AT1s caught in the crossfire but junior bank debt is here to stay

Over the course of last week, we saw several headlines around Additional Tier 1s (AT1s). First, the Dutch Finance Ministry indicated it is exploring the possibility of modifying or abolishing the asset class. And then, on Thursday, the Swiss National Bank in its annual report, said it had identified the need for action with respect to modifying AT1s. 

These latest developments follow the discussion paper by the Australian Prudential Authority, published in October 2023, where the authorities said they wanted to review the design of AT1 instruments to ensure they are fit for purpose. These are just some of the more recent examples of discussions taking place around AT1s.
 
To provide some context into these developments, let’s start by refreshing ourselves of the function of AT1s. Namely that, given banks generally benefit from low margin assets to deliver an adequate return on equity, they require a more leveraged balance sheet than non-bank corporations. Regulators are aware of this structural situation and have for a long time allowed banks to hold some form of hybrid debt supplementing its core capital (Common Equity Tier 1/CET1). 

This hybrid debt would have risk absorption features and count towards prudential capital ratios that represent one of the health check indicators for financial institutions. Due to the fact that issuing AT1s (and Tier 2 debt) is cheaper than issuing equity, the layer of hybrid capital in essence enables banks to deliver adequate return on equity, whilst retaining required solvency levels. Therefore, AT1s not only represent a critical element of banks’ liability instruments, but also play a key role in making lending available in the economy by making it more profitable for banks.
 
Over the years, regulatory/hybrid capital has significantly evolved, with arguably the biggest changes brought via the updated Basel regulations in the wake of the global financial crisis. This was the point when the AT1 asset class was created, and legacy junior subordinated instruments issued pre-2013 gradually started being phased out. Since the first modern AT1 issuance by BBVA in May 2013, the legacy junior subordinated space has been largely extinguished, providing significant returns in the process. AT1s have filled that void and now the issued amount stands at about €200bn.
 
At this point we should emphasise that the AT1 asset class has replaced legacy junior debt primarily out of the need to create going-concern hybrid debt. This form of capital – unlike Tier 2 – was meant to take losses during a stress situation of a financial institution, whilst allowing it to stay operational. AT1s were meant to achieve that through regulatory loss mechanism triggers, whereas the bonds would take losses when core capital fell below a pre-defined level. That level was initially set at around 5%. Even then, since the onset of the first AT1 issuance we have seen the UK and Swiss regulators modifying the requirements for minimum trigger requirements to a higher level (7%) – with low trigger securities being gradually phased out. 

We have also witnessed multiple discussions around the need to replace the low trigger AT1s in Europe in line with the UK/Swiss model, so that they can more credibly provide going-concern capital. These so far have not come to fruition. The asset class did, however, see changes in feature requirements for capital instruments brought through the Banking Recovery and Resolution Directive, which resulted in a subset of AT1s being disqualified from capital post their first call date – these yielded attractive returns to investors as call risk was, for all practical purposes, removed from the equation. 

The point here is that change is the only constant when it comes to features of bank regulatory capital, so investors should not be surprised that these discussions are taking place.
 
In any case, as things stand, we believe that there is little incentive for market participants to alter the current status-quo and commence sweeping reforms to AT1s. Issuers have spent vast resources to phase out legacy junior debt and issue new AT1s – there is limited need for net supply from here. Regulators are likely mindful of already attractive risk-absorption characteristics of AT1s and may be sceptical about whether a new market can be developed should the terms of these bonds be weakened any further, e.g. by increasing CET1 triggers even beyond 7%. 

Investors have also gradually warmed up to the product, notwithstanding the developments around Credit Suisse last year, and there are some signs that the asset class is gradually maturing, with the recovery of valuations in the last year able to speak to that.
 
Having said all that, the existence of AT1s in the current format is not a purpose in and of itself. The priority for the regulator is to ensure system stability and for the banking sector to provide an effective lending channel to the economy, whilst delivering adequate return to shareholders in the process. If there is credible evidence that AT1s do not serve the desired purpose or its characteristics can be changed to better achieve the stability objective, we would not rule out a reform to the asset class.
 
Ultimately, we believe that junior bank debt will always have place in European banks’ balance sheets, but it may not always be through the current format of AT1s. We do not see the changes to be imminent, but if they were to come in effect, we would expect a generous grandfathering period and gradual replacement of the existing AT1s with new junior sub-debt, leading to attractive returns for the existing stock of bank debt. This has been the mechanism through which such changes have been enacted in the past. 

Meanwhile, we take comfort in the ever-increasing solvency of the European banking sector and consolidation of balance sheets, which has further benefited from the tailwind of higher rates. As we have highlighted multiple times in the past, we view this improvement in fundamentals, as the main attraction behind investment in junior bank debt instruments now and see this as the key determinant of banking system stability. We do not believe that reinventing AT1s through a slightly different form of junior subordinated debt is ever going to materially enhance what may already be a weak business model, nor will it significantly weaken a robust one.