 capital. This proposal will add to the ongoing debate on the future of the AT1 asset class, which could have consequences for both banks’ cost of equity and investors.

What’s the issue with AT1 bonds?

AT1 capital instruments are one of three types of capital that banks can hold to support their resilience and safeguard depositor funds. The purpose of AT1 is to act as ‘going concern’ capital – in effect seeking to stabilise a bank by absorbing losses during times of stress or to support an orderly resolution in the event of failure. In such circumstances, a bank could cancel the AT1s’ discretionary coupon payments and/or convert the AT1s to equity – or write them off.

This is not the first time that regulators have discussed redesigning or abolishing AT1s. Following the collapse of Credit Suisse and the series of failures in US regional banks in March 2023, many regulators raised concerns that AT1s do not fulfil the function of ‘going concern’ capital in crises due to the risk that potential contagion could pose to financial stability. This is evident from recent crises where AT1s have only been used to absorb losses at the point of non-viability, rather than as an early crisis intervention tool.

In our opinion, the underlying issue stems from the fact that AT1s are hybrid instruments with several equity features that are held predominantly by fixed income investors who may also hold the banks’ senior debt. This mismatch between the instruments’ features and the investor base, and the fact that the same investor base is key for banks’ access to wholesale funding, means that AT1s behave during times of crisis more as ‘gone concern’ capital rather than ‘going concern’ capital.

What’s the potential impact?

Abolishing the AT1 asset class could have consequences for the cost of equity for both investors and banks.

Without the slice of AT1 capital, which sits between CET1 and T2 subordinated capital, a bank would need more CET1 capital to achieve the same level of balance sheet resilience – at a higher cost. Alternatively, per APRA’s proposal, if a bank were to replace it with Tier 2 capital, this would result in the subordination of this asset class as there is no AT1 layer. This could in turn potentially result in ratings downgrades and a higher supply of Tier 2 bonds – which could widen spreads.

The higher cost of capital would likely subsequently lead to lower profitability and smaller returns to banks’ shareholders, potentially adversely impacting banks’ access to capital and the supply of credit to the economy.

For AT1 investors, we believe the modification or phasing out of AT1s could be positive. Lower-reset AT1s – i.e. those with low back-end spreads relative to where refinancing levels are – could benefit in particular, as it would reduce the call extension risk given the instruments would not count as regulatory capital if left outstanding beyond the grandfathering period. However, over the longer term, it could reduce investors’ diversification[1] across the capital stack.

How could this affect European banks’ AT1 bonds?

Although we agree that AT1 instruments have flaws, in our opinion it is unlikely they will be re-designed or phased out in Europe for the following reasons:

• The European bank AT1 market stands at more than €200bn. If AT1s were to be abolished or modified, European banks would have to replace instruments that took over a decade to issue
• Modifying or phasing out AT1s could result in a higher cost of capital, potentially impairing lending to the real economy
• Unlike Australian banks, where more than half of AT1 instruments are held by small retail investors, European banks’ AT1s are mainly held by institutional investors. We think there is lower risk to financial stability from converting these instruments to equity or writing them off
• Although AT1 instruments have flaws, they generally work.The AT1 market crashed after the Swiss regulator had written off CHF 16.5bn of AT1 instruments as part of its resolvability and merger with UBS [2]. However, since then the AT1 market has recovered, suggesting that AT1 instruments can absorb significant losses and still be attractive to investors – suggesting they understand the potential risks

Our investment position

In our opinion, APRA’s proposal to phase out the AT1 asset class has limited read-across to Europe. However, given the flaws of the AT1 asset class as ‘going concern’ capital, we believe that regulators will continue to debate the idea of re-designing or phasing them out.

Given our expectations for more discussion on the topic, we are long low-reset AT1s as we believe they could benefit from lower call extension risk.

 

[1] It should be noted that diversification is no guarantee against a loss in a declining market.

[2] Source: FINMA, 19 December 2023