AT1 Investors Are At Risk Of Bail-In When A Bank Comes Under Pressure, Even If Nobody Presses The PONV Button

Credit Suisse is the first example since the global financial crisis of a large systemically important bank going through a "solution," even if not a formal resolution, that bails in AT1 investors as part of measures to protect senior creditors. The ability to impose losses on AT1 investors on a going-concern basis is key to the Basel regulatory approach implemented after the global financial crisis.

Many regulatory and resolution authorities put in place regulatory and legislative processes that give them considerable latitude when it comes to imposing losses on AT1 investors and enable authorities to act quickly during an emerging crisis. Many of these powers require an authority to designate a bank as nonviable, or as approaching the point of nonviability (PONV), which triggers a formal resolution process. Although the Credit Suisse solution is not part of a formal resolution, Credit Suisse is one of many banks that have issued AT1s under contracts that allow for principal conversion or have write-down triggers that could be tripped while a bank is a going concern.

Many of these powers typically relate to situations where an authority specifically designates a bank as nonviable or approaching the PONV and thereby starts a formal resolution process. But the Credit Suisse events are a reminder that the authorities have the capacity to put in place alternative solutions, such as facilitating a merger or acquisition, while still potentially triggering loss absorption for AT1 investors. The effect on AT1 investors will depend on the terms and nature of the instrument, and the legal and regulatory flexibility of the jurisdiction.

The Credit Suisse AT1s Include An Automatic Permanent Write-Down Of Principal To Zero On A "Viability Event"

An automatic and permanent write-down of the AT1 principal to zero was triggered when the regulator for Credit Suisse Group (CSG) determined that a viability event had occurred. The documentation includes two definitions (A or B) of a viability event. Here's definition B:

"Customary measures to improve CSG's capital adequacy being at the time inadequate or unfeasible, CSG has received an irrevocable commitment of extraordinary support from the public sector (beyond customary transactions and arrangements in the ordinary course) that has, or imminently will have, the effect of improving CSG's capital adequacy and without which, in the determination of the regulator, CSG would have become insolvent, bankrupt, unable to pay a material part of its debts as they fall due, or unable to carry on its business."

While market participants may not all agree with the Swiss banking regulator that such an event had taken place, the regulator decided that it had. This led automatically to a viability event notice and, therefore, a write-down event.

Credit Suisse's AT1 instruments all contain language that makes it clear that such an event would mean a complete, permanent write-down to zero, and that no partial or temporary write-downs were possible. By contrast, AT1 instruments at some other banks include partial or temporary write-down features. In addition, although Credit Suisse's instruments did not have any conversion features, some banks do issue AT1 instruments that can be converted into common equity in a stress situation.

Ability To Absorb Losses On A Going-Concern Basis Underpins AT1 Inclusion In Our Capital Measures As Well As Regulatory Capital

Typically, we assign intermediate equity content to AT1 hybrids and therefore, subject to limits, they are eligible for inclusion in total adjusted capital (our measure of bank capital) and thus in our risk-adjusted capital ratio for banks. This reflects how these instruments are typically perpetual and have no step-up coupon features or material restrictions that prevent issuers from halting payment of their noncumulative coupons. While market practice in favorable market conditions is often to call and replace these instruments, banks are not obliged to call them at any point. In theory, a bank could keep its AT1 hybrids on its balance sheet for as long as it needs them.

Banks are typically reluctant to stop paying coupons unless the stress event is more marked; for example no banks chose to stop paying AT1 coupons during the pandemic. Nevertheless, we expect banks will use these instruments to absorb losses while they remain going concerns. For example, they may choose not to pay the coupon, and could decide to write down the principal or make a discounted tender offer that mimics the effect of such a write-down. In addition, banks could convert AT1s into common equity. We also expect that regulatory intervention could influence some of these choices.

Our Rating Approach To AT1 Hybrids Reflects Going-Concern Risks

Our standard notching approach for AT1 hybrids is to deduct four notches from the SACP of the issuing bank. We may widen the notching when we see a higher risk of nonpayment, for any reason, including concerns about regulatory intervention. The regulatory role that these instruments play could lead to increased uncertainty regarding investor payments as stresses emerge. For example, on March 17, 2023, we rated the AT1 hybrids issued by Credit Suisse's nonoperating holding company at 'B' or 'B+', either six or seven notches below the senior bonds of the group's main operating companies. The difference reflected the specific terms of the different AT1s--the mandatory clauses on those rated 'B' kicked in earlier.

We also deduct two notches for subordination risk, when assigning a rating to a bank hybrid issued by a bank that has an SACP of 'bb+' or lower. This indicates that investors in such hybrids are exposed to larger potential losses when balance sheets become more fragile.

Heightened uncertainty may cause us to lower our ratings on some hybrid instruments, even if we have not downgraded the issuer. The business model problems that contributed to the demise of an independent Credit Suisse were specific to that group, but we continue to monitor European banks and their AT1 instruments and would lower our issue credit ratings if we saw an increased risk of investor nonpayment due to financial or business pressures.

Credit Suisse's Tier 2 Instruments Are Being Treated More Favorably By The Authorities Under This Transaction

Although the AT1 instruments are being written down to zero, CS has not announced any impact on Tier 2 hybrids. We note that these instruments are not included in going-concern capital buffer by the regulator, and we don't include them in our measure of capital for the bank.

Other Banks' AT1 Won't Automatically Take A Greater Hit Than Common Equity Shareholders But Are Still Built To Be Bail-Inable

One surprise to some market participants was that Credit Suisse's AT1 holders will be written down to zero even though common shareholders will retain some value--a different outcome than usually expected given typical creditor hierarchies. The CS solution has seen AT1 investors be wiped out even though common equity shareholders have not been. This is an atypical outcome but was possible given the nature of the Swiss documentation terms and regulatory framework. (We also note that many of Credit Suisse's AT1 were "high trigger" instruments that specifically mandated a principal write-down to zero if a particular regulatory capital ratio was breached, even though there would be no automatic impact on shareholders in that situation. That ratio wasn't breached in the circumstances of the Credit Suisse transaction but this feature does show that the concept of greater losses for AT1 investors than shareholders isn't completely alien to the AT1 sector.) We don't expect that this exact pattern will always be the case for future AT1 bail-ins, however. Investors in write-down AT1s are clearly exposed to the risk of a high or complete principal write-down but we expect that most such cases would involve at least the same hit to common equity shareholders.

Both the EU and U.K. authorities made statements about expected hierarchies on March 20:

• The EU authorities reminded investors that they expect common equity instruments to be the first to absorb losses; only after these have been depleted would the EU require AT1 instruments to be written down.
• The Bank of England confirmed that AT1 instruments rank ahead of common equity Tier 1 and behind Tier 2 in the hierarchy, and that holders of such instruments should expect to be exposed to losses in resolution or insolvency, based on their positions in this hierarchy.

The Bank of England used this approach recently, in the resolution of Silicon Valley Bank UK. All of Silicon Valley Bank UK's AT1 and Tier 2 instruments were written down in full and the whole of the firm's equity was transferred for a nominal sum of £1. Although this case used a typical hierarchy, the AT1 investors were still wiped out. We see this as a clear risk in a bank resolution or insolvency. In the EU, the failure of Banco Popular in 2017 had the same outcome: shareholders and capital instrument holders were wiped out, and the bank was sold for a nominal sum.

The dynamics of the Credit Suisse transaction would also have been different if its AT1 instruments had equity-conversion features, instead of write-down features.

Focus On AT1 Tail Risks Could Hamper New Issuance

AT1 investors have been reminded of their extreme vulnerability if a bank gets into trouble, and of their dependency on decisions taken by regulators and governments. We anticipate that they will take time to become comfortable with all the potential ramifications of holding AT1 hybrids in a riskier operating environment. As a result, new issuance could be more expensive and more vulnerable to sentiment.

AT1 markets have previously closed for several months, but the size of the hit to Credit Suisse's investors may lengthen the period of reduced market access. Even though the structure of AT1 instruments shows marked differences across Europe, we predict that investors will demand notably higher coupon rates for new AT1 instruments in future. The extent to which this trend plays out could vary for individual banks, jurisdictions, and instrument structures, as investors work through their revised perceptions of risk.

We therefore expect that the cost of regulatory capital will come under pressure and this may lead to reduced regulatory capital flexibility across the sector. Banks with capital needs may have to reposition toward common equity raising or reduced distribution levels, or else curtail balance sheet expansion. This trend may improve the quality of capital for those banks but may also have implications for balance sheet strategies and lending capacity.