Would the ECB say goodbye to AT1s?

On Thursday, the European Central Bank (ECB) published a report setting out a number of proposals for simplifying the regulatory framework for banks. The range of proposals is very broad but crucially includes suggestions around the suitability of Additional Tier 1 instruments (AT1s) as going-concern loss-absorbing capital. There are no specific requirements or recommendations being made at this stage, which in itself is adding a degree of confusion to the release, so for the moment we must regard this as little more than an ECB Christmas wish list, but it is worth diving into the detail a little further.

First, we would point out that earlier this year, the ECB created a High-Level Task Force on Simplification to develop recommendations for simplifying the European prudential regulatory, supervisory, and reporting framework for banks. This task force was motivated by a letter sent in February from the central bank governors of Germany, France, Italy and Spain to the European Commission. The letter called for “identifying areas where the European framework is unduly complex and may create competitive distortions at international level, without any significant financial stability benefits, [which] could also contribute to a level playing field with other major jurisdictions.”

The important message here is that the authorities are focused on simplifying unduly complex rules but keeping a level playing field with other jurisdictions. The objective of the task force was not to dilute the requirements faced by banks, merely make them simpler. We do believe that a simplification of certain rules – many of which are identified in the ECB report – would represent a net benefit to the banking sector without compromising the stability of the system.

Second, we note that the range of proposals is very broad. As an example, one of the recommendations includes “the finalisation of the savings and investment union, including completion of banking union, to reduce national fragmentation and allow for more efficient capital markets”, which would include a European deposit insurance scheme (EDIS) and the fragmented insolvency regimes across the region. For background, these initiatives are far from new. European authorities have struggled for a while in their attempts to close EDIS and complete the banking union. We are sceptical as to whether the work of this task force will be sufficient to sway the political pendulum in favour of a mutual deposit guarantee framework. Never say never, but for us the fact this recommendation is on the list may indicate that not all these proposals are that actionable (even if the ECB thinks they would be positive).

Third, in terms of the AT1 proposals, the ECB noted that “the going-concern loss-absorbing capacity of the capital stack could be improved by adjusting the design or the role of AT1 instruments”. The paper also added that “the features of AT1 instruments could be enhanced to further ensure their loss-absorption capacity in going concern and provide additional clarity to banks and investors on the going-concern loss-absorption properties of AT1 instruments. Alternatively, non-CET1 instruments could be completely removed from the going-concern capital stack.”

In short, at this stage we see the removal of AT1s (or junior subordinated debt) from bank capital stacks as improbable. As we argued when the Australian regulator made a similar proposal last year, the heterogeneity of the European banking sector means that junior subordinated debt often serves as a useful instrument in helping the leverage ratio metric, and is important in maintaining the sector’s competitiveness against US peers. In addition, it’s important to consider that this whole process was born in response to a request to address potential distortions at international level that result in an unlevel playfield. This request came from the Europeans. The US regulator has an easing bias at the moment when it comes to capital requirements. If the European regulator eliminates AT1s, assuming they would not want to reduce overall capital requirements, this would mean Common Equity Tier 1 (CET1) requirements would have to increase. It would be a bizarre outcome for a letter seeking a level playfield to result in Europe increasing its banks’ CET1 requirements at a time when the US is likely going the other way.

In terms of specific changes to the instrument, we believe that changes to documentation would add very little. There is always a possibility of lifting equity conversion triggers from 5.125% to a higher level – say to match the 7% requirements in Switzerland and the UK – but in our view it is highly debatable whether this adds anything to the going-concern capacity of these bonds. While we do not have any information that makes us think the following is under discussion, the regulator could plausibly introduce a more prescriptive profit/loss test that would lead to coupon suspension, for example consecutive years of losses at a bank leading to automatic AT1 coupon suspension until profitability is restored.

However, regulators should perhaps be careful what they wish for when it comes to the possibility of diluting the terms any further. AT1s have already acted as a canary in the coal mine when banking problems arose in the past, given they are the most junior debt in the structure. Making them more subordinated than they currently are could make the asset class more volatile at times of stress, leading to contagion higher up in the capital structure. This would have a counterproductive effect when considering the overall objective of financial stability.

To back up our perception that this report is essentially an ECB wish list, at time of writing its release has had zero impact on AT1 prices. Inevitably, the authorities will be looking to simplify the regulatory and capital framework for banks, which would be a net positive to the sector in our view. The elimination of AT1s from capital stacks cannot be ruled out (change is the only constant when it comes to capital requirements) but we would stress that we consider it a low probability event. Should it happen, we would expect existing bonds to be gradually phased out, much like in Australia, with the instruments changing their perpetual nature to effective bullets, causing little disruption to attentive AT1 investors.