Point of non-viability?

Additional Tier 1 notes were born in Switzerland, but might they be buried in Australia?

The Australian Prudential Regulatory Authority has proposed doing away with AT1s on the grounds that they don’t do what they are supposed to do and are too complicated.

In theory, a bank on the brink of disaster should be able to save itself by bailing in AT1 bonds to rebuild its capital reserves.

In practice, financial collapses happen far too quickly for AT1 notes to save institutions, especially now that bank runs can be digital. Credit Suisse and Spain’s Banco Popular were gone before their loss-absorbing notes could be triggered.

Opting not to call AT1s or pausing distributions is supposed to maintain a bank’s financial health, but it inevitably leads to a crisis of confidence among investors. Too often, AT1s are like a parachute that only opens after you hit the ground.

On top of that, even after AT1s have been wiped out, issuers can face lengthy court battles from sore investors. Bondholders have clubbed together to sue UBS for their losses on Credit Suisse AT1s, and Indian courts are still deciding whether the writedown of Yes Bank’s instruments in 2020 was lawful. Having to refund bondholders, even partially, would undermine the whole point of the instruments.

No doubt another reason that the Aussie authorities are sceptical about AT1s is that implementing a writedown of notes would be a much trickier proposition in Australia than elsewhere because (unlike in most countries, where AT1s are off limits to retail investors) a large chunk of Aussie AT1s are held by ordinary investors – about 20%–30% of the outstanding paper, at APRA’s last estimate. That means a writedown intended to contain systemic risk could end up spreading the pain where it would be felt the most.

An extra worry might be that, because the Big Four Aussie banks are so similar, in the unlikely event that one bank is looking at an AT1 trigger, they might all be doing so.

So there’s a good chance that Australia will go ahead with its proposal. It has, after all, walked its own path on bank capital before. Instead of requiring banks to raise senior non-preferred bonds for total loss-absorbing capital, for example, it raised the amount of Tier 2 capital they needed to hold.

But what about elsewhere? It’s fair to say that the instruments don’t fit particularly well with the financial architecture in much of the world. In jurisdictions like China, many of the big banks are partially state-owned so it is highly unlikely that their AT1s would ever be written off. In Japan, legislation allows the prime minister to inject state funds into a teetering bank, even before it is at the point of non-viability, if its collapse would cause a systemic shock.

In other words, big banks in both countries are paying up to compensate investors for the risk that their AT1s could convert to equity or be written down – even though there is practically zero chance of either happening. So the authorities in those countries will be watching what the Aussies do carefully.

In Europe there have also been some sceptical voices about AT1s – notably in the Dutch finance ministry and the UK’s Prudential Regulation Authority – and the Basel Committee on Banking Supervision (which created the instruments in the first place) has been gathering feedback on their effectiveness.

And yet, despite those noises and the CS debacle, AT1s in Europe are still popular with investors and issuers. The buyside is swooping on AT1s to lock in high yields while it can, and this month alone more than a dozen European banks have sold AT1s.

More to the point, the upheaval of getting rid of AT1s in Europe would be enormous, especially considering that the market for the securities (€208bn outstanding) is much larger than that in Australia (€22bn-equivalent).

None of that means, though, that there isn’t room for improvement, especially in reducing complexity. It does mean that – at least in Europe – AT1s are set to evolve rather than die.